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Tax-Free Savings Account (TFSA)

Launched in 2009, the Tax-Free Savings account (TFSA) has become increasingly popular among Canadians. A TFSA allows you to save or invest a set amount of money each year throughout your life, with any income gained in the account being generally tax-free. Learn more about tax-free savings accounts and what you should consider when investing in one below.

While the name implies that a TFSA is simply a savings account, in actuality, it can be a very powerful tool to grow your wealth through investing. Since 2009, any Canadian over 18 became eligible to open a TFSA with a contribution limit that started at $5000. Since then, the Canadian Government has provided additional contribution room to all Canadians, which now totals at $75,500 in 2021 for those 18 and over, since its inception. Most types of investments can be held in a TFSA, including stocks, bonds, exchange-traded funds and mutual funds, but you should always check with your financial institution, dealer or portfolio manager before investing in something to make sure it is eligible.

Advantages of a TFSA

The main benefit of a TFSA is that your investment gains within the account are all yours. When comparing it to a non-registered account, in which you would have to pay capital gains, dividend and investment income tax, the tax savings on your TFSA returns could be considerable over time.

Difference between a TFSA and a Registered Retirement Savings Plan (RRSP)

TFSA and RRSPs are both incredible vehicles for your investments with merits and limitations that might make one or both more suitable to your life and financial goals. The significant difference between a TFSA and an RRSP is that TFSA is tax-free, while RRSP is tax-deferred. When investing in a TFSA, your investment gains will not be taxed upon withdrawal. On the other hand, RRSP provides you with an immediate tax benefit by reducing your taxable income by the amount you contribute to your account. With an RRSP, the money you are investing today is not taxed, but instead will be taxed once you make a withdrawal. This withdrawal will likely be when you are retired and your income and tax bracket are assumed to be lower than in your working years.

When comparing the two accounts’ functionality, TFSA provides more flexibility for short-term and long-term savings, whereas RRSP was designed for retirement. Withdrawing money from your RRSP for a vacation, for instance, would be subject to withholding tax, even worse, that contribution space would be permanently removed from your RRSP. In a TFSA, your withdrawal would not be taxed, and the amount withdrawn readded to your contribution limit the following year.

Considerations when investing in a TFSA

Contribution limit based on your age
The available TFSA contribution room for you starts whenever you turn 18. If you turned 18 after 2009, your contribution room will be smaller than the total $75,500 in 2021. Before you start investing, you should review the available amount through your account on the Canadian Revenue Agency (CRA) website. It is also important to consider your contribution limit every year to ensure you do not over contribute to your account. Any amounts over your contribution limit will be taxed at the rate of 1% each month it was over the limit.

Investment losses
How your TFSA changes in value can drastically change how much or how little you can contribute in the future. If you invested $5000 and it grew to $10,000 when you withdrew your money, you would have the $10,000 plus the following year’s contribution amount to recontribute back into your TFSA. If instead, your $5000 investment dropped to $1000 and you withdrew it from the TFSA account, you would have only $1000 plus the following year’s contribution amount to deposit in your account—a permanent loss of $4000 in contribution room.

Day-trading may have your earnings taxed
Day trading is a form of trading in which an investor buys and sells securities within the same trading day. The CRA sees day trading as a business and, if conducted within a TFSA, taxed as such. The CRA considers the duration of holdings and the frequency of the transactions within the account to determine if you should be taxed.

Foreign withholding taxes
Foreign dividend-producing investments in your TFSA may be subject to withholding tax. The withholding tax rate and any exemptions available depend on Canada’s tax treaty with the country in which the public company you invested in resides. For instance, US dividend-paying stocks, ETFs, or Canada-based mutual funds that own US stock incur a 15% withholding tax.

Withdrawal limitations
TFSAs allow you to withdraw your money at any time without penalty but have an important caveat. Any withdrawals, excluding qualifying transfers and specified distribution, from your TFSA this year will only be added back to your TFSA contribution room the following year. If you do not keep track of your contribution limits when withdrawing, you may inadvertently over contribute to your account and receive penalty taxes.