How The TFSA Works
The premise of the TFSA is that it is an investment option for Canadians residents who want to invest and grow their money tax-free. The TFSA is designed to be a flexible investment account that allows the account owner to withdraw money at any time from the account, and not pay taxes.
The premise of the account is that you use after-tax income, and so when you deposit money into the account, you can also withdraw it tax-free. The benefit is that you get to avoid taxes on capital gain, interest, and dividends on the money that is saved or invested in the account.
Benefits of the TFSA
As mentioned, the biggest benefit of the TFSA is that your assets can grow tax-free inside the account and unleash the power of compound growth.
Because of the tax-free benefit of the account, you can invest in a stock, watch it grow, earn dividends, and then withdraw any earnings on the stocks at any time and not pay taxes on the capital gains. This represents significant potential savings for investors.
With its introduction, the TFSA has become a strong competitor to the RRSP in the realm of tax-free growth. Both are great vehicles and you need to understand the usage for the long and short-term.
Related: How To Maximize Your RRSP.
The Rules of the TFSA
The biggest rule of the TFSA is the amount that you can contribute each year. Up until 2012, you can only contribute $5,000 per year to your TFSA. For 2013 and onward, you will be able to contribute $5,500 with potential increases in the future. It’s worth noting that the TFSA has a carry-over aspect to it, which means that you can roll over any unused space under the $5,000 cap to the following year. For example, if you only contribute $4,000 this year, your cap increases to $6,000 the following year. This carry-over cap has no upward limit currently, which could allow for much higher contributions later in life.
However, even though you can withdraw anytime you would like, you still cannot contribute more than $5,000 per year ($5,500 starting in 2013). This means if you contribute $5,000 in January and then withdraw it in February, you have still maxed out your contribution for the year and would have to wait until next year to contribute. There is not “reinvestment” option during the same year.
To start using a TFSA account, you need to be at least 18 years old. From that point on, your contribution room starts accumulating, unlike an RRSP which requires you to earn income before you can leverage the account. For more details on opening a TFSA account, see the Canadian Revenu Agency website.
How it Compares to Other Investment Accounts
The TFSA is different than most other investment accounts because of the tax savings that it provides to investors and it is essentially the opposite of the RRSP account from a tax perspective. In the RRSP, you get a tax deduction for contributions, essentially making the contributions pre-tax money, but at that the same time, you have to pay taxes on withdrawals.
The gamble is whether you believe taxes will be higher now or in the future. If you think you will pay higher taxes now, the RRSP makes sense because of the current tax savings you receive. If you think taxes will be higher in the future, using the after-tax money now and not paying on withdraws makes sense for the TFSA.
The choice of which account to use becomes a regular topic of discussion as it hinges on predicting your future :)