The Tax Free Savings Account is a Canadian registered savings account in which any gains are exempt from income tax. It was introduced at the beginning of 2009 as a vehicle to help people efficiently save money. Today we are going to look into 3 things: Main TFSA features, differences to a RRSP, and the power of a TFSA.
You can contribute up to $5000 every year to your TFSA. Most people will only need to open up 1 TFSA. That being said, it is fine to open several TFSA’s with different institutions, however, the sum of your contributions into all accounts still cannot exceed $5000 for the calendar year. If you break this rule, there are financial penalties.
Any interest, dividends, distributions, yields, capital gains, or other income of any kind that is earned within a TFSA is exempt from income tax. That means, you do not have to claim the money earned inside a TFSA as part of your taxable income. The money can be withdrawn at any time for any reason. The only tricky part to remember here is that you cannot recontribute money withdrawn until the following calendar year.
Example: You contribute $2000 to your TFSA on January 1st, 2010. On May 15th 2010 you withdraw $1000 from your TFSA. Your contribution room for the remainder of the 2010 calendar year is still only $3000 (not $4000). However Your contribution room for the 2011 calendar year now becomes $6000 ($5000 every year + $1000 withdrawn in the previous year). Any gains made within the TFSA during 2010 are yours to keep tax free.
They are quite different actually. Money contributed to a RRSP is deferred from income tax, whereas money gained within a TFSA is exempt from income tax. The idea behind a RRSP is to defer paying income tax until later in life when ideally, you will be in a lower tax bracket. As a retiree, you can withdraw your RRSP savings to live off. The RRSP withdrawals are treated like regular income, and are taxed accordingly. Make no mistake, you will still be required to pay income tax on your RRSP contributions; just later on down the road. The important thing to remember here is that RRSP contributions are made with before-tax dollars.
On the other hand, TFSA contributions are made with after-tax dollars. Therefore money that you put into your TFSA is not exempt from income tax, or deferred from income tax. Rather, the gains you make inside the TFSA are tax free.
You can open up a TFSA and RRSP at the same time. Which one you should contribute to depends on your level of income. High income earners should max out both, every year, for maximum tax savings. But if you earn $20,000 or less annually, you must answer the following question. Will the interest earned inside a TFSA be greater than the tax savings from a RRSP on a year by year basis? If so, contribute to the TFSA and try to earn as much money inside of it as you can. Else if deferring income in a RRSP will result in significant tax savings, definitely go with the RRSP. Available tax credits for that year will play a big factor in your decision. In summary:
RRSP contributions and gains are income tax deferred.
TFSA contributions are taxed normally but gains are tax exempt.
Some people are quick to judge that a TFSA is just a joke; another pathetic kickback from the Canadian Government. They insist that the “savings” from a TFSA are so minimal that its almost negligible. Well, perhaps within the first couple years. But wait…
5 years down the road. Here is where the power of a TFSA really shines through. If you contribute the maximum of $5000 to your TFSA every year for 5 years, you will have saved at least $25,000. If you are earning a 10% return throughout that 5th year, paid monthly, you will earn $2,617.83 tax free! Not to mention you will be making even more in the 6th year, 7th, 8th, etc. I don’t care who you are, that’s a nice chunk of tax-free change!
Do you have questions about the TFSA? Ask away in the comment section below. Don’t delay, open a TFSA today!
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Another great article from your site, this time about such an important financial vehicle as the Tax Free Savings Account. Thanks for sharing this information, who couldn’t use an extra $2,617.83 tax free?
Another idea to a TFSA (if you have a long term view) is believe it or not a particpating whole life policy! If you set it up unless you can do better than 5% each and every year it has the same advantages. The key is to buy the least amount of insurance and over fund it up to the limit of the policy. The cash value for the first 5 plus years is poor but gets better as time goes by. When you factor term insurance which becomes too expensive after 20 years it looks even better.
This would not be a replacement to the TFSA but you can’t get the dividends paid out in 2008 of over 7% (paid by insurance companies that offer this). If you are interested in learning more let me know.
regards,
Brian
T.F. Savings,
Thanks for the kind comment. Tax free money is good! 1 dollar tax free is better than no dollars tax free.
BTW great website; A wealth of information on the TFSA.
See you around,
InvestAssetWealth
Brian Poncelet, CFP,
Thanks for stopping by and lending that advice. Thats a cool idea! Of course the prerequisite for using that strategy is that you want life insurance to begin with. It just shows how versatile this new tax-saving vehicle really is.
This could be a great option for people looking at life insurance. Check out Brian’s website for more information!
Take care,
InvestAssetWealth