Tax-free? Is there such a thing? Apparently, there is. A Tax-Free Savings Account (TFSA) is a registered general-purpose savings vehicle with one goal in mind – to help you meet your long-term savings goals.
The accounts are flexible, and allow you to earn tax-free investment income. Not only that, but they complement other savings plans, such as RRSPs and RESPs.
How do they work?
All Canadian residents who are 18 years of age or older can contribute up to $10,000 per calendar year to their TFSA and the income they earn is tax-free. Money withdrawn from a TFSA is also tax-free.
While TFSAs are an investment vehicle, you don’t simply deposit money directly into an account like you do for your daily banking. They're closer in nature to Registered Retirement Savings Plans (RRSPs) where you invest your money in one or more investment products, including mutual funds, bonds, and Guaranteed Investment Certificates (GICs) and government bonds.
The trick is in the taxes
The key difference between TFSAs and RRSPs is when the tax savings occur. With RRSPs, you get a refund now and will ultimately pay tax on the earnings when you withdraw the funds in retirement. With TFSAs there’s no immediate tax advantage, but any earnings within a TFSA account are non-taxable.
On January 1, 2013, the annual contribution limit was raised to $5,500. Previously, it had been $5,000 a year. As with RRSPs, any unused contribution room can be carried forward. And that’s retroactive to 2009, so anyone opening an account for the first time in 2013 would have $25,500 in room available.
Your TFSA contribution room
What’s amazing about TFSA accounts is that unused contribution room can be carried forward – and accumulates – in the following years. Not only that, but whatever you withdraw can be re-contributed to the TFSA in future years. You shouldn’t, however, re-contribute in the same year, since it could result in an over-contribution amount. Over-contributions are subject to a penalty tax.
Another advantage to TFSAs is the flexibility with which this type of investment can be used. While RRSPs are generally held until retirement (withdrawals by first time home buyers being one of the few exceptions), TFSAs investments can be used for anything at any time.
So, instead of taking out a loan for a new car, renovations, or schooling, you can withdraw funds from your TFSA to do so. Income earned from a TFSA does not affect your eligibility for federal income-tested benefits and credits, including Old Age Security, the Guaranteed Income Supplement, and the Canada Child Tax Benefit. Funds can be transferred or given to a spouse or common-law partner so that they may invest in their own TFSA.
You can also designate a beneficiary for your TFSA to ensure that your assets will be left to your family member. Contributions can be made at your convenience, or set up as automatic deposits.
How do I get one?
Any Canadian 18 years of age or older with a Social Insurance Number can open a TFSA. You can open an account with the same bank or financial advisor you buy your RRSPs through.
Unlike RRSPs, TFSA contributions are not tax-deductible.
Which means that you won't see the tax benefit in the year you contribute (like a RRSP); the tax benefit comes years later when you withdraw the money. When the TFSA was first introduced in 2009, a lot of people got burned by over contributing in a given year.
If, at any time in a calendar month, you exceed the TFSA contribution amount, you will be taxed 1% on the highest excess TFSA amount in that month. For example, if you put $10,000 into a TFSA on January 1st of 2010 and in April you want to buy a used car so you withdraw $4,000 from the account, you can’t pay back the $4,000 until January 2011. If you try to put it back into the account early, you will be over contributing $4,000 which will be charged at 1% for the number of months remaining in the year. For more information on this, visit the Canada Revenue Agency website.
Should I invest in TFSAs?
Like any investment option, it depends on your current situation and long-term goals.
RRSPs do have that immediate impact in helping reduce your tax bill, but many people forget that when it does come time to withdraw the funds, they will be considered taxable income at the time. So if you’re just starting out your career, as handy as those tax deductions are now, you may take a steep tax hit down the road if your income level in retirement is at a higher tax-rate.
For that reason, many financial advisors suggest that TFSAs are the best retirement vehicle for middle-to low-income earners and that higher-income earners (making more than about $80,000 a year) should max out their RRSPs first to reduce their annual tax bill.