What is a Tax-Free Savings Account (TFSA) and how does it work?

Whoever came up with the expression “there’s no such thing as a free lunch” likely never owned a Tax-Free Savings Account. These registered accounts allow holders to grow their wealth tax free. Since their introduction in 2009, they’ve given Canadians a flexible way to grow their savings. Read on to learn more about how these accounts work.

What is a Tax-Free Savings Account (TFSA)?

The federal government introduced the TFSA to help Canadians save more money. Although TFSA has the word “savings” baked into its name, it may be better thought of as an investment account where any interest, dividends or capital gains earned inside the account can grow tax free. While that feature may sound similar to the benefits of other registered accounts in Canada, such as the Registered Retirement Savings Plan (RRSP), the key difference with a TFSA is your withdrawals are also tax-free.

When did the TFSA start in Canada?

The TFSA launched in 2009 as a way to help Canadians 18 years of age and older grow their savings tax free throughout their lifetime.

TFSA eligibility: Who can use a TFSA?

In short, almost anyone. Any Canadian resident over the age of 18 with a valid Social Insurance Number (SIN) is eligible to open a TFSA. Apart from that age restriction, there are few other barriers to holding a TFSA. The only time your eligibility might change is if you become a non-resident of Canada for tax purposes. Should you find yourself in that situation, you will be allowed to maintain your TFSA and avoid any Canadian taxes on your earnings and withdrawals, but you will not be permitted to make any new contributions. In fact, any contributions made while you qualify as a non-resident may be subject to a 1% tax for each month they remain in the account, with some exceptions.

How does a Tax-Free Savings Account work?

The structure of a TFSA is relatively straightforward, but there are some important things to consider to ensure you don’t run afoul of the rules and incur potential penalties. The first thing to note is that once you open your TFSA, there is a limit to how much you can contribute to it each year — a number that is set by the federal government. For 2023, the contribution limit was raised to $6,500 from $6,000 in the previous year. The good news is that your contribution room is cumulative and additional contribution room becomes available at the start of the calendar year. Any withdrawals you make are completely tax free and you are allowed to recontribute the amount you took out starting in the next calendar year — or potentially earlier if you have unused contribution room.

Understanding TFSA contribution limits

How much can I contribute to my TFSA?

The amount you can contribute to a TFSA from year to year is influenced by several factors: your age, how much you’ve already contributed to the account and whether you’ve made any withdrawals.

For example, if you turned 18 in 2023 and are an eligible Canadian resident, you would be allowed to contribute $6,500 to a new TFSA. Your contribution room would then accumulate each subsequent year you remain eligible. As a further example, if you were at least 18 in 2009 — the year the TFSA was first introduced — and never contributed, you could be allowed to deposit up to $88,000 into your TFSA in 2023. Here’s how that works:

Your available contribution room starts off with a simple calculation: your total contribution room less any contributions to the account. For instance, if someone who just turned 18 opened an account in 2023 and immediately contributed $1,000, then that individual would have $5,500 in contribution room remaining.

When you withdraw money from a TFSA, you have the ability to recontribute those funds back into your account. Since the goal for everyone with a TFSA is to grow their savings, it’s possible to withdraw more from your account than you contributed to it. Under the rules, any withdrawals you make are added back to your contribution limit on January 1 of the next year. That date is important. Unless you have unused contribution room in your TFSA, you will have to wait until the calendar flips over to recontribute that money or you will face an overcontribution penalty.

What happens if I overcontribute to my TFSA?

The federal government frowns on overcontributions to TFSAs. To discourage the practice, the government imposes a tax equal to 1% on the excess amount for each month the money remains in your account. Those costs can add up quickly. Say, for example, that you overcontributed $5,000. You would have to pay a penalty tax of $50 a month or up to $600 a year until the overcontribution is resolved.

TFSA investment options: What can you hold inside a TFSA?

TFSAs are highly versatile. They can hold most investment types and asset classes. Notably, those investments don’t have to be limited to Canada. Within your TFSA, you can hold securities listed on any of the nearly 50 designated stock exchanges spanning North America, Europe, Asia and beyond. In most cases, foreign investments receive the same favourable tax treatment as any other investment within your TFSA, though there can be exceptions pertaining to dividend payments, which are discussed below. Qualifying investments eligible to be held in a TFSA include:

• Stocks that trade on Canadian and U.S. markets
• Options
• Mutual funds
• Exchange-Traded Funds (ETFs)
• Bonds
• Guaranteed Investment Certificates (GICs)
• Cash

Some notable exceptions include cryptocurrencies, direct real estate holdings and other assets like art.

What is a self-directed TFSA?

TFSAs are a great way to save for a variety of goals. A self-directed TFSA gives you the freedom to select the investments you want to hold inside your account. This way, you can truly personalize your portfolio by researching and buying individual investments like stocks or bonds. Alternatively, if you’re not comfortable picking individual stocks on your own, you still have the option to own ETFs or mutual funds. Click here to learn more or open self-directed TFSAs with TD Direct Investing.

TFSAs vs. savings accounts

Although TFSAs are described as “savings accounts,” they are quite different from your average savings account. TFSAs allow you to grow your money inside the account tax free. With a traditional savings account, you can still earn a small amount of interest on your deposits, however, the money you earn will be treated as taxable income.

Important considerations before investing in a TFSA

TFSA Pros

• Tax-free compounding: The ability to compound your gains — earning dividends on your dividends and income on your income — without having to pay tax on those earnings is one of the greatest advantages of a TFSA.
• Easy withdrawals: Unlike other registered accounts, you will not have to pay tax on your withdrawals, nor are there any requirements to pay the money back.
• Contribution room is not affected by income: Your contribution room is determined exclusively by age to ensure a level playing field.
• Withdrawals don’t affect your contribution room: When you remove money from your TFSA, the contribution room remains. You are permitted to recontribute the funds starting in the next calendar year.
• No mandatory withdrawals: If you don’t need the money, you can leave it in your TFSA to continue to grow for as long as you like. There are no stipulations that govern when you have to take money out of your account.
• Government benefits are not affected by withdrawals: Any money you generate within your TFSA will not count as income, meaning it will not affect how much you receive through government programs such as Old Age Security, the Guaranteed Income Supplement or Employment Insurance.
• No tax upon death: From an income tax perspective, the fair market value of the TFSA will be delivered tax free to your beneficiary after you pass. Any growth or income generated by the TFSA after your death, however, will be taxable.

TFSA Cons

• TFSA contributions are not tax deductible: Contributions do not generate a tax credit to offset your taxable income.
• Losses are, well, lost: Investment losses cannot be claimed on your income tax return the way losses within an unregistered account can.
• Managing your TFSA may require attention: Managing a self-directed TFSA is a commitment that requires a certain level of financial literacy to monitor contribution limits and make informed investment decisions.
• Overcontributions are penalized: Overcontributions will be immediately taxed at a rate of 1% per month.
• There are withholding taxes for U.S. dividends: The U.S. Internal Revenue Service will apply a withholding tax of 15% or more on dividends paid by U.S. companies. You can claim a foreign tax credit to recoup the withholding tax if the investment is held in an unregistered account or another registered account like a Registered Retirement Savings Plan (RRSP).
• No day-trading: Holders who frequently buy and sell investments within a TFSA may be considered by the Canada Revenue Agency (CRA) to be “carrying on a business,” which would make those earnings subject to tax.

How to open a TFSA

Opening a TFSA is easy. To open an account, you need to prove you are 18 years old and provide a valid Social Insurance Number (SIN). To register a new TFSA, contact your financial institution. Your issuer may ask for other supporting documents to verify your information.

How to withdraw money from a TFSA

Withdrawing money from your TFSA can be as simple as accessing the account through your banking app, just as you would your savings or chequing account. One of the few times you may notice a difference is when you have to sell an investment to make a withdrawal. In that scenario, you would have to wait until the transaction clears before completing the withdrawal. There are no fees or penalties for making a withdrawal and the money can be used for anything you like.

Tax-Free Savings Accounts (TFSAs) vs Registered Retirement Savings Plans (RRSPs)

While TFSAs and RRSPs both allow you to hold similar types of investments and grow your money tax free, that’s where the similarities end between these two accounts. When you put money into a TFSA, you are using after-tax income. While you won’t earn a tax credit for your contributions, you also won’t have to pay tax on any income or gains you earned within your TFSA when you withdraw those funds.

The money you contribute to your RRSP uses before-tax earnings. Unlike a TFSA, eligible RRSP contributions can be claimed on your tax return to lower your taxable income, which is why many Canadians receive a tax refund for adding to their retirement savings every year. While your money continues to grow tax free within the account, withdrawals from the account will ultimately be taxed as income in the future, with some exceptions.

For more on the difference between TFSAs and RRSPs, see RRSP vs. TFSA: Which one do I choose?