What Is a Tax-Free Savings Account (TFSA)?
A tax-free savings account (TFSA) is an account in which contributions, interest earned, dividends, and capital gains are not taxed, and can be withdrawn tax-free. While it's called a savings account, a TFSA can hold certain investments including mutual funds, securities, and bonds as well as cash. This account is available to individuals ages 18 and older in Canada and can be used for any purpose.
- Tax-free savings accounts (TSFAs) are a type of tax-advantaged account available to Canadian residents age 18 or older.
- TSFAs let you save money on taxes because the gains on investments in the account are not taxed and withdrawals can be made tax-free.
- There is an annual contribution limit to TSFAs; in 2020 that limit is C$6,000.
Understanding Tax-Free Savings Accounts (TFSAs)
Tax-free savings accounts (TFSA) were introduced in Canada in 2009 with a contribution limit of C$5,000 per year. In 2013, that limit was increased to C$5,500 annually and remained at that level through 2018, except in 2015 when the limit was C$10,000. In 2019, the contribution limit was raised to C$6,000, where it remains for 2020.
The benefit of holding an investment within a TSFA is that you won't be taxed on any income the investment earns. As an example, let's take two savers, Joe and Jane. At the beginning of the year, Joe puts C$6,000 in an investment account earning 7% per year; Jane does the same but within a TFSA. They will each have C$6,420 at the end of the year, but Jane will be able to withdraw all C$6,420 with no tax penalty, whereas Joe would be taxed on the C$420 he earned in capital gain.
The amount that you're allowed to deposit into a TFSA is called your "contribution room." Even if you didn't have a TFSA at the time, you accumulated contribution room for every year since 2009 that you were age 18 or older and were a resident of Canada.
Any unused contribution room from one year can be carried forward to the next year. For example, if you've contributed the maximum limit until 2019 when you contributed only C$3,000, you can contribute 2019's C$3,000 in 2020, in addition to the C$6,000 annual contribution limit for 2020, for a total contribution of C$9,000. Likewise, if you haven't made any contributions since 2016, your 2020 contribution room for the TFSA account will be C$23,000: C$5,500 each for the years 2017 and 2018, and C$6,000 each for the years 2019 and 2020.
The income earned by investments in your TFSA doesn't impact your contribution room for current or future years.
Any withdrawal amount is added back to your contribution room at the beginning of the following year. For example, if Jane contributes C$5,500 for the tax year 2020 (with the contribution limit being C$6,000) and withdraws C$2,000, she cannot replace the entire withdrawal amount within the same year because her available contribution room is only C$500. In this case, Jane can replace C$500 and wait until the beginning of 2021, when her withdrawal amount is added to her contribution room, to re-contribute the remaining C$1,500.
TFSAs vs. RRSPs
While a registered retirement savings plan (RRSP) account is specifically for retirement savings, a TFSA can be used to save for anything. The tax-free savings account differs from a registered retirement account in two other main ways:
- Deposits made to an RRSP are deducted from your taxable income. Deposits into a TFSA are not tax-deductible.
- Withdrawals from a retirement plan are taxed as income. Withdrawals from a TFSA are not taxed.
Any contribution made to a TFSA beyond the maximum allowable amount is considered an over-contribution. The Canada Revenue Agency (CRA) will charge a penalty of 1% per month on the excess contribution until it is withdrawn.