The best kept wealth-building secret in Canada: everything you need to know

Retire early with a completely tax-free income

 

I’m not talking about a crazy Ponzi scheme, I’m talking about the TFSA. Yes, most of us have one, but are you using it the proper way?

Most people think that it is what the name implies – a “savings” account, where you park some cash until your next vacation or kitchen reno. This perception is completely wrong. In fact, the TFSA is one of the greatest wealth-building tools available to Canadian's, regardless of your income level. Let me explain.

If you're already familiar with how the TFSA works click here to skip the basics and go straight to how you SHOULD be using it
 

First, the basics

Before I explain exactly how you should be using your TFSA, let’s quickly recap the basics.

Most types of investments can be included in your TFSA, including stocks, bonds, GIC’s, cash, mutual funds, and ETF’s. The minimum age to open a TFSA is 18 and you must have a social insurance number. Each year you can add an additional $5,500 to your TFSA (with the exception of the years 2009 thru 2012 where the limit was only $5,000, and 2015 where you were allowed to add $10,000). The following chart shows the cumulative total since it’s inception in 2009:

 
 

So, as of the year 2017 you can have up to $52,000 in your TFSA, even if you’ve never contributed in previous years, or didn’t contribute the maximum amount in those previous years. Everyone has this space, no matter what. Furthermore, you can carry forward any unused contribution room indefinitely into future years, so it’s never lost in case you don’t use it.

 

The low-down on taxes

Any contribution you make to your TFSA is made with money you’ve already paid tax on, so unlike an RRSP, the money you contribute can’t be written-off as a tax deduction. BUT, also unlike an RRSP, there are no tax penalties for taking money out of your TFSA, which means you can take cash out at any time of the year without having to pay tax on it. 

 

If I take money out will I lose my contribution room?

 

Absolutely not! All the government asks is that you wait until the following year to put the money back in.

For example, if you’ve maxed out your TFSA at $52,000 and you take out $10,000 to buy a car, you can put that $10,000 back into your TFSA on January 1st of next year. In addition, come January 1st, you’ll also get another $5,500 in contribution room added to your cumulative total, so actually, you can put $15,500 into your TFSA on January 1st. 

Note: there is a small tax penalty if you over contribute, so make sure to be aware of how much you’ve already contributed to prevent going over.

 

Here’s what makes the TFSA so great, and how you SHOULD be using it

Ok, we’ve covered the basics, now let’s talk about how you should be using your TFSA to make a mass amount of tax-free cash. 

The key to remember is that taxes don’t apply to any capital gains you make inside your TFSA. What does this mean? Well, we know you can hold lots of things besides cash in your TFSA, including stocks.

Let’s say you get a hot stock tip from your Uncle Bob at the family BBQ and you end up getting in on the ground floor of the next Apple. If the stock price goes through the roof you can literally make unlimited profits in capital gains and they are entirely tax-free! 

 

So, I picked a few good stocks that went up, I sold and made a profit. Now I have $75,000 sitting in my TFSA. What happens to my contribution room and will I get penalized for being over the limit of $52,000?

 

Here’s the beauty of it: no you won’t get penalized for being over the $52,000 limit.

The $52,000 limit only applies to contributions you make with money from outside your TFSA. Meaning, anything you make within your TFSA is fair game and simply pushes your contribution limit ceiling higher.

So, in our example above, your new current TFSA value is $75,000. You can now choose to take the entire $75,000 out of your TFSA completely tax-free, and on January 1st of next year you can put the full $75,000 back in, along with an additional $5,500 of new contribution room ($80,500 in total!).

Remember: whatever amount you take out, you can put back in the following year, regardless of the amount you initially took out.

Look at the bigger picture

Because you can hold investments with the potential for large returns (like stocks and ETF’s) the biggest mistake most Canadian’s make is using their TFSA as a savings account and simply holding cash.

With a sound investment strategy you can literally grow your TFSA into millions of dollars, then, when you're ready to retire, sell off all the risky, high-growth stuff and put the profits into safer investments paying a consistent 5% annual return. Watch the dividend cheques roll in each month essentially paying you a monthly income that you can withdraw tax-free from your TFSA without ever spending a dime of your principle. 

For example, let’s say you managed to grow your TFSA up to $1,000,000 over the years. You can now sell any risky investments (tax-free) and spread the $1,000,000 across a variety of safe, fixed-income, investments that pay a nice return of 5% ($50,000/year), tax-free. Not a bad little income! Keep the $1,000,000 invested in the safe stuff without ever spending it and you’ll have a tax-free monthly income for the rest of your life. 

 

More awesome features you NEED to know about

Another amazing feature people don’t realize about the TFSA is that if you already own stocks and investments in a non-registered account and want to move them into your TFSA, you don’t have to sell them and buy them back inside your TFSA. Simply call your bank or investment broker and ask them to transfer your stocks as an ‘in-kind’ contribution to your TFSA. You’ll pay a small capital gains tax on the value of any gains already realized on each investment, but this is a small price to pay knowing that any capital gains going forward are completely tax-free

 

If I am going to sell something at a loss am I better to sell it in my TFSA or cash account?

 

Sell it in your cash account first, then transfer it over. You can't apply capital losses towards the offset of capital gains within a TFSA. For capital losses that occur in your cash account you can go back up to 3 years and apply them to any gains. Otherwise, the capital loss can be carried forward indefinitely. 

Here’s another wonderful feature most people don’t know about: you can open up a TFSA for US dollars and US investments.

Yes, you heard that right! You can buy and sell US stocks as well as hold US cash inside your TFSA – great if you want to get in on Apple, Google, or any other US stock we can’t buy here in Canada (not to forget the benefit of the exchange rate!). Simply call your bank and they’ll set it up for you. 

 

Do I have to pay US taxes on my US TFSA investments?

 

Not to worry, any capital gains you make on US investments inside your TFSA are tax-free in both Canada and the US. The only tax you pay is 15% on any dividends from US investments, which is automatically deducted from your dividend cheques, thus, no need to pay any tax or worry about reporting any US investments on your tax return – super easy!

 

Are you using your tfsa the proper way? Let me know in the comments below.


Key takeaway: stop using the TFSA as a “savings” account – this is one of the biggest mistakes Canadians can make when it comes to their financial future.

Use it to grow things like stocks and ETF’s – investments with higher growth potential. Over the years you can amass a fortune, then, when you’re ready to retire, sell the risky stuff and spread your cash across safe, fixed-income investments. You can then live off the monthly dividend cheques tax-free without ever spending your principle!



Disclaimer: The views expressed are provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions.

Before you invest be sure to download your free copy of Building a Bulletproof Portfolio, the complete guide on how I built a winning portfolio that sailed through the 2008 stock market crash without losing a dime.