A Tax-Free Savings Account (“TFSA”) is an account used for the purposes of holding registered investments or savings with tax-free gains. With a TFSA, there is a limit each year for the amount of money that can be contributed to the account. This account is considered to be one of the most important savings accounts for people, other than the RRSP. There are important items you should know about a TFSA, many of the basics are outlined in this article.
The government had introduced this in 2009 in order to motivate people to save as they do not pay taxes on the investment income earned within such an account or any amounts as they are eventually withdrawn, as they had already paid taxes on the amounts contributed.
A TFSA is able to contain any composition of eligible investments including cash, stocks, bonds, exchange-traded certificates, guaranteed investment certificates (GICs) and mutual funds. The growth of the investments in the account will not be subject to any taxes therein.
The requirements to open a TFSA are that an individual would need to be at least 18 years old and holds an eligible Social Insurance Number. The account holder is the only person able to contribute to the account, withdraw from the account, and make decisions on how the funds in the account will be invested.
The way the account works is rather simple. After opening a TFSA, an individual will only have to deposit money, and then purchase the investments they wish to own within this account. There is a maximum amount that an individual is able to contribute to the account which is known as the contribution limit and there are limits to the amount of contributions that can be made into the account each year. This limit varies from year to year, but the account, in essence, has a cumulative contribution limit as any unused portion from previous years are carried forward to the current year. It is also worth noting that only certain types of investments will qualify to be held within a TFSA.
The CRA holds information regarding the contribution room for a given tax year. There are many means to gain access to this information which include checking your CRA online account, quick access, calling their tax information phone service line, or calling their individual inquiries line. The fastest and most efficient way of the ones listed would be to access your CRA online account. Lastly, In opposition to a Registered Retired Savings Plan (RRSP), an individual is able to withdraw money from the account any time without a penalty.
As discussed, a primary benefit to a TFSA is the flexibility with the type of eligible financial instruments that can be deposited and how they can grow, earn interest, dividends, and capital gains free of tax during their lifetime. Withdrawals from the account are tax free and they can be deposited back in the account as well, but starting the following year in order to not impact their contribution limit.
Although there are many advantages of opening a TFSA, it also holds some limitations which include that if an individual over-contributes in their account during a given year, they will be subjected to a 1% penalty per month on the excess amount contributed. In addition, individuals are not permitted to day-trade stocks in their TFSA.
Difference between RRSP and TFSA
Although on the surface, an RRSP and a TFSA seem quite similar, they have key differences in their limits, tax-deductibility, and withdrawals.
With regards to an RRSP, the contribution limit is based on the earned income from the previous year up to a common maximum amount. However, a TFSA’s contribution limit is made up of a standardized limit for everyone each year plus any additional unused contribution room carried forward and withdrawal amounts from the previous year, regardless of any income earned.
In terms of tax deductibility, contributions in an RRPS are tax-deductible and thereby reduce taxable income. Investment income and returns are tax-free until the time of withdrawal. On the other hand, contributions from a TFSA are not tax-deductible and thereby do not reduce taxable income. Investment income and returns are sheltered from taxes.
Lastly, with respect to withdrawals, in an RRSP, they are included in the taxable income for an individual at the associated marginal income tax rate, and withdrawals are not able to be re-contributed. In contrast, withdrawals from a TFSA are not included in taxable income, and withdrawals can be re-contributed (ie. withdrawals create new TFSA contribution room in the following year.)
How many TFSA accounts can you have
Individuals have the option to hold as many TFSA accounts as they wish, however, the collective contribution room of all accounts is equivalent to the amount for one account. For example, the contribution room in 2020 is $6,000, meaning that regardless of how many accounts a person holds, this is their total contribution room. It is critical to understand by holding multiple accounts, it makes it difficult to monitor and maintain track of contributions.