Newcomers to Canada looking to grow their wealth may want to take advantage of the opportunity to open a Tax-Free Savings Account (TFSA).
A TFSA is a type of investment account that allows people to invest without paying taxes on their investment earnings.
Like a Roth IRA in the U.S., TFSA contributions are made with taxed dollars (i.e., contributions are not tax deductible), but any investment earnings or income in the account, as well as any future withdrawals, are tax-free.
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Why open a TFSA?
Individuals who take advantage of the TFSA can significantly reduce the income taxes they pay on their investments over their lifetime. Consider the following example:
- Martha contributes $7,000 to her TFSA in 2024.
- From 2024 to 2065, she will continue to contribute $7,000 each year.
- Martha achieves an average annual return of 6%.
In this example, Martha would receive an investment return of $868,333.78.
If her marginal tax rate is 30%, Martha saves $260,500.13 in income taxes (assuming interest income).
Who can contribute?
Canadian residents who are 18 years of age or older and have a valid Social Insurance Number (SIN) can open a TFSA.
It does not matter what legal status the individual has in Canada (e.g. temporary residency, work/study permit, permanent residence or citizenship), what matters for the purposes of the TFSA is whether the individual is considered a resident of Canada for income tax purposes.
How much can someone contribute?
Every resident of Canada accumulates TFSA contribution room for each year they are 18 years old and a resident of Canada. For 2024, the annual contribution limit is $7,000. This contribution limit began at $5,000 in 2009 and is adjusted for inflation and rounded to the nearest $500.
Someone who was 18 years old in 2009 and has lived in Canada since then would have accumulated the maximum contribution room of $95,000.
Individuals can withdraw money from their TFSA at any time and do not have to pay taxes on it. The amount withdrawn is added to their contribution room. for the following year.
Keep track of the contribution space
If someone exceeds their contribution limit, they face a hefty penalty. The Canada Revenue Agency (CRA) imposes a tax of 1% per month on the excess contributions until all excess contributions are withdrawn.
For example, if George turns 18 in 2024 and contributes $8,000 to his TFSA, he will exceed his contribution limit by $1,000. If George realizes his mistake three months later and withdraws the $1,000 in excess contributions, he will owe the CRA $30 in taxes ($1,000 x 1% x 3).
Anyone can look up their TFSA deposit limits in their CRA account, but these numbers can be misleading because they are usually a full year old. It is the responsibility of the TFSA holder to keep their own records to make sure they do not exceed their deposit limit.
What investments can be held in a TFSA?
The word “savings” in TFSA is a bit misleading. Although many institutions allow their clients to hold and deposit cash in a TFSA, and some individuals use it for short-term or medium-term savings, the TFSA is better suited to holding long-term investments, such as exchange-traded funds (ETFs), mutual funds, guaranteed investment certificates (GICs), stocks or bonds.
Individuals benefit more from the TFSA if they hold higher-yielding investments in the account.
Most institutions apply similar rules to investment opportunities in a TFSA as they do to those in an RRSP.
What happens if the holder no longer resides in Canada?
If an individual no longer resides in Canada (for example, by moving back to their home country), they can keep their TFSA and will not be taxed in Canada on their capital gains or withdrawals.
Individuals do not receive any contribution flexibility for the years they are not resident in Canada.
If a non-resident makes withdrawals, those withdrawals will still be added to his or her contribution room for the following year, but he or she will not be able to use that contribution room until he or she re-establishes residency in Canada.
Individuals should avoid making contributions to their TFSA while not a resident of Canada, as all non-resident contributions are subject to a 1% tax per month.
How do I find out if I live in Canada?
Individuals can consult income tax form S5-F1-C1: “Determination of the residence status of an individual”.
You can also call the CRA at 1-800-959-8281 (from anywhere in Canada and the United States) or 613-940-8495 (from outside Canada and the United States).
Where can I open a TFSA?
Almost all Canadian financial institutions that offer investment accounts allow eligible customers to open a TFSA.
What happens if the owner dies?
TFSA holders can pass their TFSA to their spouse or domestic partner as the successor account holder.
Just as the original owner is not taxed, the subsequent owner is not taxed on earnings or withdrawals from the inherited account.
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