Every month you save 20% of your paycheck and decide to deposit your hard earned savings into your local bank account.
While you enjoy the satisfaction of having a secure amount of savings, the back of your head is constantly nudging you to notice the extremely low rate of interest your bank offers.
And then comes your lightbulb moment - what if I invested in a TFSA?
The TFSA (along with the RRSP) is one of the main tax-sheltered accounts available to Canadians. The TFSA is tax efficient, but you must be careful about withdrawing from them to avoid unintended tax consequences.
Fortunately, we've got you covered. This article will teach you the right way to withdraw from a TFSA.
What is TFSA?
TFSA’s were introduced by the Canadian government in 2009 to encourage people to save more money. TFSA is a post-tax savings account, where all your contributions are after you have paid any applicable taxes. Therefore, you will not pay any taxes on the money you withdraw.
Eligibility & Contributions
If you are a Canadian resident and over 18 years old, you are eligible to open a TFSA, deposit money and hopefully watch your money grow. In 2009, when the Canadian government introduced TFSA, the contribution limit was set to C$5,000. In 2020, this contribution limit has been increased to C$6,000 per year while the lifetime limit is set to C$69,500.
If you believe you missed the train, let me point out the biggest advantage of TFSA contributions – if you didn’t make contributions in any of the previous years, this amount will only be rolled over the next year, thereby increasing your overall contribution limit.
For example, let us say you missed contributing in 2019 and 2020. In the year 2021, your total allowable contribution is C$6,000 + (contribution from 2019 & 2020) = C$18,000.Instead, if you had contributed C$3,000 in 2020 but none in 2019, your allowable contribution limit for 2021 would be C$15,000.
Important Note: Any contributions made to TFSA beyond the maximum allowable limit will be considered an over-contribution by the Canadian Revenue Agency (CRA). This excess amount will incur a 1% penalty per month until it is withdrawn.
Therefore, if you deposited C$6,500 in 2020 with no contribution room from previous years, the CRA will charge a 1% penalty on the excess C$500 i.e. C$5 per month penalty.
TFSA vs RRSP
While a Registered Retirement Savings Plan (RRSP) is specifically designed for retirement savings, TFSA can be used to save for anything, short-term or long-term with fewer limitations compared to RRSP. They differ in two major ways:
- RRSP deposits are deducted from your taxable income. TFSA deposits on the other hand are not tax-deductible.
- Withdrawals from RRSP are taxed as income. TFSA withdrawals are not taxed.
TFSA Withdrawal Rules
The biggest advantage TFSA offers in terms of withdrawals is it is devoid of penalties and withdrawal taxes. This flexibility allows you to continue saving more money while always having easy access to your money in case of any unexpected events in life. In addition, taking money from your TFSA allows you to keep your RRSP savings intact.
Another advantage of withdrawing from your TFSA is that any amount you withdraw today, will be added to the amount you can contribute the following year. Therefore, if you withdrew C$4,000 in 2020 for an unexpected home repair expense, your contribution limit for 2021 increases to C$10,000.
Let me highlight the amazing rules for TFSA withdrawals:
- TFSA withdrawals are tax-free
- TFSA withdrawals are devoid of any penalties
- Withdrawals have no limits. You can withdraw any amount you like
- Withdrawals in any year are rolled over the following year, increasing your contribution room for the next year
- Once you take the cash out in a given year, you cannot put it in again if it pushes you over the contribution limit
Let me elaborate on the final point a little more with an example. In 2020, your annual contribution limit is C$6,000. You deposited C$5,000 in March and withdrew C$8,000 in June from your TFSA. In August, your company offered you a bonus of C$2,000 and you decided to deposit the entire amount into TFSA. This, however, will result in you exceeding your allowable contribution limit of C$6,000 by an extra C$1,000, thereby incurring a 1% penalty by CRA on the excess amount!
A few points need to be remembered about your contribution room. It is comprised of the following:
- Your contribution room is the annual TFSA limit (C$6,000 in 2020)
- Any unused TFSA contributions from the previous year
- Any withdrawals made in the previous year
Be sure to check with your financial institution before you find yourself paying any penalties for excess contributions.
Strategy for Increased Growth with TFSA
Although TFSA is great for short-term savings, the general rule of thumb is to let your savings work for you. This is possible when you let your savings grow over a long duration and avoid unwanted withdrawals. The prudent approach to financial freedom is to adopt a long-term view and avoid the temptations from instant gratification.
Whether you save cash, invest in mutual funds or stocks, let these investments stay untouched and turn into high-income earning investments. Allow the power of compounding to do the magic for you.The more you save, the bigger will be your tax benefits.
Here are a few simple tips for contributions and withdrawals towards TFSA for increased growth:
- Max out on your contribution limits each year
- Do not miss out on any unused TFSA contributions from previous years
- Deposit high yield investments to TFSA
- Withdraw only when necessary
- Work hard to make sure your withdrawals are deposited back the following year
- Realize that your capital gains are not taxed and make compounding your best friend
Note: If you hold any foreign stocks in your TFSA, you may be subject to foreign non-resident withholding tax. Consult an advisor to completely understand the withholding tax rates for any foreign stocks you hold as it may also affect your contribution room.
Open your TFSA today and start planning for your bright financial future today.
