If you've ever wanted to know more about TFSA's, you've come to the right place.
Suppose you were 18 and you had $5,500 to spare. Imagine that you opened an account and invested it and that by the time you were 65 you had almost $500,000 in it. If you left it there until you were 73, it could be more like a $1 million. Does that sound too good to be true? What if you had that $5,500 every year until you retired and put it in there? Can you imagine what this might grow to? Maybe $5.4 million. These numbers assume the Canadian government leaves the TSFA intact over your lifetime and that your TSFA earns an average of 9.8% each year (the average annualized total return of the S&P 500 over the past 90 years). The numbers show the power of compounding and the benefits of a Tax-Free Savings account.
First, let’s explore what compounding is. Compounding means you are earning money on your money earned. For example you begin with $5,500 in year one. It earns $539. The second year you earn another $539 on the original $5,500 plus another $53 on the $539. If you deposit another $5,500 at the beginning of the second year you earn $539 on it so that by the end of the second year, you have already accumulated $12,670. This assumes you are not taxed and you do not pull any money out. In only 2 years, your $11,000 has grown by $1,670, or by 15%. This is pretty great, don’t you think? This is what a TFSA can do for you.
The government wants to help you out
The Tax-Free Savings Account (TFSA) program began in 2009 as a way for individuals to create their own retirement fund in a tax advantaged way. With more people employed in situations where a retirement fund was not sponsored, the government decided this was a good idea.
Anyone over 18 with a social insurance number can open a TFSA. While contributions to a TFSA are not deductible for tax purposes, neither is any income earned on the money invested in a TFSA taxable. This means that withdrawals from the account are not taxed and when you withdraw money, you can put that amount back in the following year.
There are annual limits to the amount you can contribute, to date they are as follows:
What happens when you die?
The holder of a TFSA account can designate a successor holder or beneficiary. The advantage of designating either a successor holder or beneficiary is that the assets in the TFSA can flow directly to the designated successor or beneficiary without going through the estate. This means potential savings on probate fees.
From an income tax perspective, when the holder of a TFSA dies, the fair market value of the TFSA immediately before death is considered to be received tax-free by the holder of the TFSA. The decision to designate either a successor holder or beneficiary on a TFSA doesn’t affect the tax treatment upon death, but can have an impact on taxation beyond the date of death.
A Successor Holder can only be your surviving "spouse". If you designate your spouse as the successor holder, and assuming your spouse takes over the TFSA, the account continues operating as a TFSA, with a new owner.
If you designate your spouse as a Beneficiary of your TFSA, your spouse has until Dec. 31 of the year following the year of death to contribute any payments received out of your TFSA, up to the date of death value, into his or her own TFSA without affecting your spouse’s own unused TFSA contribution room. To do this, your spouse must file CRA Form RC240 within 30 days after the contribution is made.
The disadvantage is that all income earned on the TFSA assets, as well as any increase in the fair market value of the TFSA’s assets after death, from the date of death until the date the TFSA is paid out to the spouse beneficiary (or Dec. 31 of the year following death, if earlier) will be taxed as ordinary income to the Beneficiary. This includes amounts that otherwise may be tax-preferred Canadian dividends or capital gains. That’s why it may be best to name your spouse as successor holder instead of as Beneficiary.
If you designate someone other than your spouse as the TFSA beneficiary, or you don’t designate anyone at all and the TFSA proceeds have to be paid to your estate, any income earned on the TFSA assets after the date of death will, in most cases, be taxable to the beneficiary or the estate as ordinary income. A beneficiary who is not your spouse can only contribute proceeds from your TFSA to his or her own TFSA if the beneficiary has sufficient TFSA contribution room.
What experts say
Many experts see TSFA’s as a great source of funds for unusual expenses such as an emergency fund. Holding interest-earning investments is often suggested as the right thing to do because interest income is fully taxable. However, in times when interest rates are so low, this benefit erodes.
Others think you should perhaps hold equities in there that stand to grow a significant amount. Thus, even though equities currently have a tax preferred treatment, a huge capital gain could be realized and never taxed.
What about US equities? You are better not holding U.S.-listed equities inside a TFSA, however, because dividends are not eligible for a credit for the withholding U.S. tax (as they are when held in a non-registered, taxable account. If you must put these in your TFSA, invest in TSX-listed ETFs or mutual funds that hold foreign securities.
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