TFSA Pros and Cons

Everything you should know about this financial friend with (tax) benefits.

You probably hear the advice to open a Tax-Free Savings Account (TFSA) all the time, and it sounds too good to be true. What's the catch? And – rewind – what even is a TFSA exactly?

Tax-Free Savings Accounts are registered accounts available to Canadian residents over the age of 18, who have a valid social insurance number. You can open a TFSA at nearly any Canadian financial institution, and it’s pretty much exactly what it sounds like: a savings account that allows you to store cash – and investments – without requiring you to pay income tax when you withdraw your money. This means that dividends, capital gains and interest can grow tax free in your TFSA, saving you money (and paperwork).?

However, in order to reap the tax benefits that come along with your TFSA, you definitely need to be aware of the rules. For example, the Canadian government determines an annual contribution limit – and going over it can result in a fine (annoying, right?).

Basically, while TFSAs have a place in pretty much any financial plan, it's also a good idea to understand how this product compares to other options – like a high-interest savings account or Registered Retirement Savings Plan (RRSP), which also comes with tax advantages.

Not to fear! We'll help you sort through alllll the info out there on TFSAs by breaking things down nice and easy. Here are four reasons why it's a great idea to open a Tax-Free Savings Account (and a couple cons to be cautious of).

PRO: Your TFSA makes a great investment account

It's called a Tax-Free Savings Account. Where do investments come in?

You can actually hold a variety of investments in your TFSA, like mutual funds and index funds, securities listed on a stock exchange, guaranteed investment certificates, and bonds.

I don't have a lot of money to invest. Is that really something I should care about?

Here's the thing – investing isn't just for the rich. There are a ton of advantages to investing that simply aren't talked about enough, and a TFSA is a great way to make the most of your investment portfolio. This is exactly how it works on the Flahmingo app (and by the way, we're really into making investing accessible for everyone. You can start investing with Flahmingo for only $1 USD).

Basically, your Flahmingo investments – including stocks and exchange-traded funds (ETFs), which refers to a bundle of stocks and bonds – are all held in your TFSA account, reducing or eliminating the tax you will need to pay on your investment income.

What exactly do you mean by investment income?

There are three main ways to make money on your investments: dividends, capital gains and interest.

Dividends are payments made from a company to its shareholders, usually quarterly. They're essentially a way of redistributing company profits between all the people who invested in the company. In other words, if you invest money in a company that pays dividends, you can expect to receive payments just for holding onto the stock. Usually, it's the bigger, more established companies that choose to pay dividends to their shareholders – smaller companies that are still growing typically reinvest profits back into the company.

By having your dividends deposited into a TFSA account, you can avoid the confusing business of paying taxes on those funds. How confusing is it, you ask? Just take a look at our tax season breakdown.

Keep in mind that you may be required to pay foreign withholding taxes on U.S. dividends. We get into the nitty gritty of all that in our cons section.

Capital gains refers to the money you make for selling your shares for a profit. Let's say you buy a share for $5 and two years later, the price of that share is sitting at $10. When you sell that share, you would make a capital gain of $5. If you had to pay a broker fee of $1 to facilitate each trade (Flahmingo doesn't charge fees, btw) then your capital gain would be $4.

If you're curious, this is how taxation works for capital gains outside of your TFSA.

Just don't plan on using your tax-free account for day trading (buying and selling stocks in the same day in order to maximize capital gains). This could actually get you in trouble with the Canada Revenue Agency (CRA) because they view this kind of activity as business income.

Interest is the money paid on top of a loan, typically expressed as a percentage of the principal (the original value of the loan). While you're responsible for paying interest on, say, student debt and credit cards, in the investing world you can also earn interest.

One way to earn interest is by investing in bonds, which is a loan that you issue to a company or the government. In exchange for issuing this loan, you will often receive fixed interest payments, known as a coupon, and the eventual repayment of your money. In Canada, you are taxed on the interest you earn; however, interest gained within a TFSA is tax-free.

So, I should be investing instead of saving?

First of all, both saving and investing have a place in your personal finance plan; it's definitely not one or the other, so don't feel like you should convert all your savings into investments.

Your savings account is important for keeping at least some of your money liquid – meaning you can use it as an emergency fund and also have it handy for purchases you anticipate in the near future, like a spring vacation.

Holding investments in a TFSA, on the other hand, can help you grow your funds for the long-term and save money for those big milestones – like a down payment.

?

PRO: You can withdraw funds at any time, without paying taxes

How do TFSA withdrawals work?

You can withdraw money from your TFSA whenever you want! Just remember that if you decide to add the money you've withdrawn back into your TFSA within the same tax year, it will still count toward your contribution room (don't worry, we’ll explain how the annual limit works a little further down).

Basically, withdrawing funds from your TFSA is no big deal – and won’t involve tax payments.?

Read the full article.