What Is a Tax-Free Savings Account?

What Is a Tax-Free Savings Account?

Let me explain what a Tax-Free Savings Account, or TFSA, really is. It's a savings account available in Canada where you can contribute after-tax income, and then any interest, dividends, or capital gains you earn inside it grow completely tax-free. When you withdraw money, that's tax-free too.

You put in money that's already been taxed, so these contributions don't lower your taxable income like some other accounts might. Even though it's called a savings account, you can hold more than just cash in it—things like mutual funds, securities, bonds, and other investments. If you're 18 or older and live in Canada, you can open one and use it for whatever you need.

Key Takeaways

TFSAs are tax-advantaged accounts for Canadian residents who are at least 18 years old. They help you save on taxes because investment gains aren't taxed, and you can withdraw funds without paying taxes on them. There's an annual contribution limit known as contribution room, and if you don't use it all, that unused amount carries over to the next year. This carryover goes all the way back to 2009 when TFSAs started.

How Tax-Free Savings Accounts Work

TFSAs came about in Canada back in 2009 to help people save and invest over their lifetimes. You can use them for any purpose, not just retirement—maybe saving for a car, education, a home, extra expenses, or yes, retirement too. You don't even need earned income to contribute.

Generally, the earnings from investments in your TFSA aren't taxed, and you stay in control: contribute when you want, choose your investments, and withdraw anytime without penalties. When they first launched, the annual limit was C$5,000 for those 18 and up. It went up to C$5,500 in 2013, jumped to C$10,000 just for 2015, and has been C$6,000 since 2019 through 2022.

Contributions

Your contribution room is the max you can put into a TFSA each year. Starting from 2009, if you were 18 or older and a Canadian resident, you build up this room every year, even without an account open. Unused room carries forward indefinitely. For instance, if you only contributed C$3,000 out of C$6,000 in 2019, you could add that extra C$3,000 to your 2020 limit of C$6,000, making it C$9,000 total.

If you skipped contributions since 2016, by 2020 your room would be C$23,000, adding up the limits from those years. The annual limit gets adjusted for inflation and rounded to the nearest $500. Note that things like qualifying transfers or exempt contributions don't count toward your room, per the Canada Revenue Agency.

Over-Contributions

If you put in more than your contribution room, that's an over-contribution, and the CRA hits you with a 1% tax per month on the excess until you withdraw it. Be careful: withdrawing money doesn't free up room in the same year, so if you add more thinking it does, you might over-contribute and owe taxes. Taxes can also apply for contributions as a non-resident or for holding prohibited investments.

TFSA Withdrawals

When you withdraw, that amount adds back to your contribution room, but only starting the next year. Say you contributed C$5,500 in 2020 when the limit was C$6,000, leaving C$500 room. If you withdraw C$2,000, you can only add back C$500 that year, and the full C$2,000 gets added to your 2021 room.

Carryover Contribution and Withdrawal Calculation Example

Here's a quick example to show how this works. Suppose your TFSA room in January 2021 is C$6,000, and you contribute C$1,000, leaving C$5,000. Then in January 2022, you get C$6,000 new room, plus the C$5,000 carryover from 2021, plus a C$1,500 withdrawal from 2021, totaling C$12,500 for 2022.

TFSA Contribution Room Amounts

Contribution room builds up each year since 2009, whether you have a TFSA or not. Earnings or account value changes don't affect it. The annual limits have been: C$5,000 from 2009-2012, C$5,500 for 2013-2014, C$10,000 in 2015, C$5,500 from 2016-2018, and C$6,000 from 2019-2022.

Types of Investments Permitted

You can put various things in your TFSA, according to the government: cash, mutual funds, securities on designated exchanges, guaranteed investment certificates, bonds, and certain small business shares. Always check with a financial advisor to ensure your choices are allowed.

Pros and Cons of TFSAs

On the plus side, all earnings grow tax-free, and withdrawals are tax-free too. You don't need earned income to contribute, unused room carries over retroactively to 2009 or when you turned 18, and there are no required withdrawals—you can take out any amount anytime without penalty. TFSA income doesn't affect government benefits.

On the downside, contributions aren't tax-deductible, over-contributions get taxed at 1% monthly, non-resident contributions are taxed similarly, and if taxes are due, you must file a return by June 30 the next year. Also, TFSA funds aren't protected from creditors.

How to Open a TFSA

If you're a Canadian resident, 18 or older, with a valid Social Insurance Number, you can open a TFSA. You can even have multiple, but total contributions can't exceed your room. Look for institutions offering TFSAs like deposits, annuities, trusts, or self-directed ones. Apply with your SIN, birth date, and ID; once approved, it's registered with the CRA, and you can start contributing. Non-residents can open one, but contributions while non-resident get taxed 1% monthly until removed.

TFSAs vs. RRSPs

RRSPs are for retirement specifically, while TFSAs are for anything. RRSP contributions deduct from your taxable income, but TFSA ones don't. RRSP withdrawals are taxed as income, but TFSA withdrawals aren't.

How Does the Tax Advantage of a TFSA Compare to a Regular Investment Account?

Consider two people: one puts C$6,000 in a regular account earning 7%, ending with C$6,420 but taxed on the C$420 gain. The other uses a TFSA, gets the same C$6,420, and withdraws it all tax-free.

Are Contributions to a TFSA Tax Deductible?

No, you contribute with already-taxed money, so it doesn't reduce your taxable income. But withdrawals are generally tax-free.

What Is the Early Withdrawal Penalty for TFSAs?

There isn't one. You can withdraw anytime without penalty, as TFSAs are meant for any purpose, not just retirement.

The Bottom Line

TFSAs offer a great way to save and invest tax-free for whatever you want. Balances grow without taxes, withdrawals are tax-free and can be done anytime, unused room carries over, and withdrawals add back to next year's room, helping you build savings over time.