Wow, 10 years just flew by!
January 2009 feels like it was just yesterday...
I got my CFP exam passing marks, the markets were approaching levels to the downside not seen since the 1990s, Obama was just being inaugurated, and we were opening a new type of registered plan for the first time; the Tax Free Savings Account.
At that time there was still tons of confusion around the TFSA, even on the bank and brokerage side.
The misnaming of the TFSA as a “savings account” was core to a lot of confusion. “How much interest do TFSAs pay?” was a frequent question of the curious consumer. It was also believed by some they have only a $5000 permanent limit, and even a few years in some people didn’t get how the limit goes up each year, or how money withdrawn from the plan affects future contribution room.
Just to clarify for anyone reading this who still has questions: The TFSA started with a $5000 limit in 2009 for Canadian residents over 18. Each year you’re allowed to put in an additional amount of $5000 in 2009 dollars, indexed to inflation by $500 increments. Thus the annual contribution limit went up to $5500 in 2013 and is now $6000 for 2019. 2015, an election year, was an aberration where the limit was raised partway through the year to $10,000. As such, the contribution limit for someone who was over 18 in 2009, who never contributed is:
Any money withdrawn from the plan one year gets added to your contribution room the next calendar year. It’s very simple: whatever the dollar amount of the withdrawal transaction was is the amount added the next year. This has nothing to do with how much was originally contributed; ie: if you contributed $5000 in 2009, it doubled, and you withdrew $10,000 later that year, in 2010 your contribution limit was thus $15,000 (new $5000 + withdrawn $10,000). If you contributed those $15,000 in 2010, invested it all in something risky that went down to $1000, then withdrew that money, your contribution room for 2011 would have been $6000 (your withdrawn $1000 plus new $5000). Gains and losses made within your TFSA can therefore become permanent gains or losses to your lifetime TFSA “space”.
Initially, when TFSAs came out, some brokerages were reluctant to even start offering such plans, thinking the low limit to be pretty inconsequential and too much of an administrative burden. It was probably expected that most Canadians would use TFSAs as savings accounts, as opposed to investing. Starting out at a mere $5000 limit, many didn't see the power that such plans would have in the long-term.
On the bank side, I remember plenty of confusion around these plans too. The bank, of course, had a TFSA Savings Account ready to go on day one, which operated exactly like every other saving account in terms of ease of transferring cash from one account to another. A lot of Canadians treated them as such and exceeded the contribution limit by doing deposits and withdrawals throughout the year. Imagine someone contributing to the max $5000 at the beginning of 2009, then withdrawing $2000 in July, then putting that $2000 back in a few months later. They just over-contributed by $2000. The $2000 withdrawn doesn't get added back to contribution room until 2010.
Initially, a ton of over-contribution penalty letters went out (the TFSA doesn’t have a $2000 over-contribution cushion, like the RRSP). The penalty for over-contribution, just like with the RRSP, is 1% per month on the overage for each calendar month in which the TFSA is over-contributed. With the problems being so widespread, eventually, the government relented and took the approach of more “warning” letters.
At the banks too, they better trained their staff and - at least at the bank I worked at - added a sort of “flag” message whenever a customer transfers into a TFSA at the teller, for the teller to confirm with the customer that they’re aware of contribution limits and within them.
Some people knew the TFSA limit rules very well but still tried to game the system to their advantage. If you recall, after the markets bottomed, the period from March 2009 onward saw some strong market growth. If one were to put $1 million into a TFSA for part of a month, saw 5% growth, withdrew the $995,000 over-contribution and paid the $9950 penalty tax, they’d be left with a TFSA of over $45K. This in the first year of the plan, which by today could have compounded to over $100K (or closer to $200K maximum contributions each year and continued growth). I believe it was in late 2009 when the CRA became wise to this strategy and started cracking down on "deliberate over contributions".
Another area where the banks and brokerages were still figuring things out in early 2009 was how beneficiaries worked on TFSAs. If I recall correctly, the original TFSA account applications at my former firm didn't even have a field for beneficiary at first. Eventually the term "successor holder" was coined, specifying a surviving spouse who becomes owner of the TFSA upon death of the account holder (in such a case the TFSA remains sheltered), while anyone else can be designated as a beneficiary (receiving the assets unsheltered upon death of account holder).
Making full use of a TFSA
By and large, most investors seem to now be making proper use of the TFSA, as opposed to using it exclusively as a savings account.
If you’re just starting out and haven’t yet established an emergency fund of minimum 3 months of cash flow needs (ideally 6 months or more if you work in a highly cyclical business) the TFSA is a great place to store your cash and earn a little interest. Earning that interest tax-free means your cash hoard at least kind of barely keeps up with inflation.
Once you start building up more assets though and saving in your three retirement buckets - RRSP, TFSA, and non-registered - the TFSA makes a lot more sense as a very long-term pool of money. Then, you’ll want to keep your emergency fund non-registered, because the tax on 1 or 2% really doesn't amount to much anyway, while devoting TFSA room to investments you plan to hold forever.
When you look at how those three buckets are taxed, your RRSP is taxed completely as income when you start drawing from it in retirement - and draw from it you must when you reach a certain age. Your non-registered assets get taxed regularly on interest, dividends, and capital gains. Your TFSA is never taxed, even at death. It makes sense to use your TFSA assets last - if at all - and attain as high as possible a compound annual growth rate over the long-term, thus holding your riskiest assets in your TFSA.
To illustrate the difference between using your TFSA purely as a “savings account” versus treating it as your riskiest pool of money, I did a blog post a while back on what I call the TFSA Legacy Strategy.
If you have any questions about TFSAs, don't hesitate to reach out.
Markus Muhs, CFP®, CIM
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