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Melanie Lambrick/The Globe and Mail

Tax-free savings accounts are a relatively recent addition to Canadians’ financial tool kit. They may be not as well known – or understood – as other investment tools, but TFSAs offer an easy way for Canadians to accumulate wealth and plan for their financial goals. Here’s a primer on the basics of a tax-free savings account, along with insights from personal finance experts.

What is a TFSA in Canada?

A TFSA, or tax-free savings account, is an investment account and – as the name suggests – a tax shelter. A TFSA can hold cash, guaranteed investment certificates, mutual funds, index funds, exchange-traded funds or other investment products.

Unlike a registered retirement savings plan, which is also an investment account, the TFSA has no associated tax deduction, meaning contributing to it will not help you pay less in taxes right away. However, while RRSP withdrawals are taxable, money you take out of your TFSA is not subject to taxation.

The TFSA was introduced in 2009 as an additional savings vehicle for Canadians. In his budget speech, then finance minister Jim Flaherty called it “the first account of its kind in Canadian history.” In 2009, there were 4.8 million TFSA holders in Canada; by 2017, that figure had risen to 14.1 million. According to a BMO study released in January, 63 per cent of Canadians have a TFSA account, with average holdings of $34,917.

How does a TFSA work?

The TFSA is an investment account with a yearly contribution limit. The contribution limit is the maximum figure you’re allowed to add to the account.

Once money goes into a TFSA, gains become off limits to the Canada Revenue Agency. In other words, whether you’re earning interest, dividends or other kinds of investment income within the account, you do not have to pay income tax on those earnings. This is true whether you leave the money in the account or withdraw it.

You can open a TFSA account in many different ways. Banks and other financial institutions, for instance, offer TFSA products that might include high-interest savings accounts, mutual funds, GICs, or self-directed investing accounts where you can select your choice of ETFs, stocks, bonds and more. Your place of employment might also offer a group TFSA plan.

TFSA accounts are available to any resident of Canada who is 18 or older and has a valid social insurance number. Non-residents can hold existing TFSA investments, though any contributions made while a non-resident are subject to a 1 per cent tax, and contribution room only accumulates for residents.

How much can I put in my TFSA per year?

The government sets an annual contribution limit, which is indexed to inflation in $500 increments. The contribution limit applies to all Canadians equally – unlike RRSP limits, it is not related to your earnings. In 2023, the annual limit is $6,500.

Contribution limits are cumulative, meaning that if you don’t deposit the maximum in one year, you can make up for it in following years.

TFSA contribution room calculator

If you make withdrawals from your TFSA, you can recontribute the same amount, but not in the same year you took the money out. For instance, if you withdraw $10,000 in 2022, you can recontribute that $10,000 – in addition to the regular annual limit – in 2023 or later.

Keep in mind that your limit applies across all TFSA accounts you might have. While you can hold TFSA investments at multiple institutions, your contributions must be within the annual limit when added together.

What investments should I put in my TFSA?

The purpose of a TFSA is to avoid paying tax on investment income, says Investor Clinic columnist John Heinzl. Therefore, it makes sense to use your TFSA room for stocks, ETFs, mutual funds or fixed-income securities with higher yields so you can eliminate tax on the interest, dividends and capital gains. That said, Mr. Heinzl notes that if you have plenty of room in your TFSA, you can also keep low-yielding cash in the account.

Laurie Bonten, senior investment adviser with Wellington-Altus Private Wealth in Winnipeg, agrees. “For most cases, the highest-growth investments, an example might be stocks, should be tax-sheltered,” she says.

However, while higher-yield investments are a good choice for a TFSA, that’s not the same as high-risk. A TFSA shouldn’t be used to hold the riskiest investments, says Jason Pereira, partner and senior financial consultant at Woodgate Financial Inc., a financial planning firm in Toronto. Investments that he terms “speculative gambles” should instead be kept in non-registered accounts.

For investors with a time horizon of at least five to 10 years, personal finance columnist Rob Carrick suggests using your TFSA to purchase a type of ETF called an asset allocation fund. “Think of these as a fully diversified portfolio in a box,” he says, “with variations for investors of all ages and risk profiles.”

What are the pros and cons of a TFSA?

The biggest benefit of a TFSA is that you don’t pay tax on the investment earnings and withdrawals. This is in contrast to an RRSP, which is treated as taxable income when you remove money from your account, whether it’s in the near future or after retirement. TFSA withdrawals are tax-free.

Another benefit of TFSAs over RRSPs is that you are not required to take money out after age 71. This gives you more flexibility to decide how to use your savings. On a related note, any funds you withdraw from a TFSA will not affect other government benefits such as Old Age Security.

When is it better to use an RRSP, a TFSA – or both?

A TFSA downside, however, is that there are no tax advantages at the time you make contributions. Which option is best for you depends on your annual income. Since the tax deductions linked to RRSP contributions are most beneficial for higher-income earners, Ted Rechtshaffen, chief executive officer of TriDelta Financial in Toronto, recommends that those who make less than $45,000 a year save in a TFSA first and those who make more than $85,000 prioritize the RRSP. (Of course, there’s nothing preventing you from maximizing contributions into both accounts.)

Another thing to remember is that TFSAs are not designed to be used like a regular bank account. Any withdrawals you make cannot be replaced until the following calendar year, and penalties apply if you accidentally make an overcontribution. This means that if you want an account that you can move money in and out of frequently, you might be better off with a high-interest savings account.

In addition, the ease of making withdrawals from a TFSA might make it a less optimal savings vehicle for retirement, if you think you might be tempted to take the money out prematurely. RRSPs are more difficult to withdraw money from – plus, you will probably have to pay tax on those withdrawals. From a psychological point of view, this can make the funds in an RRSP feel more out of reach.

How do I check my TFSA contribution room?

You can find how much contribution room you have by checking with the CRA, for instance through the “My Account” service or by phoning the Tax Information Phone Service.

However, it’s important to note that the CRA gets its data from financial institutions, and there is a time delay between when transactions happen and when the CRA receives them and takes them into account. For this reason, it’s a good idea to stay on top of your contributions and withdrawals. Check with your financial institution to see whether they have any tools that might help.

When does TFSA contribution room reset?

The contribution limit resets on Jan. 1 of each calendar year. In theory, you could contribute one year’s maximum on Dec. 31 and then the following year’s maximum the next day, on Jan. 1. If you withdraw funds from your account, that amount can be recontributed as of the beginning of the next year.

What is the lifetime limit for TFSA contributions?

There is no lifetime limit per se on a TFSA. Instead, there is the cumulative limit from 2009 (or the year you turned 18) until the current year. You can continue contributing the maximum every year for as long as you like.

Can I have more than one TFSA?

Yes, you can hold multiple TFSA accounts. However, like the RRSP, your annual limit does not change. You can split your contributions across multiple TFSAs, but you cannot contribute more than the annual limit in one year.

Having multiple TFSA accounts can make it hard to track your contribution limits. For this reason, Ms. Bonten advises her clients to have just one TFSA at one financial institution.

What happens if I overcontribute to my TFSA?

It’s important to keep track of your limit as excess contributions will be taxed at 1 per cent per month (on the money that exceeds the limit). You can correct the excess by withdrawing the funds. You can also appeal to the CRA to cancel the penalty, in full or in part, if you explain to the agency what led to the overcontribution and it decides your reason is valid.

Can I contribute to a spouse’s or common-law spouse’s TFSA?

A partner cannot contribute to someone else’s account. But they can give their partner money as a gift, which can then be added to the TFSA, provided contribution room is available. Once the funds are given and contributed to the account, the spouse – the account holder of the TFSA – owns the assets and is entitled to any income or investment gains from the account. Note that you cannot open a joint TFSA; it is only available to individuals.

What is the average return on a TFSA?

The return on your TFSA depends on the type of investments you hold and how successful those investments have been. Those whose TFSAs include well-performing equities, for instance, will have seen a higher rate of return than people who keep their TFSA money in a savings account.

What is the average interest rate on a TFSA?

If you choose to hold some or all of your TFSA funds in a savings account, then you will benefit from choosing the highest interest rate possible. Interest rates vary over time, and they are expected to rise in the near future. As of January, “high-interest” savings accounts from big banks were offering interest rates of 0.05 or 0.1 per cent, while those from alternative banks were paying as much as 1 to 1.5 per cent.

How do I – and when should I – withdraw money from my TFSA?

Withdrawing money with relative ease is one of the perks of the TFSA. For the most part, you can remove money from the account as you like, for any event such as a home purchase, an emergency or retirement. There’s no penalty for withdrawing funds.

The specifics of how to withdraw funds will depend on the financial institution or bank where you hold your account. Check your account online or contact your institution if you are unclear on the details.

It’s important to keep track of any money you take out of your account, so that you know how much contribution room you will have in the following year.

And remember that you cannot recontribute a withdrawal in the same year you took out the funds. Doing so will be considered an overcontribution and will be subject to a 1 per cent per month penalty.

As for when you should withdraw from your TFSA – that depends on your savings goals. Seniors with both a TFSA and an RRSP/registered retirement income fund will want to create a plan for withdrawals that minimizes income tax and clawbacks of benefits. And those who are taking money out that they intend to replace should consider the timing of their withdrawal based on the calendar year. Any money taken out in December, 2022, for instance, can be replaced as early as January, 2023. But money taken out in January, 2023, cannot be replaced until January, 2024.

How much money can I take out of my TFSA each year?

There are no limits on how much you can withdraw from your TFSA in a given year. Withdrawals don’t count as income, meaning they won’t have any impact on benefits such as employment insurance or OAS.

Are you a young Canadian with money on your mind? To set yourself up for success and steer clear of costly mistakes, listen to our award-winning Stress Test podcast.

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