Tax-Free Savings Account (TFSA)

Canadian investors now have a powerful tax-planning strategy (an initiative of the 2008 federal budget). You can invest after-tax money in eligible Tax-Free Savings Account investment vehicles without paying tax on any investment growth.

This is an ideal savings plan for: retirement, starting a business, a children's education, a vehicle, or an annual vacation. Why is this? You will not pay a penny's tax on your investment income when you withdraw it for spending. It's a great way to save and a great way to invest.

Who can contribute to a TFSA?

Canadian residents age 18 and over are eligible to contribute to a TFSA, up to $5,000 per year (contribution limits increase in subsequent years, subject to inflation). Contribution limits are not related to your income. Unused contribution room can be carried forward from year to year.

TFSA contribution room accumulates every year that you are 18 or older and a resident of Canada throughout the year.

Based on information provided by the issuers, the Canada Revenue Agency (CRA) will determine the TFSA contribution room for each eligible individual. Your annual contribution room will be indicated on your notice of assessment.

Any dollar limit from the current year that you do not use will be added to your TFSA contribution room for the next year.

Withdrawals, excluding qualifying transfers, made from your TFSA in the year will be added back to your TFSA contribution room at the beginning of the following year.

You can contribute to a TFSA without filing a tax return. However, the CRA will not provide you with a TFSA room limit as this amount is shown on your notice of assessment when you file a return. You should keep track of your room limit to ensure you do not contribute more than your TFSA room.

Let us look at the example assuming there is no indexing. In 2009, Bob is allowed to contribute $5,000. He contributed $2,000 for that year.

2009 TFSA dollar limit: ................. $5,000
2009 contributions:..................... - $2,000
unused TFSA contribution room
available for future years ............. $3,000

In 2010, Bob does not contribute to his TFSA, but makes a $1,000 eligible withdrawal from his account.

2009 unused TFSA contribution room ..... $3,000
2010 TFSA dollar limit............................ + $5,000
2010 unused TFSA contribution room
available for future years.......................... $8,000

Bob's unused TFSA contribution room for 2011

2010 unused TFSA contribution room
available from previous year.................. $8,000
2010 eligible withdrawal ..................... + $1,000
2011 TFSA dollar limit......................... + $5,000
2011 TFSA contribution room ............ $ 14,000

You cannot contribute more than your TFSA contribution room in a given year, even if you make withdrawals from the account during the year. If you do so, you will be subject to a tax equal to 1% of the highest excess amount in the month, for each month you are in an overcontribution position.

Making withdrawals

Depending on the type of agreement that you have for your TFSA, you can generally withdraw any amount from the TFSA at any time and for any reason, with no tax consequence. The withdrawals will also not affect your eligibility for federal income-tested benefits and credits.

Withdrawals, excluding qualifying transfers made from your TFSA in the year will be added back to your TFSA contribution room at the beginning of the following year.

Note:  A Qualifying Transfer is a direct transfer between TFSAs of the same holder, or the amount that is transferred directly to a spouse or common-law partner or former spouse or common-law partner, if the transfer relates to a division of property due to the breakdown of their marriage of common-law partnership.

Reporting

You don't need to report any contributions or withdrawals you made during the year on your tax return, though it will be reported on your annual Notice of Assessment.

Note: Canada Revenue Agency will determine and inform you of your updated contribution room on your Notice of Assessment providing you submit a tax return year by year.

Can I recontribute money withdrawn?

You cannot contribute more than your TFSA contribution room in a given year, even if you make withdrawals from the account during the year. If you do so, you will be subject to a tax of 1% of the highest amount in the month, for each month you are in an overcontribution position.

For example, in 2009, Bob invests $5,000 in a TFSA. Later that year, he withdraws $3,000 for a trip to Europe. Unfortunately, his plans change and he cannot go. Since Bob has no unused TFSA contribution room left, he will have to wait until the beginning of 2010 to deposit the $3,000 in his TFSA. If he does so earlier, he will have overcontributed to his TFSA and will be charged a monthly tax of 1% on the overcontributed amount.

How does the TFSA contribution affect my RRSP contribution?

Amounts withdrawn can be recontributed starting the very next year. Your TFSA contribution does not affect your annual RRSP contribution limit. The differences between a TFSA and an RRSP is that TFSA contributions are not tax-deductible and income earned in your TFSA—whether interest, other investment income, or gains—is tax-free!

What investments can I make through my TFSA?

Similar to an RRSP, eligible investments include cash deposits, GICs, mutual funds, stocks, and bonds.

What happens when I want to make a withdrawal from my TFSA?

You can withdraw funds at any time and for any purpose without incurring tax. Funds withdrawn will not affect your eligibility for federal income tested benefits such as Old Age Supplement, Canada Child Tax Benefit, or Guaranteed Income Supplement. Once money is within the plan, the principle and any earnings are never taxed again. All interest, dividend, and capital gains investment income, is normally taxed differently as income. The TFSA provides you with immediate tax relief from all tax scenarios. However, the extent of the potential tax savings is determined by the way that the various types of investment income are taxed outside of this account.

The tax sheltering of the TFSA, along with the ease of access to the funds, offers an excellent method to save while investing. Consider the money you can save in taxes compared to taxable investment accounts!

The TFSA and interest income. Interest earned by the TFSA is not taxable at your marginal tax rate (MTR). Thus, the TFSA is an excellent tax shelter for interest income because it will avoid full taxation at your MTR on all interest earned once invested.

Of the types of income earned—interest income, dividend income, and capital gains—interest income would normally be the least tax effective in a non-sheltered investment account; it therefore would generate the most tax savings within a TFSA.

The TFSA and dividend income. Dividend income is substantially more tax effective than interest income. Dividends are earned by holding preferred equities, dividend-paying common stocks, or dividend investment funds.

The TFSA and capital gains. Capital gains are likewise taxed more favourably than interest income in normal circumstances outside of registered plans and the TFSA. Only half of your capital gains, net of any losses, are taxable.

Capital gains also provide an opportunity for tax deferral because the gains are only taxable when the gain is “realized,” generally through the sale or transfer of the asset. You will not pay any taxes on the “unrealized” gains for as long as you continue to hold the investment.

From a TFSA perspective, the majority of capital gains potential will generally come from equities, although you may also realize some capital gains on bonds and mutual funds under certain circumstances.

How does the TFSA compare to the RRSP?

Here is where the tax differences get exciting. All income withdrawn from an RRSP is taxed at your marginal tax rate, now or in the future, regardless of its source at origin. Interest, dividends, capital gains, and return of capital are all fully taxed exactly the same way! But all of them grow tax free inside the TFSA and are free of taxation when taken out to spend.

Certainly, equities earning gains in a non-registered account get a benefit of being only 50% exposed to taxation. And any gains can be offset by capital losses. Not so with RRSPs. All capital gains earned in an RRSP and RRIF are taxed at your marginal tax rate when taken out. And bear in mind capital losses cannot be claimed with an RRSP.