According to the Canada Revenue Agency, more than eight million Canadians had a Tax Free Savings Account (TFSA) in 2011. With more than 35 million tax filers last year, many Canadians are choosing not to open a TFSA.
The Canada Tax Act says all investment income is considered taxable. This includes interest earned on savings in bank accounts or in savings bonds. So if you had any savings, you usually received a T5 slip around tax time and the income was included on your tax return.
Introduced in 2009, the TFSA is a tax shelter that allows taxpayers to deposit up to $5,000 per calendar year into an account and they do not need to report the income or dividends earned by the account on their tax return.
Canadians who are 18 years of age or older can open a TFSA. The TFSA is different than a Registered Retirement Savings Plan (RRSP). Any contribution to your RRSP is tax deductible. This is not the case for TFSA contributions. But any interest or income earned by your TFSA is tax-free.
You do not need $5,000 to open a TFSA account, and many financial institutions are offering a variety of account types. But if you choose a traditional TFSA account that only earns interest, the initial tax savings may not add up to huge amount. For example, if you deposit $5,000 in a TFSA on January 1 earning 1.5 per cent interest, you would shelter about $75 of interest in the first year.
If you have a more aggressive TFSA account, larger returns are also sheltered. However, you cannot claim any TFSA losses on your tax return.
A TFSA provides more flexibility than an RRSP if you need to withdraw money. There is no penalty for withdrawing funds at any time and you do not lose your contribution room. But make sure you understand the rules for contributing. If you withdraw funds from your TFSA, the amount withdrawn is added back to your contribution room, but not until the next year. So if you want to put back amounts you have withdrawn, you must wait until after the end of the year before doing so.
For example, if your TFSA contribution limit is $5,000 for the calendar year and you deposit $5,000 in January and then withdraw $2,000 in June, you cannot contribute any additional funds for the year. You have already contributed your annual $5,000. You have to wait until the next calendar year before you can re-deposit the $2,000. So the contribution room is not lost but you do have to wait to use it again.
Whether you need to open a TFSA depends on your situation. Questions you should ask include:
- Are you expecting your income to increase or decrease in the next year?
- Are you going to be able to contribute the maximum amount to your RRSP?
- Are you planning to buy your first home and take advantage of the Home Buyers Plan?
- Do you need easy access to your money in case of emergencies?
If you have $5,000 or less in a savings account, it may be a good idea to transfer it to a TFSA. This means the money you do earn in interest is tax free and you will not need to claim the income on your tax return.