A tax free savings account (TFSA) is one of the best tax-advantaged accounts that you can take advantage of. Introduced in 2009, this account offers tax-free earnings on any monies invested through it.
What is a TFSA?
A TFSA, or Tax Free Savings Account, is an investment account open to Canadian residents. Despite the misleading name of the TFSA investment account, there are many types of financial activities that can be conducted within the tax-sheltered confines of your TFSA. These “qualifying investments” include:
- Cash (Savings Account)
- Mutual funds
- Publically available stocks from a listed stock exchange
- Investment certificates
- Small business corporation shares**
** There are limits on the small business corporation shares that can be sheltered in a TFSA. A tax professional should be consulted before investing these shares in a TFSA.
As you can see, there are a wide variety of options with which to choose from when investing in your TFSA. Indeed, this account is so much more than a simple savings account.
Who Can Invest?
Use of the account depends on two factors:
- Being a Canadian resident
- Age minimum of 18
How Does it Work?
Each year you can invest money up to a certain lifetime maximum into your TFSA. All of your contributions will be made on an after-tax basis, meaning you’ve already paid the taxes on every dollar you invest. Now this is where the magic happens. All investment growth on the monies that you invest can be withdrawn in the future tax free.
You can make contributions up to a lifetime maximum, determined by the factors listed above. Here’s where it gets complicated though, the lifetime maximum is affected by any withdrawals you make in the year. Any withdrawals made in this year are then added to the amount you can contribute back into the TFSA the following year. When making withdrawals, it is possible to crystalize any investment losses incurred in the account, which would decrease the amount eligible to contribute in the future. Let’s look at the formula, then run through a couple examples to show how this works.
Formula for Lifetime Contributions:
Unused Lifetime Contribution room + Withdrawals made during the year + Next Year’s contribution room = Total Contribution room at the beginning of next year.
Scenario 1: Frank turns 18 in 2008, and invests $ 5,000.00 on Jan 1, 2009.
By the end of the year, the money invested has fallen in value to $ 2,500.00.
Frank withdraws all his money before December 31st, 2009.
How much can Frank contribute in 2010?
Answer to Scenario 1:
Using the above formula, Frank can contribute:
Unused Contribution ($ 0.00) + Withdrawals ($ 2,500.00) + Contribution
Room for following year (year 2010) ($ 5,000.00) = $ 7,500.00
As you can see, the losses incurred by Frank have been crystallized, meaning when withdrawing money from the TFSA that had decreased in value, that investment contribution room is considered used already, and thereby lost. Let’s look at another scenario with similar timelines:
Scenario 2: Annie also turns 18 in 2008, and invests $ 5,000.00 on Jan 1, 2009.
By the end of the year, the money invested has increased in value to $ 10,000.00.
Annie withdraws all her money before December 31st, 2009.
How much can Annie contribute in 2010?
Answer to Scenario 2:
Using the above formula, Annie can contribute:
Unused Contribution ($ 0.00) + Withdrawals ($ 10,000.00) + Contribution
Room for following year (year 2010) ($ 5,000.00) = $ 15,000.00
This scenario showcases the true magic of the TFSA account. Annie has invested and done quite well in her account, and the $ 5,000 ( $10,000 account value, less $ 5,000.00 contributed) she earned in 2009 was tax free! And, these earnings do not go against future contributions. Annie can now earn more money, tax free through the TFSA, on the $ 15,000.00, which through gains in the account is higher than the lifetime contribution amount.
Okay, I’m with you so far. Now, How Much Can I Contribute?
There is a lifetime maximum amount that can be contributed to the TFSA, an amount that increases each year. Since the inception in 2009, the maximum contribution amount increased annually as follows: