Tax Free Savings Accounts

Guide and Strategies

• How do TFSAs (Tax Free Savings Accounts) work?
• How do TFSAs compare to RRSPs?
• Which should I invest in?

How do TFSAs (Tax Free Savings Accounts) work?

TFSAs are an exciting new way to save money free of tax. This is a new program that seems to be unique to Canada. It is a flexible plan for saving which doesn’t have any catches or gotchas.

Canadian residents aged 18 or over can deposit up to $5,000 per year into a TFSA and the earnings of the investment will not be taxed.

If one does not have the ability to deposit all or any of the $5,000 in a year, the unused portion will be carried forward indefinitely and can be used in a future year. So in 4 years there would be $20,000 or more of contribution room if one had not yet used the plan. The reason it is $20,000 or more is because the $5,000 annual amount will be indexed for inflation so that future deposits that will be allowed will probably be larger than $5,000.

Withdrawals can be made from this fund at any time for any purpose. The amount withdrawn will be added back to one’s contribution room. So let’s say Sheldon has deposited $5,000 per year for 3 years and the $15,000 has grown to $19,000. He could take the $19,000 to buy a car and there would not be any tax on the $4,000 of earnings. The $19,000 would be added back to his future contribution room and he could re-deposit $19,000 in the next calendar year.

How do TFSAs compare to RRSPs?

When one makes a deposit to an RRSP, one gets a tax deduction for the amount of the deposit. The funds grow tax free as long as they sit inside the RRSP. When money is withdrawn it is taxed as interest income.

TFSAs are the mirror image of this. There is no deduction from taxes when you deposit money to this account. The funds grow tax free as long as they are in this account. When the money is withdrawn it is tax free.

RRSPs require people to stop making deposits at age 71, with TFSAs there is no age at which one can no longer make deposits. So they can make a lot of sense for seniors who still wish to save money.

One also does not loose one’s contribution room with the TFSA plan as one does with RRSPs. For example, if Bob contributes $5,000 to an RRSP, and consequently takes that money out, Bob is not allowed to contribute it back again (there are two exceptions with RRSPs for the Home Buyer’s Plan and the Life Long Learning Plan). With a TFSA one can put money in, take it out, and then contribute it back again in the future.

Which should I invest in?

Should people invest in RRSPs, TFSAs or perhaps both? This is going to depend somewhat on their circumstances.

Anyone who has money saved in a non-registered account should consider moving the maximum allowed to a TFSA. This one is pretty much a no-brainer as they will be moving taxable assets into a non-taxable account TFSAs can generally be invested into anything one can buy in an RRSP. This would include mutual funds, publicly traded securities, GICs, bonds, and certain shares of small business corporations.

TFSAs may appeal to seniors because they can contribute to them after age 71 and use the TFSAs as a source of non-taxable income. Also because the income it not taxable, it will not reduce income tested benefits such as the GIS (guaranteed income supplement) and OAS (old age security).

Younger people can also look at TFSAs and may find them more useful than RRSPs early in their career. That is because the amount of the RRSP tax savings depends on how high one’s tax bracket is. So it would make sense for young people to save money in a TFSA in their earlier years when their income and tax bracket is lower, and contribute it to an RRSP once their income has increased so they get a larger tax break. They can accumulate money in the TFSA for upcoming goals and needed expenditures.

RRSPs remain a valuable tool for accumulating money for one’s retirement. TFSAs can be used to save money for everything else.

Myles Rempel