How tax free savings accounts work
Although it’s still early days, the new TFSA may ultimately prove to be everyone’s favourite tax shelter.
The new Tax Free Savings Account (TFSA) introduced in the 2008 Federal Budget is now a year old. And, for many families, this new-found ability to shelter several thousand dollars a year from tax is certainly worth celebrating.
Here's how these new accounts work.
What is a TFSA? The TFSA is a type of registered investment account that allows Canadian investors to earn interest, other types of investment income and capital gains tax free. You can withdraw any of your contributions plus your investment returns at any time without paying tax.
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How much can I invest in a TFSA? Canadian residents age 18 or older who have a valid Social Insurance Number can contribute up to $5,000 of after-tax cash annually to a TFSA, with unused room carried forward. Starting in 2010, the annual dollar limit will be indexed to the inflation rate and rounded to the nearest $500.
Can I deduct my contribution? No. Contributions to an RRSP are deductible and reduce your income for tax purposes. In contrast, your TFSA contributions won't be deductible. However, unlike an RRSP, investment income, including capital gains, earned in a TFSA won't be taxed, even when withdrawn.
Who should invest in a TFSA? Just about anybody should find the tax-free nature of TFSAs to be of interest. These include younger people saving for a car or house purchase, higher-income earners who have maximized their RRSP contributions, people wanting to melt down some of their RRSP and transfer money in early retirement, or seniors concerned about their investment earnings impacting federal income-tested benefits such as Old Age Security benefits.
Is a TFSA better than an RRSP? The two plans will actually produce the same results, providing your current tax rate proves to be the same as your tax rate down the road. RRSPs will make more sense where your tax rate later on proves lower than the tax rate when you originally contributed. Conversely, you'll come out ahead with a TFSA if your tax rate will be higher than it was when you contributed. There may be an advantage to intentionally storing up RRSP room, and using a TFSA in the interim. When your income jumps, TFSA funds can be withdrawn to make an RRSP contribution, creating TFSA repayment room at the same time.
Can I open more than one TFSA? Yes. But the total contributions to all your TFSA accounts can't be more than your maximum room for that year, plus any carry forward room. For example, your maximum contribution limit for 2010 will be $5,000, therefore you can open two TFSAs to which you contribute $2,500 each for total combined TFSA contribution of $5,000.
Can I put money in my spouse's TFSA? Only the TFSA account holder can contribute to their own account. However, funds can be given to a spouse or common-law partner for them to invest in their own TFSA. This means single-income families will be able to do much more income splitting since they'll have $10,000 to work with each year, all of which can be used by the higher-income earner. Right now, if you give money to your spouse to invest, any profits earned are "attributed" back to you for tax purposes. This won't apply to income earned in a TFSA.
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What am I allowed to invest in? Generally, the types of investments you can use are the same as in an RRSP. This would include mutual funds, stocks, GICs, bonds, and, in some circumstances, shares of small business corporations. If you're a little short of cash and have other investments, you can transfer them to your TFSA 'as is' and build value. Remember that when you transfer the investment into your RRSP, it's considered a disposition and you may face capital gains if the value has increased.
When can I take my money out? You can withdraw TFSA money at any time and for any reason, with no tax consequences. Any amounts withdrawn from your TFSA in a particular year will be automatically added to your contribution room for the following year. In other words, you can put back what you took out at a later date. Say you save $3,000 a year for 10 years in a TFSA, earning investment income on those savings. You then decide to open a small business and withdraw your TFSA savings, which have accumulated to $42,000, tax free. Should you sell your business in the future, you can re-contribute the $42,000 you withdrew TFSA without reducing any TFSA contribution room you would've earned in the meantime.
What happens if I leave the country? Once you cease to be a resident of Canada, the following rules apply:
- The TFSA may remain open
- No contributions may be made
- You can not accumulate contribution room
- Withdrawals will not increase contribution room
What happens if I die? The profits from your investments in a TFSA will paid out to your estate tax free. If the TFSA assets are transferred to a beneficiary under your will, they'll still be clear of tax, but any profits accruing after your death will be taxable. The money can also be transferred to a surviving spouse or partner's TFSA without affecting their own existing TFSA contribution room.
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