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3 May

A Tax-Free Savings Account, or TFSA, is a type of investment and savings plan offered by the Government of Canada. A TFSA is a registered account, which means that the activity related to the account is recorded and monitored by the Canada Revenue Agency.

The account has a unique tax structure in that no money in the plan will ever be taxed. Deposits may earn interest, dividends or capital gains but no growth is taxed within the plan. Moreover, withdrawals from the plan are made on a tax-exempt basis. In short, everything within the plan and everything that comes out of the plan is entirely tax-free. This allows the plan holder to invest without any taxes eroding his or her earnings. Awesome!

The plan has been in existence since 2009. Since then, Canadians 18 years of age and older have been allowed to contribute up to $63,500 into their own TFSA. This contribution room is cumulative; therefore, you may make up unused contribution room at any point. It’s interesting to note, also, that when you make a withdrawal from a TFSA, you recoup contribution room equivalent to the withdrawal in the following tax year. Beautiful!

When moving non-registered investments (not in an RRSP, RESP or other registered plan) into a TFSA, capital gains may apply on the non-registered investments, unless one of only a few special circumstances apply. Doing so may still be in the individual’s best interest. Paying tax on the capital gains may amount to a fraction of what the individual could save in taxes on future gains were he or she to leave the investments in the non-registered account. Fantastic!

To illustrate, if a client holds $100 000 in a non-registered account and the original investment was $60 000, there is a $40 000 gain on the investment. Should the owner choose to move this investment into a TFSA, half of a capital gain is taxable ($20 000) at the owner’s marginal income tax rate (assume 35%), resulting in this case in taxes payable of $7000. From that point on, the investments grow on a tax-free basis. If we assume a 6% annual growth rate, the investments would be worth about $179 000 after 10 years. The new growth of $79 000 would be tax-free.

If the client had chosen to leave the investments in the non-registered account, the investments would have grown to the same amount, $179 000 10 years later. However, the capital gain is now $119 000 ($179 000 – $60 000), half of which would be taxable. The tax payable at this point would be almost $29 000, far more than the $7000 in taxes payable in the first scenario. Yuck! 

Use your TFSA. It’s a beautiful thing!