Plenty of Canadian investors take advantage of the benefits of a Tax-Free Savings Account, but some manage to do so a little bit better than most of the others.
Since 2009, Canadian residents aged 18 and older have been able to earn tax-free income on a fixed annual amount through Tax-Free Savings Accounts, better known as TFSAs. Unlike most other investments, there’s no tax at all when you earn any kind of income on your Tax-Free Savings Accounts, nor is there any tax when you withdraw your funds. With TFSAs, you get to keep it all.
The more efficiently you use TFSAs, the better you’ll be able to take advantage of that rare opportunity to earn tax-free income on a slice of your investments.
Maximize your contributions…
For the past few years, the maximum annual contribution to a TFSA has been $6,000, and the same applies in 2023. Various yearly maximums ranging from $5,000 to $10,000 have applied in different years since Tax-Free Savings Accounts were introduced in 2009.
If you’ve ever missed reaching the maximum contribution in any year since 2009, you can still use any or all of that remaining contribution space whenever you want, which is great if you start earning more money and want to catch up on unused space.
If you happen to withdraw money from your TFSA in a certain year, you can repay any or all of that amount, too, but only in the year immediately following the withdrawal.
…but be careful not to overcontribute
The one thing you never want to do is exceed your TFSA contribution space, because you’ll be charged a one per cent monthly tax on the excess amount as long as it’s in there. Stay on top of any withdrawal amounts and remember to carry them forward to the following year. Check your online tax profile to track past annual contribution amounts and keep tabs on unused space, but remember that online records may not always be completely up to date.
Put that money to work
A TFSA isn’t just a place to stash some cash and leave it there to earn a small amount of interest. The best approach, presuming you’re willing to tolerate a bit of risk, is to invest the money in a mix of equities (stocks and bonds), mutual funds, and other financial products, because they’ll usually generate a superior rate of return than the basic cash rate. With a more robust investment strategy, your money earns more money. Plus, because it’s tax-free, you get to keep everything you earn.
Automate for increased efficiency
A good way to ensure you don’t forget to make TFSA contributions is to set up automatic monthly transfers into your tax-free account. Besides making sure you get the most from your annual contribution space, this approach is also helpful because it spreads your investment purchases out over the longer term, which is better than making a lump sum contribution at a time when market prices happen to be higher than normal.
Be in it for the long haul
Some people view their TFSA as a way to help reach short-term financial goals, and they’re flexible enough to make that a reality in certain situations. However, what’s most important with TFSAs is maximizing the long-term benefits of tax-free earning power, and doing that means building as big of an investment as you can, not taking money out to pay for a week at the beach. Emergency use is a different story, and a TFSA can certainly be part of your financial safety net in case of accident, illness, job loss, or something similar.
If you do take money out, remember that you can (and should) repay that amount the following calendar year. Paying back withdrawals is important, because it maximizes your income-generating power by giving you the biggest possible balance from which to earn tax-free income.