What Is a Tax-Free Savings Account (TFSA)?
A Tax-Free Savings Account (TFSA) is a special savings account available to Canadian residents. It allows contributions, interest, dividends, and capital gains to grow without being taxed. Additionally, any money you withdraw from the account is also tax-free.
The contributions you make to a TFSA are after-tax, meaning they come from income that has already been taxed. Because of this, depositing money into a TFSA doesn’t reduce your taxable income.
Despite being labeled a ‘savings account,’ a TFSA is not limited to just savings. It can hold various investments, including mutual funds, securities, bonds, and cash. This type of account is accessible to Canadian residents aged 18 and older, giving you the flexibility to use it for any purpose, from saving for a vacation to investing for retirement.
Key Points to Remember
- TFSAs are tax-advantaged accounts available to Canadian residents who are 18 or older.
- They allow you to save on taxes because the returns on investments within the account aren’t taxed, and withdrawals are also tax-free.
- There is a contribution limit, known as the “contribution room,” for how much you can deposit into a TFSA each year.
- If you contribute less than the annual limit, the unused portion can carry over to the following year.
- These carryovers apply retroactively to the year TFSAs were introduced in 2009.
Understanding How TFSAs Work
In 2009, TFSAs were created to help Canadians save and invest money throughout their lives, not just for retirement. The flexibility of a TFSA means you can use it to save for anything, such as buying a car, funding your education, purchasing a home, covering extra living expenses, or planning for retirement. Importantly, you don’t need earned income to contribute to a TFSA.
Typically, the income generated by investments within a TFSA is not taxed, with some exceptions. Additionally, TFSA holders maintain complete control over their accounts, deciding on contributions, investments, and withdrawals without facing penalties.
When TFSAs were introduced, they allowed Canadians 18 and older to make after-tax contributions of up to C$5,000 annually. This limit was increased to C$5,500 in 2013 and remained there until 2018, except for 2015, when it temporarily rose to C$10,000. In 2019, the contribution limit was set at C$6,000, which remains the same for 2022.
Contributions
The “contribution room” is the maximum amount you can deposit into a TFSA. Notably, each year since 2009, when you were 18 or older and a Canadian resident, you’ve accumulated a contribution room, even if you still don’t need to open an account.
If you use more than some of your contribution room in a given year, it carries forward to future years. For example, if you contributed the maximum amount every year until 2019 but only deposited C$3,000 of your available C$6,000 contribution room that year, you could carry over the unused C$3,000 to 2020, allowing you to contribute C$9,000 that year.
If you hadn’t contributed anything since 2016, your contribution room for 2020 would have been C$23,000: C$5,500 for 2017 and 2018 (C$11,000), plus C$6,000 each for 2019 and 2020 (C$12,000).
The TFSA annual contribution limit is indexed to inflation and rounded to the nearest $500. The Canada Revenue Agency (CRA) also states that “qualifying transfers, exempt contributions, and specified distributions” are not included in the contribution room calculation.
Over-Contributions
If you deposit more than the allowable contribution amount into a TFSA, this is considered an over-contribution. The CRA imposes a 1% per month tax penalty on the excess contribution until it is withdrawn, so it’s important to be mindful of your contributions.
Account holders should note that withdrawing money during the year doesn’t reduce the amount you’ve already contributed. If you mistakenly believe that withdrawing funds opens up additional contribution room and then contribute more money, you may end up over-contributing, resulting in tax penalties.
Taxes can also be applied for other reasons, such as contributions made by a non-resident or if prohibited or non-qualified investments are acquired within the account.
TFSA Withdrawals
When you withdraw funds from a TFSA, the amount you withdraw creates additional contribution room, but this new room is not available until the following year.
For instance, if Jane contributed C$5,500 in 2020, with an annual contribution limit of C$6,000, she would have C$500 remaining in the contribution room for that year. If she withdrew C$2,000, she couldn’t replace that amount within the same year since her available contribution room was only C$500. Instead, Jane could contribute an additional C$500 that year, and the C$2,000 withdrawal amount would be added to her contribution room for 2021.
Example of Carryover Contribution and Withdrawal Calculation
| TFSA Contribution Room in Jan. 2021 | $6,000 |
|---|---|
| Less 2021 Contribution | -$1,000 |
| Remaining 2021 Contribution Room | $5,000 |
| TFSA Contribution Room in Jan. 2022 | $6,000 |
| Plus 2021 Carryover Contribution Room | +$5,000 |
| Plus a 2021 Withdrawal | +$1,500 |
| Total 2022 TFSA Contribution Room | $12,500 |
TFSA Contribution Room Amounts
Even if you don’t need to open a TFSA, your contribution room accumulates yearly. Earnings and account value changes don’t affect it.
The annual contribution limits in Canadian dollars since 2009 are as follows:
- 2009-2012: $5,000
- 2013-2014: $5,500
- 2015: $10,000
- 2016-2018: $5,500
- 2019-2022: $6,000
Types of Investments Permitted
According to the Canadian government, the following types of investments are allowed in a TFSA:
- Cash
- Mutual funds
- Securities listed on a designated stock exchange
- Guaranteed investment certificates (GICs)
- Bonds
- Certain shares of small business corporations
It’s advisable to consult with a financial advisor or investment specialist to ensure that your chosen investments are permitted within a TFSA.
Pros and Cons of TFSAs
Pros:
- Your account’s earnings grow without being reduced by taxes, and all withdrawals are tax-free.
- You don’t need earned income to contribute to a TFSA.
- Unused contribution room carries over to subsequent years, allowing you to contribute more later.
- Carryovers apply retroactively to 2009 or the year you turned 18 (if after 2009).
- No mandatory withdrawals exist; you can take out any amount without penalty.
- Government benefits aren’t affected by the income you earn or withdraw from a TFSA.
Cons:
- Contributions aren’t tax-deductible.
- Contributions exceeding your contribution room are taxed as long as they remain in the account.
- Contributions made while you’re a non-resident of Canada are taxed at 1% per month until removed from the account.
- If taxes are due, a TFSA return must be filed by June 30 of the year following the taxable event.
- TFSA funds aren’t protected from creditors.
- Income earned within the TFSA doesn’t impact your contribution room for the current or future years.
How to Open a TFSA
Anyone who is a Canadian resident, 18 years or older, and has a valid Social Insurance Number (SIN) can open a TFSA. You can have multiple TFSAs, but the total amount you contribute to all your TFSAs must be, at most, your available contribution room for that year.
To open a TFSA:
- Look for financial institutions offering TFSAs (options include deposit, annuity, trust arrangement, and self-directed TFSAs).
- Apply for an account by providing your SIN, date of birth, and valid identification.
- Once your account is approved, the financial institution will register it with the CRA as a qualifying arrangement.
- Start funding your TFSA.
Note: Non-residents can open a TFSA, but any contributions made while a non-resident will be taxed at 1% per month until removed from the account.
TFSAs vs. RRSPs
While a Registered Retirement Savings Plan (RRSP) is specifically for retirement savings, a TFSA can be used for any savings purpose. Additionally, TFSAs differ from RRSPs in two key ways:
- Contributions to an RRSP are tax deductible and reduce your taxable income. In contrast, contributions to a TFSA are not tax-deductible.
- Withdrawals from an RRSP are taxed as income, while withdrawals from a TFSA are tax-free.
How Does the Tax Advantage of a TFSA Compare to a Regular Investment Account?
Consider two investors, Joe and Jane. Joe deposits C$6,000 into a regular investment account at the start of the year, earning 7% annually. Jane contributes the same amount to a TFSA, gaining 7%. After a year, both accounts grow to C$6,420. However, Jane can withdraw the full C$6,420 tax-free, whereas Joe would owe taxes on the C$420 earned.
Are Contributions to a TFSA Tax Deductible?
No, contributions to a TFSA are not tax-deductible. Your deposit money has already been taxed, so contributions don’t reduce your taxable income. However, with few exceptions, all withdrawals from a TFSA are entirely tax-free.
What Is the Early Withdrawal Penalty for TFSAs?
There is no penalty for withdrawing money from a TFSA. This flexibility is one of the main advantages of TFSAs, allowing you to withdraw funds at any time without incurring penalties.
The Bottom Line
Tax-Free Savings Accounts (TFSAs) offer a valuable opportunity to save and invest for any purpose, with account balances and withdrawals growing tax-free. Furthermore, TFSAs allow account holders to carry over unused contribution room to future years and add withdrawn amounts to the account the following year. This gives savers even more opportunities to build their account value over time.