What is a Tax-Free Savings Account?
A Tax-Free Savings Account, or TFSA, was first introduced in Canada in 2009. It is a type of savings account where you do not have to pay tax on the interest you earn. You can use this account for both saving money and investing it. Let’s say you want to invest in stocks. You open a TFSA, buy stocks for an amount within your contribution limit and wait for their value to increase. Over time, the book value of your investment may increase to a huge amount. It may even become greater than your contribution limit. Still, you will not have to pay taxes on any gains. What is even better, you can withdraw it at any time tax-free as the withdrawals are not added back to your income.
You can grow your money in a TFSA account faster than in any other savings account.
A Tax-Free Savings Account offers you the possibility to grow your money faster.
How to open a Tax-Free Savings Account?
Opening a TFSA is similar to opening any other savings account, provided you are eligible. You can open a TFSA in many types of financial institutions like banks, credit unions, insurance companies, investment firms, discount brokerages and also with the use of robo-advisors. Most people open a TFSA with big banks, like Scotiabank or BMO, but there are smaller banks or credit unions that often offer better interest rates on deposits.
Are you eligible for a Tax-Free Savings Account?
To be eligible, you need to meet these criteria:
- be a citizen or resident of Canada (or an eligible non-resident)
- have a Social Insurance Number (SIN)
- be 18 years old or older
If you are a non-resident, you may still be able to open a TFSA, as long as you meet the other eligibility criteria. However, if you are a non-resident, you may have to pay a 1% tax on some contributions.
You start accumulating contribution room when you are 18 years old. In most provinces, except British Columbia, New Brunswick, Newfoundland and Labrador, Nova Scotia, Northwest Territories, Nunavut, or Yukon, you can open a TFSA account on the day you turn 18 and claim the total contribution amount for that year. To give you an example, let’s say that you turn 18 on August 12, 2022. The total contribution limit for 2022 is $6,000. You can contribute up to $6,000 on the day you turn 18 when you open a TFSA account.
If you live in British Columbia, New Brunswick, Newfoundland and Labrador, Nova Scotia, Northwest Territories, Nunavut, or Yukon, you need to wait until you turn 19 to open your TFSA, but on the day you turn 19, you can claim the amount equal to that year and the previous year’s contribution limit. For example, if you turn 19 on August 12, 2022, you are able to claim up to $12,000, as the contribution limit for 2022 is $6,000 and the contribution limit for 2021 is also $6,000.
TFSA Contribution Limit
The contribution limit is the amount of money you can contribute each year to your TFSA. You cannot exceed that amount. Below are the yearly amounts in dollars since 2009:
- 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
- 2021 – $6,000
- 2022 – $6,000
- 2023 – $6,500
TFSA Contribution Room
The contribution room is the sum of all the contribution limits that you have accumulated since you became eligible for a TFSA. To illustrate, if you became eligible for a TFSA in 2009, your total contribution room in 2023 is $88,000. ($88, 000 is the sum of all the contribution limits since 2009).
Even though, a total contribution room a person may have is $88,000, it is possible to have more money than that in the TFSA. It is because you can open a TFSA for investments and your money can grow in it, so that the book value of your TFSA may exceed your contribution room.
How to use a TFSA?
You can use a TFSA account in many different ways. Some people use it as a short-term savings account (for example to save for vacation or a downpayment for a house), or as an emergency fund while others use it for long-term goals like saving for retirement.
Types of TFSAs
The type of TFSA account you open depends on your goals. Basically, there are three types of TFSA accounts that you can open:
- High-interest TFSA: this account offers a higher interest and works well as an emergency fund or short-term savings account. You can grow your money tax-free in it.
- A Term Deposit TFSA: a term deposit or GIC (Guaranteed Investment Certificate) is a type of investment account where you lock away your money for a period of time and you earn a fixed amount of interest. There are redeemable GICs where you can cash out earlier in case of emergencies, and non-redeemable GICs where you cannot cash out earlier or you lose all interest earned.
- TFSA Investment Account: an account used for investments in bonds, stocks, ETFs, mutual funds, etc. This account can be managed by an investment firm or you can manage it yourself.
Even though a TFSA is a savings account, it can be used as an investment account. Any amount you invest, up to your contribution limit, grows tax-free within it.
TFSA Withdrawals
In most cases, you can withdraw money from your TFSA at any time without penalty. That excludes money invested in GICs. If you invest your money in a non-redeemable GIC, you will lose the interest you earned on your investment, if you withdraw it earlier.
If you withdraw funds from a TFSA, and you want to replace it later in the year, you may have to recalculate your contribution limit. The withdrawn amount is added back to your contribution limit the next year after the withdrawal, so if you have always contributed the maximum amount to your TFSA, you may have to wait until the beginning of the next year to re-contribute the withdrawn amount. Otherwise, you will pay 1% tax every month on the over contributed amount.
When you may need to pay taxes on your TFSA
Even though TFSA is almost always non-taxable, there may be situations when you will be required to pay tax. That includes:
- When you exceed your contribution limit, you will need to pay 1% tax a month on the amount that exceeds your contribution limit.
- If you become a non-resident for tax-purposes, you are not eligible for new contribution room, so if you keep contributing to an existing TFSA and you exceed the contribution limit, you will be taxed on the excess amount.
- If you use your TFSA for business purposes. For example, if you decide to day trade (buy and sell stocks on a regular basis to gain profits), the CRA may consider it a business, and tax all your capital gains at the same rate it taxes your other income.
Is a TFSA good idea for you?