Your guide to understanding TFSAs with Modern Money co-founder, Erin Zorde.
What is a TFSA?
I’m sure you’ve heard the name Tax-Free Savings Account (TFSA), but what is it and how does it work?
The name “Tax Free Savings Account” sort of gives it away, but in reality, a TFSA is so much more than just a regular savings account. In a regular savings account, you are earning interest at the bank rate provided, whereas with a TFSA you can select a basket of financial instruments to generate growth on the money held in your TFSA. For example, your TFSA can hold stocks, exchange traded funds, bonds, guaranteed investment certificates and cash savings.
TFSAs were first introduced in 2009 by the Canadian government in an effort to encourage savings through tax-free investments and savings.
How Does a TFSA Work?
It’s very simple to open a TFSA – you can do it online if your financial institution allows you to (it’s 2020, so I sure hope they do), or you can go directly to your bank to open a TFSA. Once your TFSA is open, you can deposit money, kick your feet back and hopefully watch your money grow. One thing to keep in mind, to open a TFSA for yourself, you must be 18 years of age and have a valid Social Insurance Number.
The amount of money that you can contribute to your TFSA is limited each year and there is a specific contribution limit from 2009 when TFSAs were first introduced in 2009 by the Canadian government. Here is the contribution limit for each year since TFSAs were introduced:
Your contribution room accumulates beginning in the year in which you turned 18. So, for example, if you turned 18 in 2015, you would have a TFSA contribution limit of $38,500.
Unlike an RRSP, TFSAs are flexible in terms of withdrawing your money without penalty, but you have to be very careful not to over contribute to your TFSA. If you accidentally over contribute, 1% of the excess contribution will be taxed every month until it’s withdrawn. It might not seem like a lot, but it adds up quick when it’s eating away at the savings that you’re trying to grow. A good way to keep track of your contribution limit is to log in to your CRA My Account and check out your contribution limit for the year.
Benefits of a TFSA
The biggest benefit is that earnings in your TFSA are tax-free! You work so hard to earn your money and you pay tax before receiving it, so why not protect those earnings and invest them in a tax-free manner?
When you contribute to a TFSA, you don’t receive an up front tax break like you do with an RRSP, but you will receive big breaks in the future, as your investments (stocks, bonds, cash, etc.) and the gains you earn on these investments will not be subject to any taxes.
TFSA Investment Options
As noted above, a TFSA allows you to invest in a variety of financial instruments. You can choose stocks, bonds, index funds. To determine what best suits your needs, you should consider your risk tolerance and your investment horizon, as this will vary depending on the stage of life that you are in.
To better understand some of the investments that you can purchase to hold in your TFSA, check out our recent article on TFSA Investment Options and Strategies.