What is a TFSA and How You Can Make the Most of it

In this article, I will explain the basics of what a Tax Free Savings Account ("TFSA") is. I will also explain some TFSA Strategies as well as some pitfalls that one should avoid.

Basics of a TFSA

A TFSA is essentially a speical type of "Tax Free" account which can be used to earn tax free income (such as interest, dividends, and capital gains). Beginning in 2009, all Canadian Residents aged 18 and over can contribute $5,000 annually into a TFSA. Any income earned on the contributions to the TFSA is tax free.

Contributions and Withdrawals

Contributions into a TFSA are not tax deductible and withdrawals are not subject to tax. Unlike an Registered Savings Plan ("RSP"), where your contributions are tax deductible and withdrawals are subject to tax. Once a withdrawal has been made, the contribution room equivalent to the amount of the withdrawal will be made available in the next year. Contribution room not used in one year will be carried forward to the next year.

Types of TFSA

The name Tax Free Savings Account can be quite misleading. A TFSA does not solely have to be a traditional savings account. In fact, it could be a Mutual Fund account, Self Directed brokerage account or a regular brokerage account.

How to make full use of your TFSA

Many accountants and financial planners recommend contributing the full $5,000 or as much as you can as early as you can. The reason being, the longer income gets tax sheltered, the greater the benefit to you.

What types of investments should you put into a TFSA

As a first rule, you should put your highest yielding investments into a TFSA. This will allow you to shelter most of your income as possible. However, if its a toss up between say Interest and Dividends from a Canadian Corporation, then one would choose to put the Interest into a TFSA. Reason being, under the Canadian tax legislation, Dividends from a Canadian Corporation get preferential tax treatment with the Dividend Tax Credit. However, no such relief is made available to interest income.

What should you look out for?

Many TFSA users are aware that you can withdraw funds from a TFSA without having to report it as income. However, many are unaware that the contribution room that is made available by the withdrawal will only be effective in the subsequent year.

Take for example, Judy contributes $5,000 into her TFSA on Jan 1 of Year 1. On Feb 28 of the same her she withdraws $2,000 intending to put it back into the TFSA at a later date. Since her TFSA contribution is at its limit, she will have to wait until Year 2 before she can contribute again into a TFSA. If Judy contributes the $2,000 on April 1 of Year 1, the CRA will impose a overcontribution tax equal to 1% of the excess per month.