Tax-Free Savings Accounts: What You Need to Know
Canadians are very accustomed to being taxed on everything. Once in a while though, the government will be nice and introduce a way to provide tax breaks. Essentially a Tax-Free Savings Account (TFSA) provides citizens with a maximum of $5000 of non-taxable cash to save and invest. The great thing about it is that the interest, dividends, and capital gains that may be earned while your money is in this account, is not taxed as well. The money may be withdrawn at any point and the withdrawal isn’t taxed. Basically, it’s a great way to save and invest a relatively small amount of money and benefit from the dividends.
TFSAs are often described by comparisons to Registered Retirement Savings Plans (RRSP). Contributing to RRSPs will allow for income tax deductions while there are no tax deductions for TFSAs. Also, unlike RRSPs, when saving in a TFSA you are putting in income that has already been taxed. With RRSPs, you are putting in money that hasn’t yet been taxed but will be when you make a withdrawal. With TFSAs you are always tax-free. Through the money you put in has already been taxed through your income taxes that is the extent of your tax worries. Withdrawal, earnings, and deposits are tax-free.
What it’s all about
TFSAs are not only simple savings accounts. If your goal with the TFSA is to save by investing you may do so. You can invest your tax-free dollars in mutual funds, GICs, stocks or bonds. The best thing about investing through the TFSA is that everything you put in, earn, and take out is tax-free, unlike other investments.
There is a strict contribution limit per year when it comes to TFSAs. Right now in 2012, it’s $5000, but keep in mind that that amount can change (if you’re reading this and it’s not 2012, please double check the current contribution limitations, we continue to use $5000 as an example) If there is less than a $5000 contribution in one year the remainder may be carried over to the next year. This has very strict limitations, though. If you over contribute you will be fined. For example, if in January 2010 you put $5000 into your TFSA you have effectively reached your contribution limit until the following January (2011). If you decide to put in $5000 in January and take out all of it in September you cannot put in any more money until the following year. You are not permitted to make further contributions in the same calendar year regardless of what you withdrew. However, in the following year, you are allowed to put in an equal amount to your withdrawal as well as your $5000. This rule has led to a lot of confusion.
A good thing about the TFSA is that you will always be allowed to put in $5000 a year. So say in January 2010 you put in $5000 and then don’t contribute any money until 2014. In 2014 you will be allowed to contribute as much as $5000 for every year you didn’t. So, in this case, you may put in $20,000.
All in all a TFSA is an extremely flexible way to invest and save money as long as you understand the rules. The money you put in and take out is not taxed, neither are your earnings and you can withdraw whenever the cash is needed.