If you are looking for a simple and very effective way to shelter your investment income from income tax, consider a Tax-Free Savings Account (“TFSA”).
What is a Tax-Free Savings Account?
A TFSA is a type of registered investment account which is available to individuals aged 18 and older. They were first introduced in 2009.
Investment income and capital gains earned on the investment of your contributions within your TFSA are not subject to income tax. Nor do you pay tax when you withdraw funds from your TFSA, even on the income earned on your contributions.
What kind of investments can my TFSA make?
TFSA investments must be “qualified investments” which generally means cash, guaranteed investment certificates, government and corporate bonds, mutual funds, publicly-traded stocks and Exchange Traded Funds.
If your TFSA holds a non-qualified investment, you will be subject to penalty taxes, and your TFSA will be taxed on the investment income and capital gains earned on the non-qualified investment.
Note that while foreign investments can be “qualified investments”, income and capital gains from foreign investments are often subject to withholding tax in the foreign jurisdiction. In addition, foreign taxes paid inside your TFSA are not eligible for a foreign tax credit, meaning they cannot be recovered. This effectively reduces the rate of return on these investments held within your TFSA.
Are my TFSA contributions tax-deductible?
No. Unlike contributions to your Registered Retirement Savings Plan, contributions to your TFSA are not tax-deductible. Neither are any administrative or other fees charged to it, or any interest on money borrowed to make your contributions. On the plus side, there is no tax on income earned inside your TFSA or on any amounts you withdraw from it.
How much can I contribute?
Your overall annual contribution room is the total of:
- The annual dollar limit (for 2024, the annual limit is $7,000). Each year the limit is indexed for inflation and then rounded up to the next $500);
- Any unused contribution room carried forward from previous tax years, starting from 2009 (individuals 18 or older can contribute up to the annual dollar limit. If you have not used your annual limit in any year, and provided you have filed a tax return for that year, you can carry forward your unused annual dollar limit and use in any future year), and
- Any withdrawals or re-contributions you made in previous years.
Assuming that you were 18 or older in 2009 and have not made any TFSA contributions, your total TFSA contribution limit in 2024 would be $95,000.
Can I withdraw funds?
Yes, you can withdraw any amount, at any time, for any purpose. There are no taxes or penalties on withdrawals, nor any requirement to re-contribute them.
Can I replace withdrawn funds?
Yes, you can replace withdrawn funds. The amount of any withdrawal is added back to your annual contribution room in the next calendar year, which allows you to recontribute withdrawn amounts in the future if you wish.
Be careful if you recontribute funds in the same you withdrew them. You must have sufficient available TFSA contribution room to make the re-contribution; otherwise, you will have over-contributed to your TFSA for the year. In this situation, you should wait until the next calendar year to recontribute, when the amount of your withdrawal has been added back to your overall contribution limit.
What happens if I contribute more than my limit?
Over-contributions are subject to a penalty tax of one percent of the highest excess amount in the month, for each month the over-contribution remains your TFSA. Therefore, you should withdraw over-contributions as soon as possible. You are also required to calculate and self-assess the penalty. It is possible that CRA may waive penalties under certain circumstances.
Do you need help with your Tax-Free Savings Account? The experienced team of professionals at Ernst and Company is available for personalized assistance. Please contact us today.
