TFSAs and RRSPs: Which one is right for your financial future?
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Canadians are plowing more money into their tax-free savings account than ever during the pandemic, according to the latest BMO annual TFSA study.
But the study also finds they are leaving the biggest portion of their savings in cash; making the “tax-free” benefit of their TFSAs pointless.
According to the study, the average cash weighting is 38 per cent, followed by mutual funds at 23 per cent and stocks at 18 per cent.
BMO found only half of respondents were aware they can hold more than cash in their TFSAs, and one-quarter don’t know what can be included.
Holding cash in your tax-free savings account is like buying a car and leaving it in the garage. As the name implies the “tax-free” benefits just apply to gains made on most investments within the registered account. The only gains from cash go to the bank, which uses it to generate gains for themselves.
Money in TFSAs can be invested in just about anything: mutual funds, exchange-traded funds (ETFs), real estate investment trusts (REITs), stocks, bonds, guaranteed investment certificates (GICs) and even options. They can be sold and the cash can be withdrawn at any time.
Tax savings from gains on bonds and GICs are minimal because interest rates are holding yields at rock-bottom lows but savings are unlimited for gains on stocks and equity funds, half of which would be taxed outside a registered account. The tax-free status from TFSA also applies to dividend payouts.
Earlier this month, the Canada Revenue Agency (CRA) announced Canadian adults will be able to add another $6,000 to their tax-free savings accounts in the new year.
The TFSA was introduced in the aftermath of the 2008 global financial meltdown and consequent market plunge in an effort by the federal government to encourage Canadians to get back into the financial markets. Since then, allowable contribution levels have crept up each year. As of Jan. 1, the total contribution limit for anyone who was at least 18 years old in 2009 will be $75,500. Inflation adjusted contribution limits are expected to continue rising in future years, although Ottawa gives no guarantee and increases could end at any time.
Contribution space from TFSA withdrawals can be reclaimed the following calendar year. Over-contributions are subject to penalties from the Canada Revenue Agency (CRA). If you want to know your personal limit the CRA provides them in annual Notice of Assessments on individual tax returns, and for individual tax payers who set up a CRA online account. A word of warning: contribution limits posted by the CRA are usually for the previous year, so be sure to include contributions made in the current year.
It’s hard to know exactly why Canadians are holding so much cash in their TFSAs. It could be because they are being cautious until the air surrounding the pandemic’s impact on the markets clears.
It is also possible they are confusing their TFSAs with their registered retirement savings plans. Contributions made to an RRSP can be deducted from taxable income, providing a tax deferral until it is withdrawn whether it stays in cash or not.
Some of the blame should go to the federal government for giving the TFSA the wrong name. Calling it a savings account implies it is a standard savings account that only holds cash.
A more accurate name would be “tax-free investment account” but introducing a TFIA at this point would probably just add to the confusion.
Payback Time is a weekly column by personal finance columnist Dale Jackson about how to prepare your finances for retirement. Have a question you want answered? Email firstname.lastname@example.org.