A few years ago, a close friend received a phone call from his bank suggesting he open up a TFSA (Tax Free Savings Account). They extolled the benefits of the account and made it sound like a great idea. Naturally, as a skeptical millennial in tech, he came to me with the question “Is it too good to be true?”

In today’s episode, I’ll answer that question and help you determine if a TFSA is right for you. I’m Susan Daley and this is Your Money, Your Choices.

So, then, what on earth is a TFSA? Admittedly, it sounds like a security task force, but it’s better than that. The TFSA stands for Tax Free Savings Account, and is a tax-sheltered account created by the government in 2009. Depending on your age, you can contribute up to a maximum of $52,000 after-tax dollars as of January 1st 2017 into a TFSA.

I’ve included a link to a calculator in the description below that will allow you to calculate your TFSA room based on your age, and past contributions and withdrawals. You can also find out your room as of January 1st on CRA’s MyAccount.

As a side note, after-tax dollars means money you have to spend after you’ve paid tax on your income, typically through automatic deductions from your paycheque. For example, say you earn a salary of $50,000. About $8,500 of that $50,000 goes to the government in taxes, meaning you have $41,500 in after-tax income to spend or save.

So what are the benefits of the TFSA? Where does the ‘tax-free’ status come into play?

When you invest your money in a regular savings or investment account, you have to pay tax on your investment return in the year you earned the return. If your money is in a savings account earning 1.5% and you’re making a $50,000 salary, you’ll have to pay tax at your marginal rate, 29.65%, on your 1.5% return. This means that, instead of getting 1.5% on that money, you are actually only making 1.06% return.

Yeah…not cool.

With the TFSA, all earnings are tax-free, so you get to keep the whole 1.5% return. Think of it as a gift from the government! Much better, right?

One thing to note though, is that even though you may not be paying tax on the investment return, you have to do some research into whether the TFSA is the best option for you. Doing your homework will pay off as different banks offer different rates.

For example, say you bank with BMO, and do not want to complicate your life and open a TFSA at another institution. BMO offers a high interest TFSA with a rate of 0.50% per year. Their regular savings account with a balance of $5,000 would get you 1.2% per year. Even after paying a 29.65% tax rate, you’d still be ahead with the regular savings account rather than the TFSA. It can pay to look around for the best option, and make sure your investments in the TFSA are appropriate for you.

Another benefit is that the only conditions to receive contribution room are that you are a Canadian resident over the age of 18. Unlike an RRSP, you don’t have to earn income to open a TFSA, so any money received, like gifts and inheritances can go into a TFSA. Or if you don’t work and your spouse does, they can contribute to your TFSA.

One thing that I don’t like about the TFSA is its name: Tax Free Savings Account. This makes it sound like just a regular bank savings account, but it is much more than that. You can invest in high interest securities, but you can also hold other investments like stocks, bonds, ETF’s, and mutual funds. I think this account should have been called a Tax Free Investment Account to reduce that confusion.

Though TFSAs are really flexible, there are certain rules you have to abide by to avoid major penalties:

Number one, you must stay within your contribution limit. If you contribute more, you’ll get dinged by a 1% per month penalty on any over-contributions by the government. Enough to eliminate any tax savings.

Number two, though you don’t lose your contribution room (like you do with the RRSP) when you withdraw money from the TFSA, it is only added back the following calendar year. Many people got into trouble by using the TFSA as a regular bank account in the early years, ignoring the rule that withdrawals could not be recontributed until the following year, and caused them to incur the steep 1% per month penalty on their over-contributions.

That being said, the TFSA provides a lot of leeway to save for your goals. You can withdraw money at any time, tax free, no questions asked, and with little to no documentation required. This makes the TFSA a good choice for saving towards a down payment, wedding, education, emergency savings, and other short-to-medium term goals.

To summarize, the TFSA is a type of account created by the government to encourage Canadians to save without having to pay taxes on their investment returns. It’s a great tool to save for short, medium, and long-term goals because of its flexibility. The trick to making the most out of the TFSA is to make sure you don’t over-contribute and incur a 1% per month penalty, and to invest the money in the most appropriate investments in order to meet your goals.

So is the TFSA too good to be true? The answer is, not if you use it right!

If you have any questions about TFSAs or anything else for that matter, leave a comment below, and don’t forget to subscribe. I put out these videos every two weeks on Wednesday.

http://www.cra-arc.gc.ca/tfsa/

http://www.cra-arc.gc.ca/esrvc-srvce/tx/ndvdls/myccnt/menu-eng.html

https://pwlcapitaltw.wpengine.com/basic-financial-terminology-explained/