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A tax-free savings account (TFSA) is a type of Canadian savings account that allows you to save a certain amount of money per year for retirement, or any other goal, without paying tax on the earnings. However, these accounts come with specific contribution and withdrawal restrictions that are important to understand.Here’s a closer look at TFSAs, including how they work, their pros and cons, and how to get the most out of a tax-free savings account.
What Is a Tax-Free Savings Account?
A tax-free savings account, or TFSA, is a tax-advantaged savings account available to all Canadians 18 years or older who have a Social Insurance Number (SIN). It was created by the Canadian government in 2009 to help Canadians save and invest their money for future needs. You use after-tax money to contribute to a TFSA but you generally aren’t taxed on the earnings.
How Do Tax-Free Savings Accounts Work?
You can open a tax-free savings account with a bank, credit union, or insurance company. There is an annual contribution limit (more on that below) that is referred to as your “contribution room.” Any unused contributions from previous years, however, roll over and increase your contribution room for the following year. You can have more than one TFSA. However, your total contribution room doesn’t change. It just gets spread out across all of your TFSA accounts. Once you have funds in your TFSA, you can choose to keep the money as cash (and earn interest), or you can invest the money in mutual funds, stocks, bonds, exchange-traded funds (ETFs), and other investment vehicles. The money your money earns in a TFSA is not typically taxed. And you can generally withdraw funds whenever you want without paying any taxes or penalties. As a result, a TFSA can be used for any type of savings goal.
Key Features of Tax-Free Savings Accounts
TFSAs have some features that are unlike other types of bank accounts. Here’s a closer look.
Contribution Room
The annual limit is determined by the Canadian Revenue Agency (CRA) each year. In 2023, the limit is $6,500. However, the annual limit is not necessarily the same as your contribution room. If you don’t use your full contribution limit in a given year, any unused amount will roll over into the next year, allowing you to contribute more than the annual limit.
Over-Contribution Penalty
It's important to accurately track your contribution room because you will incur a penalty if you contribute more than allowed. Any excess contribution you make will be charged 1% every month that excess amount is in the account.
Withdrawal Process
In most cases, you can withdraw funds from your TFSA at any time. (The exception is if you own investment products in your TFSA that have withdrawal restrictions, such as a maturity date.) After you make a withdrawal, the amount you take out is added back to your contribution room on January 1 of the following year. You can’t, however, withdraw money then add it back in the same calendar year (unless you have available contribution room). Typically, none of your withdrawals are taxed, including any earnings from interest, dividends, or investment growth.
Tips for Opening a Tax-Free Savings Account
Here are some tips to keep in mind when opening a new TFSA account.Consider your goals It’s a good idea to think about how you plan to use your TFSA when you open your account. A TFSA meaning for you could be a retirement fund, or it could be a place to save for your child's future education — or a combination of several goals. Match your investment strategy to your goals Understanding your savings goals, and the timeline for those goals, can guide you toward the right investment strategy. For example, If you’re saving for a home you want to purchase in five years, you might choose lower-risk investment vehicles than if you’re saving for your retirement that is decades away.Max out your contribution room To take advantage of tax-free growth, you’ll want to contribute as much as possible to your TFSA. You can even automate the process to make contributing even easier. Recommended: Saving vs Investing: Which is Right For You?
Advantages and Disadvantages of Tax-Free Savings Accounts
TFSAs come with numerous benefits. However, there are also some drawbacks to keep in mind. Here’s a look at the pros and cons.
Pros
Cons
• Earnings and withdrawals are tax-free
• No immediate tax advantage
• Withdrawals can generally be made at any time for any reason
• Rules are complicated
• Unused contribution room carries over each year
• You must keep track of your contribution room; if you over-contribute, you’ll pay a penalty
• Flexible investment options
• May require additional tax paperwork
Tax-Free Savings Account Contribution Limits
To help you determine your contribution room, here’s a look at the annual TFSA limits from 2009 through 2023.
2009 through 2012: $5,000
2013 and 2014: $5,500
2015: $10,000
2016 through 2018: $5,500
2019 through 2022: $6,000
2023: $6,500
Moving a TFSA From Another Bank or Financial Institution
You can move TFSA funds from one financial institution to another without any tax implications as long as you get the institution to complete a direct transfer for you. If you withdraw the funds yourself and then deposit them in a different TFSA, they will be counted as a new contribution. As a result, you could potentially exceed your contribution room and get hit with a 1% monthly fee on the overage. Also, keep in mind that you may have a choice of transferring your account “as cash” or moving your current holdings “as is.” Depending on how your funds are invested, there could be fees involved depending on which option you choose.
Recommended: Guide to Transferring Money Between Banks
Tax-Free Savings Accounts vs Registered Retirement Savings Plan
Tax-free savings accounts and registered retirement savings plans (RRSP) are two types of Canadian accounts that have some similarities. Both help people save and invest for the future. Both also have contribution limits. And, neither has withdrawal limits. However, they differ when it comes to tax benefits. A TFSA doesn't help lower your taxable income in the year you make contributions, but does allow for tax-free growth and tax-free withdrawals at any time. An RRSP, on the other hand, allows you to deduct your contributions from your annual income in the tax year you make them. Money invested in the plan grows tax-deferred but withdrawals are taxable income.
Tax-Free Savings Accounts vs Traditional Savings Accounts
There are some key differences between tax-free savings accounts and traditional savings accounts. One is how they are taxed. TFSAs offer tax-free growth, whereas a savings account does not. Any interest you earn on a high-yield savings account, for example, is considered taxable income.Another key difference is how much you can contribute each year. TFSAs have yearly contribution limits, while regular savings accounts generally don’t have any limits on how much you can contribute each year. Also, keep in mind that savings accounts hold cash, whereas TFSAs can hold cash and investments. Recommended: Guide to Savings Accounts
What Happens When a TFSA Holder Dies?
It depends. If the original account holder named their spouse or common-law partner as a successor holder, then the TFSA is transferred to that individual without incurring any tax penalties. If the TFSA holder named a spouse/partner or anyone else as a designated beneficiary, then that person would receive the cash from the TFSA. They could then put that cash in their own TFSA without impacting their contribution room, or they could choose to put the cash in a taxable account.
The Takeaway
A tax-free savings account can be an effective way to save for a variety of goals while benefiting from tax-free growth. TFSAs also allow you to carry over unused portions of your contribution room to the following year. Even if you withdraw money from the account, you can put that amount back into the account the following year. This adds to your total contribution amount and can help you reach your savings goals faster.
3 Money Tips
1. Checking accounts are ideal for everyday transactions but earn little or no interest. Savings accounts are better for storing and growing your money — they earn higher interest but often restrict how many withdrawals you can make per month.2. An emergency fund is a key financial safety net. Aim to have three- to six-months’ worth of living expenses tucked away in a separate account that earns interest, but allows you to access the money if needed (such as a high-yield savings account). In some situations, it may be appropriate to have up to 12 months of living expenses saved.3. To set up a simple monthly spending budget, consider the 50/30/20 rule. This involves splitting your after-tax income into three categories of spending: 50% on needs, 30% on wants, and 20% on savings.
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Frequently Asked Questions
Is there any sanction for withdrawing TFSAs early?
Should I use a tax-free savings account as an emergency fund?
Can you lose money in a tax-free savings account?
Photo credit: iStock/Zhanna Hapanovich
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About the Author
Lauren Ward
Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
