TFSA basics explained

You might have heard of the TFSA. But what is a TFSA? It is an acronym for the Tax Free Savings Account, where you can accumulate money tax free. Unlike the RRSP, there are no taxes refunded when money is deposited into a TFSA account, and there are no taxes paid when money is withdrawn.

The word “savings” in the TFSA has led to confusion because there are many uses for the TFSA account. Savings is one of the reasons for having a TFSA account, you can also use this account for investment, tax planning, and estate planning purposes. A TFSA account is opened like any bank account or investment account at a financial institution. The difference between the TFSA account and other accounts is how they are treated for tax purposes.

Here's how you can use the TFSA.

To collect savings

An ordinary bank account would accomplish the same goal, but there would be no taxes on the interest generated inside the account. Since many accounts do not pay interest anyway, using a TFSA to accumulate interest may or may not matter if your only objective is to generate savings.

For an emergency or reserve fund

The concept is to accumulate money for a large, unexpected expense such as a trip, large tax bill, house or car repair, or paying bills in the event of job or income loss. This is a variation of the savings theme, but the money is left in the account for a specific type of expenditure. The reason the TFSA is a good idea for this purpose is because money can be withdrawn and redeposited without tax consequences. The main exception is a situation below:

Let’s say you contributed $40,000 to a TFSA, and then withdrew $10,000 in October of 2015 and redeposited $9,000 in November of 2015. The maximum contribution room allowed to date is $46,500. This means that if you had $40,000 and you added another $10,000, you would have exceeded the maximum contribution allowed of $46,500 by depositing a total of $49,000.

The fact that you withdrew $10,000 would be accounted for in the following calendar year. Exceeding the maximum would result in penalties from the CRA. If you had the same example where you had $30,000 contributed, withdrew $10,000 and then redeposited $9000, the total contributions for that year would be $39,000 and there would be no penalty. Note that this rule applies to contributions and not the account totals because balances will have income and gains or losses included in the account over time.

To hold your investments

Many people hold investments in their registered accounts. Since there are no taxes payable on the money earned inside the account, there would no taxes on dividends, interest, or capital gains. If you lose money in a TFSA account, you would not be able to claim these losses on your tax return. If you contributed money to a TFSA, invest it, and lose the entire amount, you would not be able to recontribute until more room is generated over time, or if you are able to withdraw money and lower your contribution maximum.

For planning your estate

There are no taxes paid on a TFSA account until the day of death. Any monies earned after the day of death are taxable, but these amounts tend to be small because the time between the day of death and the day the money is distributed to the beneficiaries is usually short.

Bottom line

The TFSA account is a tool with various uses, depending on your situation. Aligning what you want to do with your money and the options you have with the TFSA account will allow you to maximize the benefit of having a TFSA account.