The Tax-Free Savings Account (TFSA) was introduced in 2009 yet is often misunderstood and underutilized. It can play a pivotal role in saving for both your short and long-term goals if used effectively. Any individual who has a Social Insurance Number and is 18 years of age or older can open a TFSA under federal law. Certain provinces have an age limit of 19. These are registered accounts that are administered by financial institutions, such as banks, credit unions or insurance companies. You can contact your financial institution to open an account if you are eligible.
Once your account is opened, you can make contributions subject to your contribution room. Contribution room begins to accumulate beginning in the year that you turn 18 and increases by the annual limit each year. Contribution room accumulates regardless of whether you have opened an account. If you were 18 years of age or older in 2009 and have not previously contributed to a TFSA, you have contribution room available in the amount of $75,500 as of 2021. The current annual limit as of 2021 is $6,000 which will be indexed to inflation each year and rounded to the nearest $500. You can confirm your current contribution with Canada Revenue Agency either online or by phone.
Amounts deposited to a TFSA can be withdrawn at any time. Any amounts withdrawn during a calendar year are added to your contribution room on January 1st of the subsequent year. Therefore, on January 1st of each year, you can calculate your contribution room as the total of:
Annual limit for the year ($6,000 as of 2021)
Unused contribution room from prior years (up to $75,500 as of 2021)
Total withdrawals in the prior year
Now that we have outlined the mechanics of the account, we can discuss the benefits. Contributions to a TFSA are not tax-deductible unlike the Registered Retirement Savings Plan (RRSP). The benefit of this account is right in the name; the income earned in the account as well as the withdrawals from the account are tax-free. The tax-free nature and flexible withdrawals make this a great all-purpose financial vehicle. It can be used for short-term savings such as an emergency fund, medium-term savings such as a down payment on a home, or it can be used as a tax-free supplement to your retirement income. The account can be used as your primary savings account or it can be used in conjunction with other accounts such as RRSPs or non-registered investment accounts.
A common misconception is that this is a “savings” account. While you can certainly choose to deposit cash and earn interest income, there are many more investment options available. You can use the account to purchase securities such as stocks, bonds, mutual funds, exchange-traded funds, or options. You can also use the TFSA to purchase annuity contracts. You can potentially earn many years of compound, tax-free growth by maximizing your annual contributions in your income-earning years and holding the funds in the account for an extended period.
Purchasing marketable securities in the account can be very beneficial, but you must be earning passive income. Those in the business of trading marketable securities, commonly referred to as day trading, are not eligible to use a TFSA for this business. If you are buying and selling securities on a frequent basis or purchasing securities that are highly speculative in nature, you may be deemed to be running a business.
On top of the previous issue, there are other situations where you may be subject to tax if you misuse the account. You may be subject to tax if you contribute excess amounts above your contribution room, if you contribute to the account while you are a non-resident of Canada, or if you own prohibited or non-qualified investments in the account. As mentioned above, withdrawals from the account are not added back to your contribution room until the subsequent calendar year. It is not uncommon for individuals to withdraw and recontribute funds during the same calendar year which can trigger a tax on excess amounts. The tax on excess amounts or non-resident contributions is 1% per month of the applicable amount. Prohibited investments and non-qualified investments are subject to a tax calculated as 50% of the fair market value of the applicable investment. You may be able to request a waiver of these taxes in certain situations, such as if they arose due to a reasonable error.
As the income earned within the account is not taxable, any expenses incurred with respect to the account are not deductible, such as interest or management fees. Losses incurred within a TFSA are also not deductible against any other source of income.
Most adults living in Canada can benefit from a TFSA as they work towards their financial goals.
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