Tax-Free Savings Accounts, TFSAs, are a savings incentive and investment vehicle many Canadians take advantage of. It is a type of account that imposes no taxes on contributions or the interest income earned, sometimes beyond the owner's lifetime. Also, the initial contributions, interest income, and dividends growth can be withdrawn tax-free. To be eligible, the contributor must be a Canadian resident, over 18, and have a valid social insurance number (S.I.N).
Canada introduced the TFSA in 2009, capping initial annual contributions at $5000. The contribution limits through 2021 are $6,000 annually.1 The amount you contribute is based on your after-tax dollars, and while contributions are not tax-deductible, they grow tax-free and help increase your overall tax-free savings account room.
TFSA Contribution Limits and Carryovers
If you have not reached your cumulative contribution limit for a year, you can carry over the "unused room" next year. For example, if in 2020 you contributed $2,000 of your $6,000 limit, your 2021 contribution can be $8,000. If you were over 18 and not a Canadian resident, you would not qualify for contribution room in those years.1
Withdrawing Money from your TFSA
When funds are withdrawn from your TFSA, that amount withdrawn increases your available contribution limit at the beginning of the following year. Limits for replacing the money later depend on the contribution room remaining after the withdrawal, your cumulative limit, and how much was contributed during that year.
To avoid over-contribution penalties, paying attention to your account's cumulative limit and the annual carryover eligibility is essential.
Penalty for Contributing Over the Maximum Amount
If you over-contribute to your TFSA, meaning your contribution is higher than the annual limit or above your allowable cumulative limit, the CRA considers it an over-contribution. If that happens, the CRA will apply a tax penalty of 1% for each month on the excess over-contribution until it is withdrawn.
A TFSA Can Hold More than Cash
A TFSA account can hold a variety of investments. This includes bonds, stocks, mutual funds, ETFs, etc. They help you maximize your investment growth by minimizing tax. Investment income in Canada is typically taxed at the highest marginal rate. This means the investment income earned is added to your earned income and increases the amount of tax you pay.
You can lower your taxable income by ensuring you first maximize the use of your TFSA account since the growth of the investments and passive income inside the TFSA account are not taxable. It’s a good strategy for less volatile investments since there is no credit for capital losses to offset the gains in a non-TFSA account. This is because under Canadian tax law, they are separate entities.
A TFSA May Be Used as an Education Savings Plan Alternative
While there are still many choices, the Canada Education Savings Grant (CESG) is restricted to qualified post-secondary education programs. Those restrictions do not apply when TFSA funds are used.2 This may benefit a very limited few, and your child does not attend a qualified post-secondary education program and needs funds to pay those school expenses now. Using the TFSA as an alternative strategy, you are giving up the Canada Education Savings Grant and other benefits RESPs have to offer.
Transferring Your TFSA Assets
When a TFSA holder dies, the assets can be transferred to the spouse without impacting their existing contribution limit, tax-sheltered. When there is no surviving spouse, the assets on death may be transferred to the spouse's estate or named beneficiary tax-free.
Many Canadians use the TFSA to invest in a lifetime of savings with the hopes of having it as an additional nest egg for retirement. Based on current contribution limits, a 45-year-old who contributes the annual maximum for 20 years that earns a 5% return will have a value of over $186,000 at age 65. And never be taxed on the income earned inside the TFSA.
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