What Is A Tax-Free Savings Account And How Does It Work?

Posted Oct 10, 2021

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Canadians looking to build their wealth for the future have many options. One of these is a tax-free savings account, or TFSA. Not only does this function as a savings account, but it also can serve as an investment vehicle. Here’s what you need to know about Canadian tax-free savings accounts before you open one.

How Does a Tax-Free Savings Account Work?

As the name implies, a tax-free savings account allows you to make contributions without being taxed. Withdrawals from a TFSA are also not taxed. You can use a TFSA to hold cash, just like a traditional savings account, but you can also use it to hold many different types of investments, such as stocks, bonds, and mutual funds. Unlike some other types of Canadian long-term savings accounts, contributions to your TFSA are not tax-deductible.

Benefits of Tax-Free Savings Accounts

There are many benefits to setting up a tax-free savings account. Because contributions and gains from investments are not taxed, you can grow your wealth faster. You also don’t have to worry about paying taxes on withdrawals. While many people use their TFSA to save for retirement, you don’t have to use it for this purpose. Tax-free savings accounts are very flexible, as you can use them to save for anything. You can also make withdrawals at any time without any penalties.

How To Set Up A Tax-Free Savings Account

In Canada, many banks, credit unions, and insurance companies offer tax-free savings accounts. To sign up, you need to be a Canadian over 18 years of age and have a valid Social Insurance Number. There is a good chance that a financial institution you already have an account with offers TFSAs, and it’s easy to sign up. The set-up process typically takes less than 30 minutes, and you’ll need to provide a few standard pieces of information to verify your identity.

TFSA Contribution Amounts

Currently, you can contribute up to $6,000 per year to a tax-free savings account. When TFSAs were initially launched in 2009, the contribution limit was only $5,000, but the limit was raised in 2019 and is currently $6,000. Your contributions can roll over from year to year. For example, if you only contributed $2,000 in 2020, the remaining $4,000 will roll over to 2021. In this situation, you would be able to contribute a total of $10,000 in 2021 - the rollover of $4,000 plus the remaining $6,000. If you contribute more than your allotted contribution amount, you will have to pay a 1 percent penalty.

Any withdrawals that you make can also affect the contributions you make. Let’s say you contribute $4,500 but withdraw $2,000 within the same year. Despite the withdrawal, you can only contribute the remaining $1,500 to your account that year. The next year, you will be able to re-contribute the $2,000 that you withdrew.

Final Thoughts

Tax-free savings accounts offer plenty of benefits for Canadians looking to grow their wealth. They are a great savings option for people of all ages because they are so flexible. They allow many different types of investments, including foreign investments, and you can withdraw at any time. While there are contribution limits, they do roll over from year to year.

It’s important to note that TFSA contributions are not tax-deductible, unlike contributions to a registered retirement savings plan. However, they aren’t taxed when you withdraw, saving you money down the line.

 

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Investments such as stocks, bonds and mutual funds have the potential to lose value during the life of the investment.

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