In 2009, Canadian citizens were given a new way to save for retirement or any other financial goal, thanks to Canadian Finance Minister Jim Flaherty. This article examines the guidelines of these accounts, explains for whom they were created, how they are taxed and the types of investments that can be used in them. (For background reading, see Tax Breaks For Canadian Families.)
In a nutshell, tax-free savings accounts (TFSAs) are a registered, flexible, general-purpose savings accounts that allow all investments within them to grow tax free. Any Canadian citizen over the age of 18 with a Social Insurance Number (SIN) is eligible to open one, and all are encouraged to do so. Those who have made the maximum contribution to a registered retirement savings plan (RRSP) are prime candidates for TFSA accounts, as well as senior citizens who may lose federal income or credit benefits as a result of taxable investment income. Ultimately, anyone who wants to put money away and let it grow tax free should take advantage of this savings opportunity. (For more on Canadian retirement savings, see the RRSPs Tutorial.)
Any arm's length type of investment that qualifies for use in an RRSP can be used in a TFSA. This includes any type of publicly traded security, such as stocks, bonds and mutual funds. Term deposits, guaranteed investment certficiates (GICs) and demand deposit accounts are also permissible vehicles for this account. Some shares of closely held stock in small businesses may also qualify.
Account holders can contribute a maximum of $5,500 per year to a TFSA in 2013. This amount is increased for inflation and rounded to the nearest $500 each year in order to keep pace with increasing prices. One of the chief advantages that these accounts offer is the ability to carry over unused contributions from prior years. For example, if an account holder contributes $3,000 to his or her TFSA in 2013, then he or she can contribute the remaining $2,500 the following year in addition to the maximum $5,500 plus the indexed increase in 2014. Therefore, the total allowable contribution for this person in 2014 would be $8,000 plus the indexed increase. In fact, recontributions are even allowed for amounts withdrawn. If the account holder in the previous example were to withdraw $1,000 of the $3,000 contributed in 2013, he or she could recontribute that amount in a later year as well, bringing the total allowable contribution amount for 2014 to $9,000 plus the indexed increase.
Another major advantage of the TFSA is that account holders do not need to have earned income in order to make contributions as they do with RRSPs. Contributions to TFSAs also differ from RRSPs in that they may only be made with nondeductible, after-tax dollars.
The Canada Revenue Agency (CRA) will determine each year how much the account holder is eligible to contribute to the TFSA, and the account custodian must then notify the account holder of this amount. Account holders who overcontribute to their TFSAs within a given year must pay a tax equal to 1% of their excess contribution for each month that the disallowed amount remains in the account.
Married account holders and those with domestic partners can also make TFSA contributions on behalf of their spouse or partner, provided that they contribute to their own accounts as well. TFSAs cannot be opened as joint accounts. However, funds received by a spouse or partner from a deceased spouse or partner's TFSA do not count toward the annual contribution limit. In the event of divorce or separation, the account balances can be redistributed between the former spouses or partners with no effect on the contribution limits for either party. Account holders who relinquish Canadian citizenship can retain their TFSA account(s), but they cannot make further contributions into the account. Make-up contributions for years in which the account holder is a nonresident are also disallowed. (For more on the division of plan assets upon divorce, read Getting A Divorce? Understanding The Rules Of Dividing Plan Assets.)
Because contributions are nondeductible, TFSA withdrawals are unconditionally tax-free. Furthermore, distributions can be taken at any time during the account holder's life, and not just after retirement. The proceeds can be used for any purpose, whether to supplement retirement income, make a purchase, pay off debts or just take a vacation. There is also no limit to the amount that can be withdrawn. The entire account balance can be accessed at any time, for any reason. Furthermore, TFSA accounts never have to be converted to any kind of income payment option, such as a registered retirement income fund (RRIF) or annuity, regardless of the account holder's age. As stated previously, any income or capital gains that are realized inside a TFSA do not affect the account holder's eligibility to receive federal income-tested benefits or credits of any kind.
Finally, TFSA balances are transferable to a spouse or domestic partner at death. If a partner or spouse is not named as the beneficiary on the account, then any earnings paid after the death of the account holder become taxable. It is important to note that the funds may be removed without any tax consequences, but depending on the instrument in which the saver is invested, there may be exit fees upon withdrawal.
Account holders cannot deduct interest that they accumulate on money that they borrow in order to make TFSA contributions, but they can use the assets in their TFSA accounts as loan collateral. As with other types of accounts, more than one TFSA may be held by the same account owner, although all aggregate contributions will be subject to the annual limit.
The TFSA offers tremendous flexibility and tax advantages for virtually all Canadian citizens. Its provisions are fairly straightforward, and enable a larger percentage of the population to shelter a substantial amount of assets from taxation over time. (For more on how to max out your RRSP, see Maxing Out Your RRSP.)
For more information, visit the Canada Revenue Agency website or consult your financial advisor.