The Tax Free Savings Account (TFSA) is a tax-sheltered account created in 2008 to help Canadians save for retirement and achieve other financial goals. For my American readers, a TFSA is similar to the Roth IRA.
In this article, I'm going to review everything Canadians need to know about RRSPs
What is a TFSA?
The TFSA is an investment account available to Canadians over the age of 18. The account draws its name from the fact that any capital gains, interest, and dividends accrued inside the account are exempt from tax.
The TFSA is a perfect complement to the RRSP.
Contributions to an RRSP are deductible against your taxable income but withdrawals are added to your taxable income.
Contributions to a TFSA are not deductible against your taxable income but withdrawals are not added to your taxable income.
With a TFSA, you pay tax on your contributions, then you can invest your money on a tax-free basis and eventually withdraw your investment gains on a tax-free basis. This is summarized in the chart below.
How much can I contribute to a TFSA?
Each year every Canadian over the age of 18 receives the same increase in contribution room for their TFSAs regardless of income. In 2020, every Canadian can contribute an additional $6,000 into their TFSA.
You can also carry forward the previous unused contribution room from past years. The maximum contribution for someone who has never contributed to a TFSA would be $69,500 in 2020.
The best part about TFSA contributions is that if you withdraw from your TFSA you can get that contribution back in the next year. So, if you withdraw $10,000 from your TFSA this year you can contribute $16,000 next year.
Total TFSA contribution room= Unused room + new room + withdrawals from last year
What investments can I hold inside a TFSA?
You can hold all manner of investments inside your TFSA including.
Cash
stocks
bonds
options
GICs
Mutual fund
Index funds & ETFs
Why holding individual stocks inside a TFSA is particularly risky
If you've followed my work for a while, you know I am not a fan of investing in individual stocks. After reviewing the research, it seems clear to me that the rational investing strategy is to invest in low-cost index funds.
Even investors who generally agree that index funds are the way to go often give in to the lure of investing in individual stocks inside their TFSA. Their reasoning is that if they get lucky and increase their investment 10X, they can take those huge profits tax-free.
That does sound appealing, but here is the likely reality of picking individual stocks. The following stats come from a 2018 paper by Hendrik Bessembinder from Arizona State University entitled “Do Stocks Outperform Treasury Bills?”. Here is a summary of the paper.
Bessembinder studied the lifetime performance of individual stocks in the U.S dating back to 1926.
60% of all stocks that he studied had a lifetime return less than a 30-day U.S Treasury Bill (T-Bills).
That means that you would have had better returns if you had invested in T-Bills (which are risk-free) than if you had invested in the majority of U.S stocks since 1926.
4% of U.S stocks accounted for 100% of the gains in the U.S stock market since 1926.
Bessembinder concluded that “The results help to explain why poorly-diversified active strategies most often underperform market averages.”
The results of this research make it clear that picking stocks is a losing game. By picking individual stocks you have a higher probability of underperforming a risk-free asset than you do of beating the market.
Picking and losing on individual stocks inside your TFSA is particularly painful for two reasons.
You can't get that contribution room back. You can get more contribution room each year, but if you use $6,000 of TFSA contribution to buy a stock and that stock goes bust, you've lost that $6,000 that could have been invested in more reliable assets.
If you lost money on the stock (which is not unlikely) inside a TFSA you can't write off the capital loss against your income.
The second point is particularly important to keep in mind. If you invest in a taxable investment account and you are forced to sell that investment at a loss, you are able to write that capital loss off against your current taxable income or future capital gains.
Given the "tax-free" nature of a TFSA, that also means you don't get to write off capital losses.
I don't advocate investing in individual stocks or other speculative assets, but if you must do so it makes more sense to do it in a taxable account rather than your TFSA.
Be aware of how your investments are structured in your TFSA
If you plan on investing in ETFs that hold U.S & international stocks inside your TFSA be aware of how that fund is structured. It will impact the level of withholding tax you need to pay.
There are two levels of withholding taxes that could potentially apply to dividends received from foreign companies.
Level 1 (L1) withholding tax: These are withholding taxes levied by a foreign government when a Canadian investor receives dividends from a company in that country.
Level 2 (L2) withholding tax: This is an additional withholding tax (typically 15%) applied by the U.S government. Level 2 withholding tax applies to dividends paid to a Canadian investor by a Canadian-listed ETF that owns a US-listed ETF. You still have to pay level 1 withholding tax in addition to this 15% withholding tax to the U.S government.
Obviously, the name of the game should be to avoid level 2 withholding tax.
This infographic summarizes how different ETFs attract level 1 or level 2 withholding tax depending on what type of account you hold them in.
For a full breakdown of the withholding taxes that Canadian investors may have to pay, read this article.
How to open a TFSA in Questrade
As I've written in the past, I believe Questrade is the best platform for Canadian DIY investors and is where I manage my own investments, including my TFSA.
To open a TFSA in Questrade click "Open an account" on the top right of the home screen.
Then select Tax Free Savings Account (TFSA).
From there you will be asked a series of questions to open your account. If you have any difficulty or are confused, you can always use the "Chat" feature at the bottom of the screen to chat with an agent who can help you.
Are you using your TFSA? If, so are you using it for short term goals or retirement savings? Let me know in the comments.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.