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What Is A Tax-Free Savings Account (TFSA)?

A tax-free savings account (TFSA) is a way to save and invest money without paying taxes on the interest, investment gains or withdrawals.

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A tax-free savings account (TFSA) is a type of account where all contributions, interest, dividends and capital gains grow tax-free, and no taxes are charged on withdrawals. As the name suggests, a TFSA can hold cash like a savings account, but it can also house stocks, bonds and other kinds of securities. Since its introduction in 2009, the TFSA has become a popular way to save and invest money for a variety of financial goals including retirement, buying a home, travelling or building an emergency fund.

Understanding TFSAs

A TFSA is a type of registered account, which means it is given special tax-sheltered status from the federal government. TFSAs were created to incentivize Canadians to put away money for different savings goals without being taxed on earnings and withdrawals later on. To open a TFSA, you must be 18 or 19 years old – it depends on the age of majority in your province – a resident of Canada, and have a valid social insurance number (SIN). If you do live an a province where 19 is the majority age, you can still accumulate TFSA room starting at age 18.

When you invest in a TFSA, you contribute after-tax dollars, which means income tax on your money has already been deducted by the Canada Revenue Agency (CRA).

Once that money is inside of the TFSA, any interest and investment earnings can grow tax-free for life. Because you use after-tax dollars, there’s no type of tax deduction offered for contributing to a TFSA like there is with a registered retirement savings account (RRSP). TFSAs do have annual contribution limits, and any unused contribution room rolls over to the next year.

TFSA benefits

The TFSA offers a few advantages for savers and investors:

Tax-free compounding: As you add more money into the account, the interest and investment gains on those dollars start to benefit from compounding, which is when interest grows on top of already accumulated interest. Again, none of those gains are taxed.

Easy withdrawals: TFSAs can work like a savings account, where you can easily withdraw money at any time if needed. If your TFSA money is invested, it might be harder or take longer to withdraw. Be sure to check if your TFSA provider charges for withdrawals or transfers.

Flat contribution room: The CRA sets annual TFSA contribution limits, which are the same for everyone regardless of income.

Use your spouse’s TFSA: You can’t share a TFSA, but you can give your spouse or common-law partner cash, which they can then contribute to their own TFSA without any tax liabilities on your part.

TFSA drawbacks

There are a few drawbacks to consider before setting up a TFSA:

No protection from creditors: Assets held in a TFSA aren’t protected from creditors if you file for bankruptcy.

You lose contribution room if you move away: If you emigrate from Canada and are classified as a non-resident for tax purposes, you will not accrue contribution room during the years you live outside the country. However, there are a few exceptions, outlined later on, for non-residents and Canadian residents who move.

Penalties for over-contributing: You will be penalized for exceeding your total contribution limit. (That limit will continue to grow every year, so wait until January 1 before putting more money in.) If you have maxed out your room, you can save additional dollars in an RRSP, assuming you have room there, in a savings account or into a non-registered investment account.

TFSA investing

Besides cash, TFSAs can also hold a number of investments including stocks, bonds, guaranteed investment certificates (GICs), exchange-traded funds (ETFs) and mutual funds. You can open multiple TFSA accounts with different holdings and investment strategies, but you can’t exceed your personal annual contribution limit across all accounts.

If you open a TFSA and start contributing the year you turn 18, your money will have more time to compound and grow. But if you can’t save and invest until a bit later in life, that’s OK, too—any unused contribution room will keep rolling over year-after-year. Once you open a TFSA, you can hold onto it for the rest of your life.

How to set up a TFSA

TFSAs can be opened at banks, credit unions, caisses populaires, trust companies, investment firms or insurance companies.

If you’re ready to open a TFSA, here’s how to do it:

  1. Decide how you want to save or invest: A TFSA can be used like a regular savings account, where you deposit money and have it sit there accruing interest. The money is accessible if you need to withdraw it quickly, for example, in the case of an emergency fund. Your financial goals will influence how you manage the money in your account.
  2. Choose a financial institution: TFSAs are widely available through major banks and credit unions/caisses populaires, so take your time comparing accounts, interest rates, withdrawal rules and investment options to find the best account for your needs.
  3. Fund your account: Once your TFSA is open and ready to go, you can make your first contribution by transferring funds from an existing account, such as a chequing or savings account.

If you’re looking to invest, you can manage your own self-directed TFSA by setting up a trading account through a robo-advisor or discount brokerage, or get investment advice through a financial advisor. Each has different costs associated with trading, advising and managing your account.

Here’s what you should know about each approach.

Automated: Robo-advisors offer a set-it-and-forget-it approach by asking you a few questions, assessing your risk profile and using algorithms to appropriately invest your money. You’re normally invested in a broad section of the market, such as in an S&P 500 or S&P/TSX Composite Index-tracking exchange-traded fund. Robo-advisors have low opening balance requirements and are inexpensive, with fees much lower than the cost of a financial advisor (0.4%-1% of your investments).

Robo-advisors often require little human interaction, but many platforms provide some financial advice in the form of online tools or access to a financial advisor. They’re advantageous for hands-off investors who don’t want a DIY investment portfolio.

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DIY: A discount brokerage is much more hands-on. You can pick your own stocks, bonds or funds that you want to invest in and trading fees are low (from between zero to $10 per trade depending on the institution). They can be a good fit for investors who want to trade frequently, though trading fees can add up. Discount brokerages don’t offer any financial advice.

Financial advisor: A financial advisor is someone who provides financial planning advice and can, in many cases, invest money on your behalf. The fees for a financial advisor are generally higher than a robo-advisor or a discount brokerage–often 1% to 2% of the assets they manage.

Now that there are more low-cost options for investors, some financial advisors are only taking on higher net worth clients, often those with investable assets of $100,000 or above. Still, there are many advisors who will work with people across the income spectrum. They can be useful if you have a complicated financial situation, or if you need help budgeting.

TFSAs for non-residents

If you live in Canada and have a valid social insurance number (SIN) but are a non-resident, you can still open a TFSA. However, any contributions made by non-residents are subject to a 1% tax for each month the contribution stays in your account.

For tax purposes, a “non-resident” is anyone who “normally, customarily, or routinely” lives outside Canada, doesn’t have residential ties, and/or stays in Canada for less than 183 days in the tax year. However, residency is decided on a case-by-case basis, and there are exceptions based on secondary financial, social or familial ties.
If your residency status changes, TFSA rules change. If you’re a non-resident who becomes a resident of Canada, standard TFSA rules apply.

If you’re a Canadian resident who moves abroad and becomes a non-resident, you can still keep your TFSA. You won’t be taxed by the Canadian government on any earnings or withdrawals from your account, but you may have to pay foreign taxes. For example, U.S. citizens and green card holders must report yearly TFSA earnings on their personal U.S. tax returns.

Contribution room doesn’t accrue during years where you’re a non-resident of Canada. However, you can get that contribution room back if you return to Canada and re-establish residency.

TFSA contribution limits

TFSAs have annual contribution limits that may change from year to year. For 2020, the annual contribution limit is $6,000. Contribution room starts accumulating on January 1 of the year you turn 18. If you were at least 18 years old when TFSAs were introduced in 2009, your room would have started accruing that year.

You can find your TFSA annual contribution room information by logging into your online CRA account.
Any unused contribution room from one year and can be carried over to the next year. For example, if you were at least 18 years old in 2009, a resident of Canada and have never contributed to a TFSA, you would have $69,500 in accumulated contribution room as of 2020.

Here are the historical contribution limits:

  • 2009: $5,000
  • 2010: $5,000
  • 2011: $5,000
  • 2012: $5,000
  • 2013: $5,500
  • 2014: $5,500
  • 2015: $10,000
  • 2016: $5,500
  • 2017: $5,500
  • 2018: $5,500
  • 2019: $6,000
  • 2020: $6,000

TFSA over-contributions

If you exceed the contribution limit (even accidentally), you could get dinged with a tax penalty by the CRA. Every excess dollar you contribute is subject to a 1% penalty tax for every month it stays in your account. For example, if you over contributed by $1,000, you will be taxed $10 a month as long as that excess amount remains in your account.

TFSA withdrawals

TFSA money can be withdrawn at any time. When you withdraw funds, that amount is added back to your amount of available contribution room, but not until the beginning of the next calendar year. For example, if you withdraw $5,000 from your TFSA on November 30, you’ll get that contribution room back, but not until January 1.

If your money is invested, it may take a few business days for withdrawals to be processed. If your money is locked into a non-redeemable investment such as a GIC, you won’t be able to access that money until the maturity date.

If you lose money on any investments held in your TFSA, the losses aren’t considered a withdrawal and won’t affect your contribution room. A qualifying transfer from one TFSA to another also isn’t considered a withdrawal.

TFSA vs. RRSP

Before the TFSA arrived in 2009, there was one other tax-efficient way to save money: the registered retirement savings plan (RRSP). Like a TFSA, an RRSP is a type of registered account that can hold cash and investments and has certain tax benefits.

The two are often compared, but you don’t have to choose between using one or the other. Both can be used as part of your financial plan to accomplish different savings goals. However, there are a few big differences between how TFSAs and RRSPs work:

Contributions: TFSA contributions are made with after-tax dollars, and withdrawals are tax-free. TFSA contributions aren’t eligible for income tax deductions. RRSP contributions are made with pre-tax dollars, and can be claimed as a tax deduction on your annual income tax return. RRSP withdrawals are taxed as income, with the idea being that you’ll remove your money in retirement when you’ll be in a lower tax bracket.

Contribution limits: TFSAs have a set annual contribution limit. With RRSPs, the annual contribution limit is the lesser of 18% of your income from the previous tax year or the annual maximum dollar limit set by the CRA (for the 2020 tax year, it’s $27,230).

Age limits: You can open a TFSA the year you turn 18 and hold it for life. You can open an RRSP at any age, as long as you have a valid SIN and file income taxes. However, you must close your RRSP account when you turn 71. After that, you have three options: take it as a lump sum of cash, convert it into an income-producing account such as a registered retirement income fund (RRIF), or buy an annuity. You can also do some combination of the three.

Withdrawals and taxes: TFSA withdrawals aren’t taxed; RRSP withdrawals are taxed. If you withdraw money from an RRSP before retirement, you’ll also be charged a federal withholding tax.

Social benefits: TFSA withdrawals aren’t considered income because they’ve already been taxed, so they won’t affect income-tested seniors’ benefits such as the Guaranteed Income Supplement (GIS) or Old Age Security (OAS). RRSP withdrawals are considered income, and withdrawing a lot of money from an RRSP or RRIF can trigger clawbacks on GIS and OAS payments.

TFSA vs. savings account

A TFSA can function like a savings account in many ways, but a savings account can’t function like a TFSA. Much like the TFSA vs. RRSP debate, you can use different types of accounts in conjunction for a variety of financial goals. Here’s a look at a few of the differences between TFSAs and savings accounts:

Contribution limits: TFSAs have annual contribution limits; savings accounts don’t.

Interest and taxes: TFSAs typically offer lower interest rates on cash than high-interest savings accounts. However, regular savings accounts don’t have any tax-sheltered benefits, and you have to pay income tax on any interest earned.

Investing: TFSAs can hold different types of investments, but savings accounts can only hold cash deposits.

Withdrawals: As mentioned above, TFSA earnings and withdrawals won’t affect any government old-age benefits. However, any interest earned from a savings account must be reported on your annual income tax and benefit return. If you earn a significant amount of interest from a savings account, you may end up having to repay some of your government benefits.

Overall, TFSAs are a flexible option to save and invest without worrying about any future taxation on earned interest, investment gains or withdrawals. A TFSA can be used for both short and long-term financial goals, and can also be a useful emergency fund. When opening a TFSA, consider what you’re saving for, your time horizon, and how accessible you want your money to be.

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Writer

Jane Switzer is a Toronto-based personal finance writer and editor. Driven by her interest in financial journalism, she completed the Canadian Securities Course and has covered topics including saving, debt, credit scores and investing for websites like Ratehub. Her work has appeared in several publications such as the National Post, Globe and Mail, Toronto Star and Maclean's.

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