The Canadian government introduced the Tax Free Savings Account, (TFSA), in 2009. This investment account allows residents of Canada to invest in various financial products without having to pay income tax on subsequent gains. This can be a great opportunity to boost portfolio value in preparation for retirement or other life events.
The Tax Free Savings Account is similar to the Registered Retirement Savings Plan, (RRSP), but there are significant differences as well. Any money deposited in an RRSP is counted as a tax deduction. Money deposited into the Tax Free Savings Account is after tax. That is, there is no tax deduction available for the TFSA. While yearly capital gains are shielded from tax in both cases, withdrawals from the RRSP are taxed. There are also significant differences in the contribution levels of the two plans.
The Tax Free Savings Account was started in 2009 allowing contributions of up to $5000 per Canadian resident over 18 years of age. This limit also applied for 2010 and 2011. Each TFSA may now have contributions up to $15,000. There is a provision to increase the contribution amount in 2012 and subsequent years to index for inflation.
Canadian residents would be best to move their high yield investments into the TFSA. They may open a TFSA at their normal banking institution. The contribution can be made in cash or by transferring an investment from another investment account. The latter option will require that you pay any tax due as of the date the asset was transfered. Consult your financial advisor if this option is of interest to you.
Despite the account having the word "Savings" in it, you may invest in most any type of security. You can set up a self directed account at your banking institution. This will give you the ability to have stocks, bonds, mutual funds, income products and other investments in your account. In fact, most people will not have cash savings in the account at all. This is due to the low rate of return typically earned by these assets. Instead, stocks and derivatives are more likely to be in the TFSA. If the asset increases in value, all of the gain will be earned and none will be subject to income tax.
Comparing various investment strategies for Canadians, the tax due would be as follows on a $15,000 account having a 5% yearly gain:
- RRSP investment: $750 gain taxed as income when withdrawn
- Non-sheltered investment: $750 taxed as income during each year
- TFSA investment: $750 gain not taxed at all
The non-sheltered investment might be subject to capital gains requirements which would mean that only half, or $375, would be taxable in each year.
Clearly, the TFSA is an interesting option for Canadians would want to invest in equities such as stocks that may have substantial gains over time. The TFSA allows for cummulative contribution levels. That means that any unused contributions may be used later. If you don't have a TFSA now, you may deposit $5,000 for each of 2009, 2010 and 2011 and begin your account with $15,000 in funds.