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How to make a million dollars … tax-free

Robyn K. Thompson for

Yes, you can beat the taxman! In fact, you have the legal right to arrange your financial affairs within the law to pay the least amount of taxes possible. Make sure you exercise that right. This is legitimate tax planning, and nothing to feel guilty about (unlike breaking that New Year’s resolution to diet and exercise). The result of proper tax planning is more money in your pocket and less to the Canada Revenue Agency (CRA). In fact, the government goes so far as to make it easy to slash your tax bill, if only you’d take the trouble to do it. One of the best ways is something called the Tax-Free Savings Account (TFSA).

TFSA know-how

The TFSA is your best bet for creating immediate tax-free dollars. A TFSA is a special government-registered account that lets any investments held within it accumulate tax-free. In addition, withdrawals from the account are also completely tax-free.

[More: Go beyond saving: 6 ways to invest your TFSA]

As you’d expect, there are a number of rules, some of which can be quite complicated. Basically, you can contribute up to a maximum $5,000 to a TFSA for every year since it began in 2009, up to this year. For 2013, the government has raised the limit to $5,500. The contribution limit is not income-tested, the way it is for an RRSP, so anyone can contribute the maximum every year regardless of their income level. Unused “contribution room” can be carried forward and used in future years.

Withdrawals can be made at any time, but you have to be careful you don’t contribute, withdraw, and recontribute in the same year. This is one of the “complications” I mentioned above. If you do start using your TFSA like a straight deposit savings account, you may fall afoul of the penalties for overcontributing in a given year, and these can be pretty stiff. So make sure you check with your advisor if you plan to make withdrawals from your TFSA. As a rule of thumb, treat your TFSA as a tax-sheltered investment vehicle, much like an RRSP, and not as a place to park cash for day-to-day expenditures.

[More: TFSA traps that’ll cost you money: 5 things to watch out for]

There’s no deduction for contributions, as there is for RRSPs, but that’s offset by the tax-free nature of income generated within the plan, as well as on withdrawals.

Here’s an example of how a TFSA can build your net worth in a big way...

Let’s say you are 30 years old today and make $50,000 a year. You have $10,000 in your Tax-Free Savings Account, and you contribute $5,000 at the start of each and every year until you stop working at age 65.

And let’s assume your combined investments inside the Tax-Free Savings Account can earn an average 8% per year.

Make a million tax-free!

When you reach age 65, you will have accumulated $1, 067 412. Yes, read that again – over one million dollars from a $5,000-a-year investment!

If you were to invest this same amount in an open account or taxable account, using the same numbers, you would have accumulated $728,226 and paid a whopping $271,774 to the CRA. This is because the growth on your investments is taxed annually at your marginal tax rate (in this case using a 31.15% tax rate), leaving you an after-tax rate of return of 6.4%. Congratulations! You have just given the CRA a bonus of $270,000 for absolutely no reason!

[More: Got a financial question? Experts respond to your pressing money dilemmas]

The secret is that you never ever pay tax on the money inside your TFSA – ever! So you can invest in interest-bearing investments like bonds and GICs, or aim for growth in the form of investments like common stocks, ETFs, and other growth-type assets.

Stop giving your money away!

So go ahead, and open your Tax-Free Savings Account. Contribute the maximum (or as much as you can) every year. And do it regardless of how old or young you are today. Stop giving your money away! And start creating those tax-free dollars right now.

[Read more from Robyn Thompson on ] is a free personal finance and education site for women.

Nothing contained herein is intended to provide personalized financial, legal or tax advice. Before implementing any financial strategy, you should obtain information and advice from your financial, legal and/or tax advisers who are fully aware of your individual circumstances.

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