What is a TFSA?
Tax-Free Savings Accounts are a savings mechanism introduced by the federal government in 2009. They are meant to encourage people to save by allowing deposits inside the TFSA to grow tax-free. Unlike Registered Retirement Savings Plans, funds placed in a TFSA are not tax-deductible. But all income earned within the plan remains tax-free regardless of when it is withdrawn. Anyone over age 18 with a Social Insurance Number can open and contribute to a TFSA.
TFSAs can hold any type of investment that is eligible for an RRSP: cash savings accounts, mutual funds, individual stocks (including some shares of private corporations), GICs, bonds and others. TFSA holdings are not creditor-protected.
There is a limit to how much you can place in your TFSA. As of 2019, the annual amount is $6,000. However, if you do not use your contribution room for a given year, you may carry it forward indefinitely. You may contribute amounts up to the limit for any years since 2009 that you were at least age 18. So if you contribute nothing this year, next year you will be able to contribute $12,000. The Canada Revenue Agency periodically increases the annual limit (in 2015 only, the limit was $10,000). Contribution room is increased January 1 of each year. For people who have been over 18 since the program began, the total contribution room is $63,500 (2019).
Investment gains or losses within the TFSA do not affect your contribution room. You can also transfer amounts between your TFSA accounts – for example, if you move funds from a TFSA cash account to a TFSA mutual fund account – without the transfer being considered a contribution or withdrawal.
If you contribute more than you are permitted to, you will be taxed 1% per month on the excess amounts, so pay careful attention to how much you have put in.
You may give money to your spouse to contribute to their TFSA, as long as the amount is within their contribution limit, without the related investment earnings being attributed back to you and taxed in your hands.
You can check your contribution room through My Account on the CRA’s website.
Withdrawing funds from your TFSA
You may withdraw funds from your TFSA at any time for any purpose. Because you have already paid tax on the funds you put in the fund, and because earnings are tax-free, withdrawals have no tax consequences. When you withdraw, the amount of your withdrawal is added back onto your overall contribution room in the following year, so you may recontribute funds you have withdrawn as long as you stay within your contribution limit.
But be careful: if you recontribute funds in the same year they were withdrawn, the recontribution will be counted as a new contribution. If that new contribution puts you over your limit, you will be taxed on the excess. So if you take funds out, and then want to contribute again, check whether you will still be within your limit for the year. This is a very common mistake that can result in an unexpected tax bill.
TFSAs for retirement income
Funds withdrawn from your TFSA in retirement do not affect your eligibility for Old Age Security or Guaranteed Income Supplement payments.
When you open a TFSA, designate a beneficiary so that the account transfers immediately to the beneficiary without passing through your estate, thus avoiding probate costs.
Many Canadians are not using their TFSAs to full advantage. Even many of those who maximize their contributions don’t actively invest within the TFSA, but instead leave the funds sitting in cash accounts. So invest within your TFSA the same way you would in your RRSP, whether you are aiming for income, growth or capital preservation.
If you have not maximized your annual contributions, you will have some room open. If you find yourself with excess funds to invest suddenly – for example, if you inherit some money – your TFSA is a great place to invest it, up to your limit.
As for whether you should put funds in your TFSA or your RRSP, it depends. If your income is higher now, you will want the tax deduction that comes with RRSP contributions. If you’re in a low tax bracket, maximize your TFSA because its earnings will never be taxed. Ideally, maximize both.
Meet with your financial advisor to discuss what kinds of investments will work for you in your TFSA and how to coordinate contributions to it with your RRSP contributions. You will need to look at your long-term goals and cash flow needs.