What is a Tax-Free Savings Account (TFSA)?

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What is a Tax-Free Savings Account (TFSA)?

Here’s the deal: the world of banking and finances can be so intimidating that sometimes it pays to get back to the basics. Even if you consider yourself an individual with a high financial caliber, allow us to sound like your high school math teacher for a second when we tell you that it never hurts to check your work.

Although the question “what is a TFSA?” may seem rudimentary, we’re trying to say this: it is shining a light on one of the most underutilized and beneficial parts of banking in Canada.

In this Wealth Rocket article, we’ll dive into an explanation of what exactly a Tax-Free Savings Account (TFSA) is. We’ll also cover why it is one of the best tools Canadians have at their disposal — provided they know how to use it.

Table of Contents

What is a Tax Free Savings Account (TFSA)?

A Tax-Free Savings Account (or TFSA) is somewhat of an enigma on the Canadian financial scene. Although not truly a savings account in the purest sense of the term, a TFSA is recognizable as both a savings and investing account. It offers Canadian citizens an opportunity to make money off of the money they set aside tax-free.

The Government of Canada first introduced the TFSA in 2009. In doing so, they hoped that they would help encourage the general populace to save money (something we Canadians are notoriously not the greatest at, considering we are one of the most debt-raddled countries on Earth on an individual level!)

How Much Money Should I Keep In My Savings

How Does a Tax Free Savings Account (TFSA) Work?

As mentioned above, the main benefit of a TFSA is to earn interest on savings and investments without paying taxes on their gains.

However, the other basic idea behind opening a TFSA is that you can access your money through early withdrawals without worrying about financial penalties.

In the place of pushing penalties for early withdrawal, such as the case for a Registered Retirement Savings Plan (RRSP), Canadians are instead limited in how much they can add to their TFSAs through what is known as an annual TFSA contribution limit.

The government-set maximum contributions for a TFSA change every year, but they are generally around $5,000 to $6,000.

If an individual goes beyond their contribution limits, the Canada Revenue Agency will likely issue a penalty as high as 1% of the overage amount per month.

There is another thing to keep in mind concerning withdrawals, too: if you decide to withdraw within any given calendar year, it will not reset the amount for you within that same year. Instead, it will increase your contribution limit for the following year.

The interest that you earn in your TFSA is not taxed by the government, nor is it taxed when you remove money from your account.

The idea behind this is simple: since the total contributions of a TFSA have already been taxed when the income was earned, you are not taxed a second time when the funds are removed from your account. That's why you will sometimes hear a TFSA referred to as a “tax-advantaged” account.

Since TFSAs can hold cash savings, stocks, bonds, Exchange Traded Funds (ETFs), Guaranteed Investment Certificates (GICs), and mutual funds, knowing how you'll use a TFSA is more important than the type you'll end up choosing.

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How Do I Choose a Tax-Free Savings Account (TFSA)?

When it comes to using a TFSA for savings, you'll want to find a TFSA with an interest rate that beats inflation. Generally, this is an interest rate higher than 1.5%, though this changes from year to year.

It is possible to open a TFSA through both a traditional financial institution and several online banks such as Simplii Financial, Tangerine or motusbank, among many others.

Using a TFSA for stocks, bonds, ETFs, or mutual funds allows you to earn tax-free returns.

If you opt for this type of TFSA, you or a fund manager will buy and sell investments in an attempt to help you profit off of your TFSA. As you may have guessed, while this type of investment may be lucrative, it also comes with a level of risk that may be uncomfortable for some people.

Another option is to put your TFSA in the hand of a robo-advisor that will choose which ETFs to invest in based on an individual's portfolio, goal, and overall risk tolerance. Popular robo-advisors in Canada include Wealthsimple, Questwealth, and Invisor, among others.

Ultimately, an individual should choose their TFSA type based on their risk analysis, goal, and available timeline. As you probably could have guessed, TFSAs that involve stock trading are among the riskiest, but they may also result in the highest interest earnings.

How Do I Open a Tax-Free Savings Account (TFSA)?

TFSAs are available to any resident of Canada who has a valid Social Insurance Number (SIN) once they turn 18 or 19, depending on the province in which they reside.

At the time of opening your account, you may require documentation that proves your Canadian residency, as well as your personal identification.

Overall, a TFSA is one of the least complicated ways for the average Canadian to save money.

As long as you keep an eye on your contributions to ensure that you do not exceed the government-mandated limits, they are risk-free and refreshingly easy to use. It pays to start saving as soon as possible.

It is possible to open a TFSA through both a traditional financial institution and several online banks such as Simplii Financial, Tangerine or motusbank, among many others.

Using a TFSA for stocks, bonds, ETFs, or mutual funds allows you to earn tax-free returns.

If you opt for this type of TFSA, you or a fund manager will buy and sell investments in an attempt to help you profit off of your TFSA. As you may have guessed, while this type of investment may be lucrative, it also comes with a level of risk that may be uncomfortable for some people.

Another option is to put your TFSA in the hand of a robo-advisor that will choose which ETFs to invest in based on an individual's portfolio, goal, and overall risk tolerance. Popular robo-advisors in Canada include Wealthsimple, Questwealth, and Invisor, among others.

Ultimately, an individual should choose their TFSA type based on their risk analysis, goal, and available timeline. As you probably could have guessed, TFSAs that involve stock trading are among the riskiest, but they may also result in the highest interest earnings.

Frequently Asked Questions

A TFSA allows you to contribute up to a government-mandated maximum to a savings account without tax penalties.

The Government of Canada introduced TFSAs to make it easier for Canadians to save money.

If you are looking for more intense returns, though, you may want to look into investing in the stock market — although keep in mind that this could come with a higher degree of risk.

While an RRSP and a TFSA are both tax-deferring accounts used for saving and investing, an RRSP is intended for retirement saving and, as a result, penalizes early withdrawals. On the other hand, a TFSA is intended for short-term savings goals and permits withdrawals at any time without penalty.

The TFSA contribution room for 2021 is $6,000. The TFSA contribution room refers to the maximum amount that the government allows Canadians to contribute to their TFSA in one year. While this number changes depending on the year, it is generally anywhere from $5,000 to $6,000.

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