ELI5: What Is A TFSA? The TFSA Explained To A 5-Year Old

The Tax-Free-Savings-Account (TFSA) is a great way to save and invest for the future. In our opinion, it’s the best tax advantaged account in Canada, and probably the first tax advantaged account most people should use (versus an RRSP or RESP). But with all the rules it can be very misunderstood.

To get the most out of your TFSA you have to have a good idea of how it works, what the benefits are, and what the limitations are.

The Canadian government introduced TFSAs in 2009 as an incentive to help any Canadians 18 years or older save more money. Although called a “Tax Free Savings Account”, the TFSA is more than an average savings account.

Even though the TFSA has been around for 10+ years, there is still a lot of confusion about how TFSAs work and what the benefits are.

In this post we’ll do an ELI5 for the TFSA (ELI5 = explain it like i’m 5-years old) and share some of the important considerations when using a TFSA.

ELI5: The TFSA Explained To A 5-Year Old

The simplest way to think about a TFSA is to imagine a box.

The box is magic, anything placed inside the box grows faster than it would if it was outside the box. This is because inside the box there is no “tax”, which is something that makes things grow slower.

You can put lots of different things inside the box, it’s entirely up to you, but we normally prefer to put things inside the box that grow big and grow fast.

Kind of like a person, the box grows bigger as it gets older. Each year on January 1st (which is kind of like the box’s birthday) the box grows a bit larger so that you can put more stuff inside the box. This happens every year on its birthday.

Because the box is magic the box also grows larger when the things inside the box grow larger. If something inside the box doubles in size then the box gets bigger to make sure there is still enough room.

But, the box can also shrink when the things inside the box get smaller.

The box will also shrink when you take things out, but this is only temporary, the box regrows by the exact same amount on its birthday of January 1st, so you can always put that same thing back in later.

You can take things out of the box at any time, but you can only put things into the box if there is room, otherwise the box overflows. If the box overflows you’ll start to lose part of the overflow each month, this is a punishment for not following the rules and you can’t get it back, so make sure you don’t let the box overflow.

We want the box to grow as big as possible. The bigger our TFSA box gets, the more things can go inside it, and things inside the box grow faster because the box is magic so we want to put as much as we can inside the box.

To grow the box as big as possible we want to put things into the box as soon as there is extra room. This is usually on the box’s birthday, January 1st.

We also want to put things into the box that grow big and grow fast, that way the box grows larger as the things inside the box grow larger.

TFSA Explained: Breaking It Down

The explanation above might be a good for a 5-year old but lets break it down further and use some of the same language that a bank or online investment broker might use.

“The simplest way to think about a TFSA is to imagine a box.

 

The box is magic, anything placed inside the box grows faster than it would if it was outside the box. This is because inside the box there is no “tax”, which is something that makes things grow slower.

 

You can put lots of different things inside the box, it’s entirely up to you, but we normally prefer to put things inside the box that grow big and grow fast.”

This means that the TFSA is just an account. Sometimes people think that a TFSA is an investment itself, but this isn’t the case. You can put different types of investments inside your TFSA. Your TFSA could hold a high-interest savings account, a GIC, stocks, bonds, mutual funds, index ETFs etc etc. Anything inside the TFSA will grow tax free. This is a big advantage over time. So we would prefer to use our TFSA for investments that grow fast and could incur a lot of tax.

“Kind of like a person, the box grows bigger as it gets older. Each year on January 1st (which is kind of like the box’s birthday) the box grows a bit larger so that you can put more stuff inside the box. This happens every year on its birthday.”

Every year your TFSA contribution room grows which means you can put more money inside your TFSA. This happens every January 1st. The exact amount will increase will inflation. Check out this post to see the current TFSA contribution room and how it might increase in the future.

“Because the box is magic the box also grows larger when the things inside the box grow larger. If something inside the box doubles in size then the box gets bigger to make sure there is still enough room.

 

But, the box can also shrink when the things inside the box get smaller.”

This means that when an investment inside a TFSA grows, this growth doesn’t take away from your contribution room, the TFSA actually gets larger to accommodate this growth. This is a big advantage to starting a TFSA early. If you start investing in a TFSA early then it can grow very large, even $1M+, even though your contributions to the TFSA are much, much smaller.

But, the opposite can also happen. Your TFSA can get smaller if investments inside your TFSA decrease in value.

“The box will also shrink when you take things out, but this is only temporary, the box regrows by the exact same amount on its birthday of January 1st, so you can always put that same thing back in later.”

This part can be confusing for some people and has caused issues with over contribution in the past. With the TFSA you can make a withdrawal at any time, and you get that contribution room back, but only on January 1st of the following year. So if you take out $16,000 on August 15th, you can put that $16,000 back into your TFSA in the future, but only after January 1st of the next year, this is when that contribution room comes back.

“You can take things out of the box at any time, but you can only put things into the box if there is room, otherwise the box overflows. If the box overflows you’ll start to lose part of the overflow each month, this is a punishment for not following the rules and you can’t get it back, so make sure you don’t let the box overflow.”

Because of the unique contribution limits & withdrawal rules it can be easy to over contribute to a TFSA if you’re not careful. This will incur a steep 1% per month penalty for any amount above your contribution limit. Use the CRA website to check your contribution limit but also make sure to keep your own records of contributions and withdrawals, most of the time the CRA website is out of date by 6-12 months.

“We want the box to grow as big as possible. The bigger our TFSA box gets, the more things can go inside it, and things inside the box grow faster because the box is magic so we want to put as much as we can inside the box.

 

To grow the box as big as possible we want to put things into the box as soon as there is extra room. This is usually on the box’s birthday, January 1st.

 

We also want to put things into the box that grow big and grow fast, that way the box grows larger as the things inside the box grow larger.”

The TFSA is an amazing account. To take advantage of the TFSA the best strategy is to max it out as soon as possible each year. The other strategy is to use the TFSA for long-term investments like retirement and to put higher growth investments inside the TFSA (like an index ETF versus a GIC). Over time the investment growth will outstrip your contributions and you’ll end up with a TFSA worth $1M, $2M, $3M+ even though you’ve only contributed $100,000 to $200,000.

For more info on the TFSA and some additional reading see the sections below.

Contributing To A TFSA

Each year there is an annual contribution limit for the TFSA. This amount can increase from year to year with inflation. For 2020 the limit is $6,000. You can see the past contribution limits here… TFSA Contribution Limits.

If you are opening a TFSA for the first time in 2020 then you may be able to contribute as much as $69,500 if you were 18-years or older in 2009.

If you weren’t 18-years old in 2009 then you need to add together the annual contribution limit from the year you turned 18.

Another way to confirm your TFSA contribution limit is to log into MyCRA and confirm your limit with the CRA. The CRA tracks your contribution limit but be warned that this amount is only updated once per year and may not reflect any recent contributions/withdrawals.

Remember that if you withdraw from a TFSA and want to replace that money later on, unless you have extra contribution room, you have to wait until the following year to get that contribution room back. For example, if you withdraw $12,000 from your TFSA and wish to replace it, unless you have extra contribution room, you have to wait until January 1st of next year to get that $12,000 contribution room back.

The TFSA Is Not Just A Savings Account

The other great thing about the TFSA is that almost anything can go into them. It’s not just for savings and short-term investments. There are many investment options inside a TFSA. These can include:

• High-Interest Savings
• Guaranteed Investment Certificates (GICs)
• Individual Stocks
• Individual Bonds
• Mutual Funds
• Exchange Traded Funds (ETFs)

Because we want our TFSA to grow big and grow fast we typically want to choose an investment option that has a high growth rate like stocks, bonds, or ETFs. But this needs to be inline with investment goals and timelines. For short-term goals (1-5 years) we want to invest in something safe like a GIC or High-Interest Savings Account.

More About The TFSA…

Hopefully this gives you a decent understanding of how the TFSA works and what it can be used for. But this is just the tip of the iceberg when it comes to the TFSA.

The TFSA is a powerful tax-advantaged account and it can be helpful to see how the TFSA can be used and what it’s limitations are.
Here are a few other articles we recommend checking out…

• The New TFSA Contribution Limit! How Big Could Your TFSA Get If You Contribute The Max Each Year?
• Understanding TFSA’s: The 8 Benefits (And 3 Drawbacks) of TFSA’s
• Our 1 Million Dollar Goal: How We’re Using Our TFSA for Retirement
• Getting Our TFSAs to One Million: An Update
• TFSA Beneficiary vs Successor Holder? The difference is HUGE!