Tax-Free Savings Account - TFSA

DEFINITION of 'Tax-Free Savings Account - TFSA'

An account that does not charge taxes on any contributions, interest earned, dividends or capital gains, and can be withdrawn tax free. Tax-free savings accounts were introduced in Canada in 2009 with a limit of $5,000 per year, which is indexed for subsequent years. In 2013, the contribution limit was increased to $5,500 annually The contributions are not tax deductible and any unused room can be carried forward. This savings account is available to individuals aged 18 and older and can be used for any purpose.

BREAKING DOWN 'Tax-Free Savings Account - TFSA'

The benefits of a TFSA come from the exemption of taxation on any earned income from the investment. To illustrate this, let's take two savers: Joe and Jane. Joe puts his money in a investment making him 7% per year; Jane does the same but within a TFSA.

If both Jane and Joe make a $5,000 lump sum investment, they will each have $5,350 at the end of the year. Jane will be able withdraw all $5,350 without penalty, whereas Joe would be taxed on the $350 he earned.

A registered retirement savings account (RRSP) is for retirement, while a TFSA can be used to save for anything else. The tax-free savings account differs from a registered retirement account in two main ways:

1. Deposits in a registered retirement plan are deducted from your taxable income. Deposits into a TFSA are not tax deductible.2. Withdrawals from a retirement plan will be fully taxed according to that year's income. Withdrawals from a TFSA are not taxed.

The TSFA addresses some of the flaws that many believe exist in the RRSP program, including the ability to return withdrawals to a TFSA at a later date without reducing unused contribution room.

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