Do you know that the tax-free savings account (TFSA) is one of the most powerful wealth building instruments in Canada?
It’s true. Shielding your dividends, interest and capital gains from taxation, a TFSA significantly boosts your total returns compared to holding investments in a taxable account.
To some extent, the Registered Retirement Savings Plan (RRSP) shares these benefits. However, RRSP funds become taxable when withdrawn, whereas TFSA money is never taxable (provided you abide by the account rules). It’s for this reason that the TFSA is perhaps the best account to hold investments in, turning your portfolio into a tax-free “gold mine” of passive income. In this article, I will explore how you can establish a gold mine of your own, starting with as little as $10,000.
Find out your contribution limit
The first step in building a $10,000 TFSA “gold mine” is to find out whether you are eligible to do it. Your available TFSA contribution room is determined by how many years worth of new contribution room accumulated since you turned 18, and the annual amounts. If you turn/turned 18 this year, you have only $7,000 worth of contribution room. If you were born in 1991 or earlier, you have $95,000 worth of contribution room (assuming you haven’t used any). You can find out your exact amount of TFSA contribution room on CRA MyAccount, which can be accessed on the Canada Revenue Agency (CRA) website.
Deposit funds
Once you know your TFSA contribution limit, you can safely deposit funds. I say “safely” because the cost of contributing more than you’re allowed to is a 1% monthly tax. You want to retain your TFSA’s tax-free status, as this quality is what makes your TFSA worth investing in. So, only once you have checked your contribution limit on CRA MyAccount should you deposit funds. If you are 19 and haven’t made any contributions yet, you should be able to deposit the $10,000 mentioned at the start of this article.
Invest in income-bearing investments
Once you have a TFSA funded, you need to decide what to invest in. In general, dividend stocks and interest bearing bonds are good TFSA holdings. Stocks that offer only capital gains do not make the best use of the TFSA’s tax shelter, because you can defer paying taxes on them for a very long time. If you hold a non-dividend stock for life, you never pay taxes on it at all!
So, dividend stocks and bonds are ideal TFSA holdings.
Consider The Toronto-Dominion Bank (TSX:TD), for example. It’s a dividend stock with a 5.1% yield at today’s prices. If you invest $10,000 in it, you get $513 in annual dividend income. By holding the stock in a TFSA, you can avoid paying taxes on those dividends, as well as on any capital gains you may realize by selling the stock.
How much money can you save by holding TD in a TFSA?
First, let’s figure out how much tax you’d pay on TD shares in a taxable account. For this exercise, we will assume that you live in Ontario.
Canadian dividends are “grossed up” by 38%, so the $513 in dividends becomes $708 for tax purposes. If your marginal tax rate is 33%, you’d pay $236 in taxes on $708 in employment income. However, since this is dividend income, it is reduced by two dividend tax credits: the 15% federal credit ($106.2) and the 10% Ontario credit ($70.80). So the $236 tax is reduced to $59. That’s quite a bit of savings right there from the dividend tax credit. However, by holding TD in a TFSA, you pay $0 in taxes. So, you save $59.
As you can see, holding dividend stocks in a TFSA can save you a lot of money in taxes. So be sure to hold at least some of your investments inside one. It’s just a plain logical thing to do!
