What is a Tax-Free Savings Account (TFSA)?

Even if you consider yourself an individual with a high financial caliber, allow us to sound like your high school math teacher for a second when we tell you that it never hurts to check your work.

Although it may seem rudimentary, what we’re trying to say is this: the TFSA is a shining light and one of the most underutilized and beneficial parts of banking in Canada.

In this WealthRocket article, we’ll dive into an explanation of what exactly a Tax-Free Savings Account (TFSA) is. We’ll also cover why it is one of the best tools Canadians have at their disposal — provided they know how to use it.

A Tax-Free Savings Account (TFSA) is somewhat of an enigma on the Canadian financial scene. Although not truly a savings account in the purest sense of the term, a TFSA is recognizable as both a savings and investing account. It offers Canadian citizens an opportunity to make money off of the money they set aside, tax-free.

As mentioned above, the main benefit of a TFSA is to avoid paying taxes on interest or capital gains on savings or investments.

Tax-Free Savings Accounts (TFSA) can hold:

• Cash savings
• Stocks
• Bonds
• Exchange-Traded Funds (ETFs)
• Guaranteed Investment Certificates (GICs)
• Mutual funds
• Options

What makes a TFSA unique is its flexibility, which allows Canadians to access their money through withdrawals, without worrying about any financial penalties. That means you’re allowed to withdraw money tax-free as well.

In place of pushing penalties for early withdrawal, such as the case for a Registered Retirement Savings Plan (RRSP), Canadians are instead limited in how much they can add to their TFSAs through what is known as an annual TFSA contribution limit.

The government-set maximum contributions for a TFSA change every year, but they are generally around $5,000 to $6,000.

You are eligible for a TFSA when you turn 18, depending on the age of the majority in your province. The contribution room grows each year by the TFSA contribution limit set by the Canada Revenue Agency (CRA) Unused TFSA room carries over to the next year.

So, say, you turned 18 in 2009. Your TFSA contribution limit today will be $75,500.

If an individual goes above their TFSA contribution limit, the CRA will issue a penalty of 1% on the amount over the limit each month.

There is another thing to keep in mind concerning withdrawals, too: if you decide to withdraw within any given calendar year, that room is gone from your entire limit until the following year, when it resets.

The idea behind this is simple: since the total contributions of a TFSA have already been taxed when the income was earned, you are not taxed a second time when the funds are removed from your account. That’s why you will sometimes hear a TFSA referred to as a “tax-advantaged” account.

You can open a TFSA with any bank, credit union, robo-advisor, or online brokerage in Canada.

A good way to choose a TFSA depends on what you’ll use it for. If you’re using it for savings, try and find TFSA savings account with an interest rate of 1% or higher. If you’re using a TFSA for investing, find an account with lower management fees.

TFSAs are available to any resident of Canada who has a valid Social Insurance Number (SIN) once they turn 18, depending on the province in which they reside.

At the time of opening your account, you may require documentation that proves your Canadian residency, as well as your personal identification.

TFSAs and RRSPs have a lot in common, but they also have a lot that makes them different.

While they are both tax-deferring accounts used for saving and investing, a TFSA is intended for short-term savings goals and permits withdrawals at any time without penalty. On the other hand, an RRSP is intended for retirement savings and, as a result, penalizes early withdrawals.

Like a TFSA, an RRSP has a contribution limit that increases each year. RRSPs also hold savings and investments, which can grow tax-free.

It is also registered with the Government of Canada.

However, unlike a TFSA, RRSPs do not permit tax-free withdrawals and are taxable according to the amount of the withdrawal. Also, unlike a TFSA, the contribution room does not renew following a withdrawal. Finally, an RRSP has a few tax-free withdrawal programs, such as the Home Buyers’ Plan (HBP).

While RRSPs do not offer tax-free withdrawals, they do offer tax incentives. Contributing to your RRSP every year lowers your income tax for the following year.

In any case, using both accounts is excellent, and free to open with most financial institutions.

TFSAs come with a multitude of benefits that the average Canadian can use to their advantage.

Below, we’ll take a look at some of the most common benefits of a Tax-Free Savings Account.

1. Tax-free growth

Of course, one of the most redeeming qualities of the TFSA is that it allows your money to grow tax-free.

To clarify, interest or capital gains earned from savings or investments can grow tax-free. That means you won’t need to claim any earnings on your taxes as you would in non-registered savings or investing accounts.

TFSAs also permit tax-free withdrawals, which allow you to access your money as needed without facing any penalties.

2. Versatility

As mentioned earlier in this article, TFSAs are versatile and can hold various types of savings and investments, including cash savings, GICs, stocks, bonds, mutual funds, and ETFs.

So, if the total amount you’ve contributed is currently at $0, you can contribute to various types of accounts and have a diverse, tax-free portfolio.

3. Yearly contribution limit

At the beginning of each year since its introduction in 2009, the TFSA’s yearly contribution limit has increased yearly. At the beginning of each year, the contribution limit increases, allowing Canadians to place as much money in their TFSAs as possible. The average contribution room increase floats between $5,000 and $6,000.

Overall, a TFSA is one of the least complicated ways for the average Canadian to save money.

As long as you keep an eye on your contributions to ensure that you do not exceed the government-mandated limits, they are free and refreshingly easy to use. It pays to start saving as soon as possible.