What is a Tax-Free Savings Account?

You’re likely no stranger to the savings account options offered by most lenders. You can get basic savings accounts, high interest savings accounts, business savings accounts, youth savings accounts, and the list goes on and on. However, in the 2008 federal budget, Jim Flaherty (the former finance minister of Canada) introduced a savings account unlike any other: the tax-free savings account (TFSA).

Launched on January 1, 2009, TFSAs have quickly grown to become one of the most popular, and also most widely misunderstood, accounts chosen by Canadians who want to save and invest their money. Here’s an introduction to how they work and why you should have at least one in your investment portfolio.

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What is a tax-free savings account?

TFSAs are registered savings accounts that allow Canadians to earn investment income and withdraw money tax-free. Sounds simple enough, right? And it is – for the most part. However, TFSAs do come with some restrictions; most importantly, how much you can contribute. Understanding the intricacies of how TFSA contributions and withdrawals work is something many Canadians still fail to grasp , so we’ll try to explain it here1.

How much can you contribute to tax-free savings accounts?

The maximum amount you can contribute to your TFSA each calendar year is determined by your TFSA contribution room. When TFSAs were first introduced in 2009, the contribution room was set at $5,000 per year. In 2013, that increased to $5,500 per year. Now in 2015, you can contribute up to $10,000 every year. If you’re a Canadian resident2, have a valid social insurance number and have been 18 years of age or older since before 20093, your total TFSA contribution room so far is:

Year Contribution Room
2009 $5,000.00
2010 $5,000.00
2011 $5,000.00
2012 $5,000.00
2013 $5,500.00
2014 $5,500.00
2015 $10,000.00
Total So Far $41,000.00

What happens if you don’t contribute the full amount each year?

If you don’t contribute the maximum amount each year (known as “maxing out” your TFSA), any amount leftover is carried forward to future years. For example, if you only contributed $3,500 in 2009, how much could you carry over and contribute in future years?

Example: Determining Available Contribution
$5,000 Contribution Room in 2009 $3,500 Your Contributions =
$1,500 Extra Room Carried Over

You’d have $1,500 carried over that you could contribute in future years. That means you could either contribute a maximum of $6,500 ($5,000 + $1,500) in 2010, or only contribute some and continue to carry room forward. For every year you can’t max out your TFSA, the contribution room is carried forward, so you don’t have to worry about ever losing that room.

Fun Fact: You can have as many TFSAs as you want! However, the total amount you contribute to all your TFSAs cannot be more than your TFSA contribution room.

What does/does not count as a contribution to your tax-free savings account?

Here’s where some of the confusion starts to come in: what counts as a contribution to your TFSA and what doesn’t?

  • Regular cash deposits do count as contributions
  • Investment income earned does not count as a contribution
  • Replacement/re-contribution of amounts previously withdrawn from your TFSAs do count as contributions
  • Qualifying transfers (from one TFSA to another) do not count as contributions (but must be completed by a financial institution)

Also, note that you, as the account holder, are the only person who can contribute to your TFSA. Someone could give you money to do so, but you still can’t contribute more than your total contribution room allows.

When tax-free savings account contributions may get taxed

Whenever you contribute funds to your TFSA, your lender will ask you to confirm that you know the amount is not more than your total contribution room. You have to select this box and take responsibility for whether or not that’s actually true.

If you ever contribute more than what’s left in your total TFSA contribution room, the Canada Revenue Agency (CRA) will determine that you’ve over-contributed, and charge you a penalty tax equal to 1.00% of the excess amount you’ve gone over, and for each month you stay in that excess position. For example, if you contributed $1,000 more than you were allowed to, and your TFSA held that balance for the last 6 months of a calendar year, your penalty tax would be:

Example: Determining Over-Contribution Penalty
$1,000 Over-Contribution Amount 6 Months Left in Year 0.01 1.00% =
$60 Penalty Tax

You’d have to pay the CRA $60 for going over your total TFSA contribution room. While this example may not seem like a lot, some returns on TFSAs are low, which means this tax could wipe out a good portion of your earnings for the year. For that reason, it’s important to keep track of your total TFSA contribution room.

What happens when you withdraw funds from tax-free savings accounts?

Depending on the type of TFSA you have, you can withdraw your savings anytime (it just may take a couple days, if it’s held in an investment) – and you can use the money for whatever you want.

The withdrawal you make does not reduce your contribution room for that year. For example: If you maxed out your TFSA in 2009 and 2010 (so you had $10,000 in savings), and you withdrew $2,000 in 2011, you were still allowed to contribute $5,000 that year.

Any amount you withdraw, however, gets added back to your contribution room the following year. So, the $2,000 you withdrew would be added back to your contribution room in the next year – 2012 – so you could contribute $7,000 that year instead of the usual $5,000, or just continue to carry that available room forward until you had enough money to max out your TFSA again.

Since the inception of TFSAs, there have been countless stories in the media about Canadians getting hit with penalty taxes for making withdrawals and then over-contributing to their TFSAs afterwards (the fee for which is explained above). Unfortunately, there’s no simple solution to this problem, other than to never withdraw funds and just simply max out your TFSA each year. The banks are not responsible for keeping track of your total contribution room – you are. If you call the CRA, they will be able to tell you the total amount of unused contribution room you have.

Can you transfer funds between tax-free savings accounts?

One more thing to consider about contributions and withdrawals: transfers from one of your own TFSAs to another, as well as between accounts when a marriage or common-law partnership dissolves, are considered “qualifying transfers”. If completed by a financial institution, they are not counted as contributions and will have no tax implications. However, if you withdraw and re-contribute the funds yourself, it could look like a contribution. And, if you’ve already maxed out your contribution room, you may be subject to a penalty (as outlined above).

Now, let’s move onto the fun stuff!

What types of tax-free savings accounts exist?

Despite the name, a TFSA isn’t always just a regular cash savings account. Similar to RRSPs, TFSAs can hold investments, such as mutual funds, certain stocks, bonds, and guaranteed investment certificates. For this reason, it’s not uncommon for people to have a number of TFSAs in their investment portfolio.

What are the advantages of using a tax-free savings account?

The advantages of TFSAs are obvious:

  • Investment income earned is tax-free
  • Withdrawals made are tax-free
  • Unused TFSA contribution room is carried forward
  • Any withdrawn money can be re-contributed to a TFSA the following years, and
  • You can choose from a wide range of investment options.

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What are the disadvantages of using a tax-free savings account?

Of course, despite the fact that it’s a registered account, there’s one drawback of TFSAs:

  • Unlike RRSPs, contributions are not deductible for income tax purposes.

As well, if you’re not careful about monitoring your contributions and withdrawals, you could potentially get dinged with a penalty tax for over-contributing to a TFSA (as outlined above).

Why use a tax-free savings account?

Canadians use TFSAs to help them save for a number of short-term and long-term goals. In the short term, some may choose to use a regular TFSA to save for things like an emergency fund, vacation, car or home. If you have time on your side, you may want to use an investment TFSA to save for something bigger, like extra retirement savings.

It’s advantageous to use a TFSA to save for pre-retirement needs, given the absence of tax consequences on withdrawals, and the ability to avoid the use of your RRSP contribution room for non-retirement savings needs.

Recognizing that many Canadians use TFSAs as short-term savings accounts, and withdraw the money often, the federal government decided that the full amount withdrawn could be re-contributed to a TFSA in subsequent years.

How to choose the best tax-free savings account

Before you start using our tax-free savings account comparison tool, you should ask yourself two questions:

  • How much do you need to save and for what? For example: Are you saving $3,000 for a vacation, $10,000 for an emergency fund, or an unknown (but much larger) amount for retirement?
  • How long will you be saving for? The length of time you think you’ll be saving for should influence which type of TFSA to get. Essentially, the longer period of time you have, the greater the risk you can take with your investment.

Once you know the answers to these questions, you can start comparing TFSAs until you find the best one for you; this is when you can start to compare interest rates and/or potential returns, to ensure you choose one that will help you achieve your financial goals that much sooner.

References and Notes

  1. http://www.cbc.ca/news/business/tfsa-withdrawal-rule-keeps-catching-unwitting-canadians-1.2733001
  2. The only other time you would not be eligible to accumulate the contribution room for a specific year is if you were non-resident in Canada for the entire year.
  3. If you turned 18 after 2009, you would only be eligible to accumulate the contribution room for every year you’ve been the legal age – the amount is not prorated for partial years. For example: If you turned 18 in 2011, your total TFSA contribution room would be just $26,000 so far ($5,000 from 2012 + $5,500 from 2013 + $5,500 from 2014 + $10,000 from 2015).