How Does a TFSA Work?

Tax-free saving accounts, more commonly known as TFSA, were first introduced in 2009 by the federal government. Similar to the idea behind the RRSP, it was created to encourage Canadians to save more for their retirement. Anyone 18 years of age or older with a social insurance number can open a TFSA account.

What is the Contribution Limit for TFSA?

When announced, the starting contribution limit was $5,000.00. That amount stayed the same till the end of 2012. An individual could have contributed $20,000.00 from 2009-to 2012. The government slightly increased the limit to $5,500.00 for 2013 and 2014 while dramatically increasing the contribution limit to $10,000.00 for 2015.

They reversed course and decreased it to $5,500 for 2016. If you were eligible to open a TFSA account in 2009, you would be entitled to contribute $81,500.00 to the account, including the 2022 contribution room, assuming no withdrawals. Contribution rooms are received each year even if the individual does not file an income tax or open a TFSA. The annual TFSA room limit is indexed to inflation and rounded to the nearest $500. See the chart below that outlines the total contribution limit available.

How to Calculate TFSA contribution Room

1. Determine the TFSA dollar limit for the current year
2. Add any unused TFSA contribution room from previous years
3. Add any withdrawals made from the TFSA in the previous year

A TFSA contribution is not tax-deductible against your current year’s income. The contributions are still able to grow tax-free, hence the name. While most Canadians open a TFSA account, the vast majority of their holdings are in cash, defeating the whole idea behind the account. I blamed its name as most people believe the TFSA account is nothing more than a saving account in that you don’t pay tax on the funds. The account should have been named the tax-free investment account. But I guess TFIA doesn’t sound as cool as TFSA, in all fairness.

Any potential capital gain, dividend, and interest from an investment held in the TFSA can grow completely tax-free. More importantly, though, the withdrawal of the funds (both principle and gains) is entirely tax-free.

What can you Invest in a TFSA

TFSA accounts can hold similar investment products that an RRSP account holds, such as cash, mutual funds, and bonds, to name a few. Unlike an RRSP account, withdrawing money from a TFSA will not result in any withholding tax or additional taxes. However, funds pulled out from the account cannot be replaced until the following calendar year unless you still have contribution room from the current or previous years.

While it is possible to have more than one TFSA account, the total contributions made to your various accounts cannot exceed your individual or set contribution limits for the year or available room. TFSA and RRSP accounts can be an excellent combination for retirement planning.

The income you generate from your TFSA will also not impact government-sponsored programs such as the guaranteed income supplement (GIS), employment insurance (EI), or old age security (OAS) benefits, which is another bonus.

TFSA accounts offer another excellent investment vehicle for short or long-term saving or retirement planning. It’s a great compliment to an existing RRSP account.