Tax-Free Savings Account (TFSA) in Canada: Overview

Every avid saver knows conventional savings accounts generate taxable interest in Canada. In other words, while working with a regular savings account, your earnings will be subject to taxation. Is that something to smile about? Not really. After all, taxes are deductions that reduce your overall earnings. With that in mind, we have some good news for you.

As a Canadian, you can save money and earn tax-free returns. It’s easy; just put your money in a TFSA (tax-free savings account). But before you go and set up this account, there are a few things you should familiarize yourself with. They range from the definition of a tax-free saving account to answers to vital questions like how does a TFSA work in Canada? We have addressed these and many other concepts in this guide. 

What is a TFSA?

Let’s open with a crucial question: what is a TFSA?

A tax-free savings account allows Canadians aged 18 and above to save money throughout their lifetime and enjoy tax-free returns. With a TFSA, you get to earn tax-free dividends, capital gains, or interest.

To open a TFSA in the Great White North, you must be a Canadian aged 18+. You also need a valid Social Insurance Number and can hold your TFSA for as long as you like.

TFSAs were introduced to Canadians in 2009. Their primary goal was to provide Canadians with optimum financial flexibility and promote individual savings, which is indispensable in facilitating financial independence. That said, different types of TFSAs are available in Canada, including:

• Deposit TFSAs: A deposit TFSA is a basic account that allows holders to earn interest on cash savings. It’s ideal for Canadians who want to avoid the pitfalls of investing hard-earned money in volatile assets like long-duration bonds and stocks.
• Annuity Contract TFSAs: As the name suggests, annuities are involved in annuity TFSAs. An annuity is a contract you make with an insurance company that lets you make payments on a particular basis and receive disbursements at a predetermined date. In other words, an annuity contract TFSA lets you enjoy the perks of receiving regular payments over a specific period.   
• Arrangement in Trust TFSAs: If you have assets held up in a specific trust, you can set up an Arrangement in Trust TFSA. Ultimately, the trust’s beneficiaries will receive tax-free returns or incomes, all thanks to your initiative. 

Other TFSA categories are available besides the aforementioned ones. These range from self-directed TFSAs, which let you pick and manage your investments, to robo-advisor TFSAs managed by automated investment platforms. For informed decision-making, research and familiarize yourself with all popular types of TFSAs.

How does a TFSA work in Canada?

If you’d like to keep some money aside and earn tax-free returns with a TFSA, here’s how you should go about it:

Key Features of a TFSA

To help you gain a better understanding of TFSAs, here is a summary of some of these saving accounts’ key features:

1. Tax-free growth and withdrawals

In Canada, all income earned by a TFSA account is tax-free. The same applies to contributions and withdrawals. In other words, there’s no need to fret over high taxes undermining the dividends, interest, or capital gains you get from a TFSA. Also, you won’t be subject to taxation while funding your account or cashing out.

2. No contribution age limit

Unlike alternatives like RRSPs, tax-free savings accounts haven’t capped the age for making contributions. You can deposit money into your TFSA for a lifetime, provided you have a contribution room.

3. Flexible contributions

TFSAs don’t have a set minimum contribution amount. That means you can contribute whatever is within your budget; talk about convenience, eh? That said, there’s a threshold you can’t exceed. In 2024, Canadians with TFSAs are subject to a $7,000 maximum annual contribution limit. Not to forget, your contribution room also dictates the maximum amount you can deposit in your TFSA.

4. Diverse investment options

TFSAs support a range of investment options, from cash, stocks, and ETFs to mutual funds, bonds, and GICs. That gives you enough room to choose the most suitable investment product and diversify your portfolio for better risk management.

5. Re-contribution ability

Suppose you withdraw funds from your TFSA. In that case, you won’t lose your contribution room. In fact, the amount you withdraw will be added to your contribution year next year. Simply put, TFSAs allow account holders to recontribute withdrawn funds without compromising their contribution room.

6. No impact on government benefits

When withdrawing money from your TFSA, your eligibility for income-tested benefits and subsequent government benefits won’t be affected. The same applies to credits. The benefits and credits that can’t be affected by TFSA withdrawals range from Old Age Security and Employment Insurance to the Canada workers benefit and the Guaranteed Income Supplement.

7. Multiple accounts

As a Canadian, you can open and contribute to multiple TFSA accounts with one or multiple financial institutions. Multiple TFSAs offer you the opportunity to invest in different assets and mitigate risk exposure. That said, your total contributions to your TFSAs are still subject to the stipulated yearly maximum contribution room.

8. Penalties for over-contributions

If you exceed the maximum contribution room for a specific year, your over-contributions will attract a 1% tax penalty. This penalty will apply each month you exceed the allowable threshold.

How Does a TFSA Compare to Other Accounts?

To ensure you reach your financial goals without encountering too many challenges, we encourage you to compare TFSAs with other accounts. Here’s a summary of the accounts you should compare with TFSAs before making a long-term commitment:

1. RRSP (Registered Retirement Savings Plan)

An RRSP is a savings account tailored to help you prepare for retirement. Like TFSAs, RRSPs support diverse investment products, including mutual funds, GICs, and bonds. The main difference between TFSAs and RRSPs is that the former offers tax-free withdrawals, but withdrawals from RRSPs are subject to withholding tax.

2. Regular savings account

Whereas TFSAs are tailored to help you hit your long-term savings goals, regular savings accounts are better suited for people interested in setting up emergency funds and short-term savings. Moreover, interest earned in savings accounts is subject to income tax in Canada.

3. Non-registered investment account

Here’s what separates TFSAs from non-registered investment accounts. The income you earn after investing in a non-registered investment income is taxable. On the other hand, returns from TFSAs are tax-free.

4. FHSA (First-Home Savings Account)

A FHSA is tailored solely to help you buy your first home. On the other hand, you can use a TFSA to achieve a variety of purposes, from preparing for retirement to making major purchases and ensuring you have enough emergency funds.

Common Misconceptions About TFSAs

Many Canadians are missing out on the golden opportunities that come with TFSA, courtesy of numerous misconceptions. We’ve listed and deconstructed some of the most common misconceptions below:

1. TFSAs are exclusively for saving cash

Yes, you can hold cash in a TFSA and earn interest. Despite what many believe, TFSA accounts can hold a range of assets, including mutual funds, bonds, and stocks. The flexibility afforded by TFSAs makes it possible for account holders to build diverse portfolios easily.

2. Withdrawals from TFSAs affect contribution room

No, any withdrawals you make from your TFSA won’t undermine your contribution room. In most cases, your TFSA withdrawals will be added to your contribution when the next year starts. Please note that this general rule of thumb doesn’t apply to specified distributions and qualifying transfers.

3. TFSA contributions are tax-deductible

If you were misled into thinking TFSA contributions are tax-deductible, here’s the truth: they are not. In other words, the money you contribute to TFSAs won’t make you eligible for tax deductions. But on the bright side, returns and withdrawals associated with TFSAs are tax-free.

4. TFSAs have a lifetime contribution limit

Tax-free savings accounts don’t come with a lifetime contribution limit. Moreover, when using a TFSA, your unused contribution room will always be carried forward indefinitely. In other words, you can contribute the allowable maximum and leverage any used room for as long as you like after opening a TFSA with a good service provider.

5. Higher income leads to taxable TFSA earnings

Some people say that the earnings from TFSAs held by high-income individuals are taxable; that’s false. Returns from TFSAs associated with both high-income and low-income individuals are tax-free, from dividends to capital gains.

6. TFSAs are exclusively for long-term savings

Despite being a fitting solution for people with long-term savings goals, TFSAs can also help you hit short-term financial targets. With a TFSA, you can save for emergencies, vacations, and sizable expenses like home renovation.

Penalties and Avoiding Mistakes

While using a TFSA, there are numerous mistakes you can make that will attract significant penalties. Since penalties undermine your net returns, we’d like to help you avoid them by introducing you to must-avoid mistakes:

Conclusion

Opening a TFSA is a smart financial move, and we encourage you to do so as soon as possible. If you’ve already hit 18, do it today. For the best returns, try contributing as much as possible while adhering to set annual limits. In addition, avoid mistakes that can negatively impact your potential returns, like over-contributing and topping up your account after becoming a non-resident of Canada.