Tax-Free Savings Account

A Tax-Free Savings Account (TFSA) is a type of savings account where the profit from investing money by a depositor is tax-free throughout his or her lifetime. Suppose you deposit $10,000 under this saving system and purchase some shares by it. Now, if the value of the capital stock for you is to be grown fivefold, then you no longer have to pay any tax to the government for $40,000 capital gains. There is also no restriction for withdrawal from the account and you can withdraw money from your TFSA account any time and use it for whatever purpose you want.

TFSA was first introduced in 2009 with the permission of the Government of Canada to inspire Canadians to save and invest for their futures. Shortly after introduction of TFSA by Canadian government, TFSA became one of the most popular investment vehicles for Canadian. The terms and advantages of TFSA make it a proper tool for saving and investing, especially for medium and long-term goals such as for wedding expenses, buying a car, buying a house, or even boosting capital. The main differentiation between TFSA and typical bank accounts such as checking or savings accounts where only cash can be kept is that with TFSA you will have a wide range of investment options such as stocks, bonds, investment funds, term deposits, and so forth. Moreover, any capital gains in TFSA is fully tax-free. Despite the opportunity that TFSA presents, this account is not without limitation.

Terms, provisions, and restrictions of using the TFSA account

  • Anyone over the age of 18 who is a permanent resident of Canada or a Canadian citizen can open a TFSA account, without a need for having a job or income.

  • The amount you can deposit into your TFSA account annually is a certain amount and you are not allowed to deposit more than this amount. If you do deposit more than allowed, you will have to pay a fine. It is worth mentioning that you are not forced to deposit into your TFSA account up to the limit determined each year. When you failed to contribute into your account in some years, your contribution limit will be accumulated and transferred to later years and will not expire.

The table below shows the allowable subscription limit for the TFSA account from its first introduction in 2009 until this year (2020).

The rate of allowed contribution each year (Canadian dollars)
2020
6000
2019
6000
2018
5500
2017
5500
2016
5500
2015
10000
2014
5500
2013
5500
2012
5000
2011
5000
2010
5000
2009
5000
Total unit 2020
65900

The above figures are for all Canadians and are not dependent on income or other provisions. For example, if you were a Canadian citizen or a permanent resident in Canada over the age of 18 in 2009 and had no contribution to your TFSA account till today, now you are permitted to contribute up to $69,500. But, if you have been a Canadian citizen from 2009 or have been in Canada but less than the age of 18, then you are allowed to contribute only from the years when you met all the provisions (age and residence). For example, if you have immigrated to Canada in 2015 and been over 18 at the time, you can apply for a contribution of up to $38,500. However, the best way to know the highest allowable rate for contribution to your TFSA account is to open an account with Canada Revenue Agency (CRA). This account enables you to view the remaining allowable contribution limit to your TFSA and Registered Retirement Savings Plan (RRSP).

Unlike the RRSP account, TFSA does not offer tax rebate advantage. That is the money you deposit into this account will be from your net income. However, upon transferring money into the TFSA account and investing in it, the resulting profits will always be tax-free.

Note: Tax exemption for RRSP account is only in effect while the money stays in RRSP. Upon the withdrawal of capital from this account, you should pay tax on the profit & principle. Your financial contributions to your RRSP account are all tax-deductible. For example, if you get $40,000 and deposit $5,000 of it into your RRSP account at the end of the year, the government will re-calculate your annual tax just for $35,000 and the tax overpayment for that year will be refunded to you. In this case, the tax difference will be about $1,000, which will be refunded to you. However, there is no possibility for tax relief or return in the TFSA account.

Overall, for the RRSP account, the return on investment is tax-deductible as long as it is inside the account. Upon withdrawal, the tax must be paid. However, for the TFSA account, profits gained within this account are permanently tax-free. You can use the money in this account (initial investment plus its gains) at any time without paying taxes.

For the RRSP account, you will be provided with the tax-deferral possibility, however, you will need to pay back tax if you take out your money. For the TFSA account, you cannot enjoy the tax-rebate, but you will never pay tax for any appreciation of your capital.

A wide range of investments can be made under the TFSA account. Types of stocks, bonds, mutual funds, GICs, bank deposits, and more are some of the kinds of investments you can make in your TFSA account. It is even possible to keep cash in your TFSA account, although it does not make sense. Due to the nature of this account since the allowable dollar contribution is limited, and the gains are tax-free, it is recommended to keep investments that come with a high capital appreciation potential. For example, if you purchase a $100,000 one-year GIC from your bank with a 1.5 percent interest rate, you will have a profit of about $1,500 at the end of the year. The tax on this $1,500 shall be paid according to your tax bracket if kept outside registered accounts. Suppose you have a median income and are in the tax bracket of 35%. For this, you shall pay $525 to the government as a tax on your gains. Now, if you keep the same $100,000 of GIC in your TFSA account, you no longer need to pay any taxes.

Note: The above figures are just an example. As explained above, the highest possible rate of contribution in 2020 is $69,500, and practically no one can deposit $100,000 into TFSA. This means, even depositing $100,000 of low-profit investments like GICs in a TFSA account will save you only a few hundred dollars. Thereby, it is better to always keep more risky investments with a higher profit potential (e.g., stocks) in this type of account. In general, if you are a pretty cautious investor who makes practically no investment other than bank deposits and secured GICs or your total capital is small, you can deposit all of your capital into the TFSA account using low return investments without any concern.

  • Process, time, and rate of contribution to the TFSA account. The rate of your annual contribution to the TFSA account is equal to the allowable rate of the same year plus the sum of free contribution room of previous years that you did not use. If you contribute to the TFSA account more than your allowable rate, then you will be fined 1% of your excess contribution for every month you keep money in TFSA. When contributing to your account, note that if you have withdrawn from your TFSA account during the year, the allowable room will not be automatically reinstated. For this, you shall wait until the next year for the withdrawal to be re-added to your authorized limit.

Example: Suppose you have a $20,000 TFSA allowable limit and you have deposited all of it over the years. Now in the middle of this year, you suddenly need the money and would like to withdraw $10,000. Then, your problem gets solved in a week later and you want to reinvest the withdrawn money. You cannot technically do this and shall wait until next year. If you fail to wait, you will be fined for this re-contribution. Next year, you can re-deposit the $10,000 into your TFSA account plus the allowed limit for the new year ($5,000 i.e.). For example, if you withdraw $10,000 in late December, you only need to wait a few days to re-deposit, but if you withdraw it early in January, you shall wait nearly a year before you can re-deposit it into the TFSA account.

As another example, suppose your allowable limit is $30,000 and you have deposited $20,000 into your TFSA account. If you withdraw $10,000, you can re-deposit into your TFSA account the following week, since practically you still have $10,000 free capacity for that year even before withdrawing that money. Note that by re-depositing that $10,000 into your TFSA account, you have the same $20,000 in your previous account but according to the tax office, you have filled out your contribution limit for this year and shall wait until next year for the re-addition of that 10,000$ withdrawal into your account. In general, the maximum value you can contribute to a TFSA account is the rate you are qualified for at the start of the year, plus any withdrawal or not-used contributions of previous years.

  • Type of contribution. For self-direct TSFAs, in most cases, your initial contribution is in cash. Upon transferring your capital into the TFSA account, you can buy all types of investments you want. The advantage of cash contribution is the simplicity of calculating the allowable rate. The second type of contribution is “contribution in kind”, which is when you already have shares or similar items for investment and aim to transfer them to your TFSA account. But the amount considered is equal to the market value of those shares at the time of transfer, not the amount you originally paid. For example, if you bought $10,000 worth of stock a few years ago, with a current worth of $25,000, and you want to transfer it to your TFSA, the amount that the tax office will consider will be its current market value of $25,000. For the transfer of no cash capital, be sure to consider the current value of that capital and your allowable rate of contribution.

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