Dale Jackson

Personal Finance Columnist, Payback Time

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This year’s massive hike in interest rates has finally made the “savings” part of the tax-free savings account (TFSA) worthwhile.

Until now, the TFSA has functioned as more of a tax-free investment account. 

When it was launched in the wake of the 2008 global financial meltdown, the world’s major central banks conspired to lower their benchmark interest rates to near zero to keep the financial system from collapsing. As a result, yields on fixed income remained near rock bottom to the start of 2022. 

Before this year’s 18 per cent pullback in the S&P 500, the TFSA became a very effective tool for investors and speculators to tap into the cheap-money-fueled bull market that rocketed the stock market benchmark to seven times its value.  

A NEW YEAR FOR SAVERS

Times have changed. As equities languish, annual yields on fixed-income products like money market funds, guaranteed investment certificates (GICs) and government bonds have spiked to over five per cent in some cases.

That allows TFSA holders to compound their savings over time without having to take on equity market risk or pay income tax on those gains. Compounding occurs when the yield itself generates its own yield in addition to the original investment, and so on.

To get an idea of how compounding works, if you start with $50,000 and add $10,000 each year at five per cent, you will end up with $197,224 after 10 years. It adds up to nearly $50,000 in interest alone.

Hopefully, that five per cent return will come on top of inflation, assuming the central bank motive to combat higher costs by raising interest rates works. If it doesn’t, further rate increases should result in higher yields.

TFSA HAS BETTER TAX ADVANTAGE FOR INCOME

Gains on all TFSA contributions, other than U.S. dividends, are never taxed, but interest income has the best advantage because it would be fully taxed outside a TFSA.

In contrast, only half of the gains from equity investments outside a TFSA are taxed when they are sold. Holding equities outside a TFSA also permits investors to offset losses on equities sold against gains going back three years or into the future indefinitely.

Even dividend income from eligible stocks held outside a TFSA can generate a tax credit.

TFSA AS A RETIREMENT INVESTMENT TOOL       

The total TFSA contribution limit for anyone over 18 years old will be expanded by $6,500 starting Jan. 1, 2023. That means an additional $6,500 in contribution space for the vast majority of Canadians who have not contributed the maximum allowable amount in previous years. Allowable amounts are carried forward.

Total contribution space varies for individuals based on contributions and withdrawals made over the years. To get an idea of how significant the TFSA has become, the total allowable amount for those 18 years or older when it was introduced in 2009 will be $88,000 in the new year.

Originally billed as a short-term savings vehicle for things like vacations or home renovations, the TFSA has grown into a potential retirement tax-planning tool that can compliment a registered retirement savings plan (RRSP). 

Their differences are their strengths. RRSP contributions can be deducted from taxable income (unlike TFSAs), but those contributions and the returns they generate over time are fully taxed at the individual’s marginal rate when they are withdrawn.

With proper planning, RRSP withdrawals can be capped at a low marginal tax rate in retirement and topped up with tax-free money from a TFSA - lowering the overall tax bill significantly.

Both RRSPs and TFSAs can hold just about any type of investment including stocks traded on major exchanges, bonds, mutual funds or exchange-traded funds (ETFs).

The big difference is any amount can be withdrawn from a TFSA at any time without taxes or penalties.

Anyone looking for an effective resolution for the new year can contribute to their RRSP before the March 1 deadline and put the tax refund in their TFSA.