If you live in Canada, you have likely heard about the Tax-Free Savings Account (TFSA). A TFSA is a special tool that the Canadian government introduced a few years ago. Many people confuse them with RRSPs (registered retirement savings plans). Although both of these special accounts have some similar benefits, there are important differences that you need to understand in order to maximize their usefulness.
Benefits of a TFSA
Tax free growth. As the name suggests, anything you earn within your TFSA is not taxed. Whether you earn interest, dividends, or capital gains, it’s yours to keep. This can have a significant long term impact on your savings because you can compound your growth every year without the tax man eroding your earnings.
The second benefit is that they are more accessible for withdrawals than RRSPs. When you withdraw money from an RRSP, you lose your contribution room forever (with the exception of special Home Buyers plans or Educational plans). This is not the case for TFSA. If you withdraw money, your contribution room is returned to you in the following year.
Thirdly, a TFSA can hold a variety of investments (as can an RRSP). A tricky misconception is that a TFSA is not, itself, an account, but is a special status that you can put on an account. You can add TFSA status to almost many of the accounts you’re currently familiar with: high interest savings accounts, mutual funds, equities, bonds, etc. You can hold as many of these different types of investments as you wish, as long as the combined contribution to all those investments does not exceed your contribution limit for the year.
A few words of caution:
While TFSAs are great tools to grow your wealth, there are a few things you need to keep in mind. There is no tax refund associated with these accounts as there is with RRSPs. Depending on your tax bracket, you might be better off contributing to an RRSP first in order to maximize your tax savings. It is vital that you consult with your financial advisor to build the strategy that is right for you and your family.
Secondly, there are stiff penalties if you go over your contribution limit. Each year the government will allow you to contribute a specific amount to your TFSA, but if you go over that amount you will have to pay a penalty tax of 1% every month that your account is over the limit. Your contribution limit can be found in your CRA online account or your most recent tax return.
Overall, the TFSA is an incredible tool that is available to Canadian investors. The ability to grow your savings in a tax free environment can have a significant impact on the long-term growth of your investments.