Tax Free Savings Accounts (abbreviated to TFSA) are special investment accounts designed to make saving more tax efficient. Tax Free Savings Accounts were introduced by the federal Finance Minister, Jim Flaherty in 2008, and came into effect on January 1, 2009.
How the tax works
Although a contribution to a Tax Free Savings Account will not be deductible against income tax any investment income that arises from the Tax Free Savings Account will not be taxed, even after withdrawal. This tax free treatment also includes capital gains.
Tax Free Savings Accounts have a flexible structure allowing money to be withdrawn free of tax at any time. As well as being free of tax, Tax Free Savings Account do not count towards income tested credits or benefits.
How Tax Free Savings Accounts work
There is a $5,000 cap (called “contribution room”) every year for all Canadian residents over the age of 18, and this contribution room can be distributed over more than one account. Lower earning spouses or common law partners are allowed to have their accounts to be topped up by higher earning spouses. The annual contribution room will be indexed in increments of $500.
This amount can be carried forward if it is not used and there is no lifetime cap. If there have been any withdrawals in previous years then these can also go towards the contribution room. Excess contributions are subject to tax of one percent per month.
Depositors can open an account at the same financial institutions that are able to issue Registered Retirement Savings Plans. These include life insurance companies, Canadian trust companies, credit unions and banks. Depositors need to provide their social insurance number at the opening of the account.
Withdrawals can be made at any time and for any reason. Withdrawals are not taxed and do not count towards benefits. TFSAs can be used as security for loans.
If the account holder dies then the income becomes taxable, although spouses can be named as successor account holders, in which case the accounts continue undisturbed. If a Canadian resident becomes non-resident the accounts continue, although new accounts cannot be opened during the nonresident period.
How Tax Free Savings Accounts differ from Registered Retirement Savings Plans
TFSA are designed to be complimentary with Registered Retirement Savings Plans. The tax treatment could be said to be the opposite of the RRSP as with retirement savings there is a deduction for contributions, but income is taxed on withdrawal with tax free savings accounts there is no tax on withdrawal or exemption on contributions.
The Tax Free Savings Account also complements the Registered Education Savings Plans (RESP), which like the Retirement Plans are more long term than the TFSA.
TFSA can hold the same sort of investments that RRSP can. These include:
• Depository receipts
• Savings accounts
• Certain types of private shares
Some of the more speculative investments available are:
• Stocks quoted on the Toronto Stock exchange
• Shares traded on the TSX Venture Exchange
• REITs - Real Estate Investment Trusts
• Forex - Foreign Exchange
• GICs - Guaranteed Investment Certificates
• Mutual funds
• Foreign stocks
• A limited amount of derivatives and debt obligations
• Royalty and partnership units