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The Tax-Free Savings Account (TFSA)

By Evelyn Jacks

Because the TFSA is so new, it is important that you understand its potentially powerful position in your portfolio. Available starting January 1, 2009, the Tax-Free Savings Account (TFSA) is a ­registered account in which investment earnings, including capital gains, accumulate tax-free. Its benefits are as clear as its name: you earn the income it produces tax-free.

Investors must be 18 to contribute up to $5,000 each year to such an account and they must have "TFSA contribution room" to do so, which is created by simply filing a tax return. The maximum deposit level will be indexed and adjusted in $500 increments in the future. There is no upper age barrier, which means you can contribute annually for the rest of your life.

If a taxpayer's TFSA contribution room is not used in one year it may be carried forward to the next, allowing for a larger contribution then as the room is cumulative. Unlike the RRSP, contributions to a TSFA do not result in an income tax deduction when they are made, but withdrawals are not reported as income. None of the earnings from the plan are included in income for any income-tested benefits, such as the Canada Child Tax Benefit or Goods and Services Tax Credit.

Consider the potential of making a contribution into the TFSA for each adult in the family:

Chart showing the growth of $5,000 invested annually in a TFSA over 45 years Spacer
  • $5000 invested each year for a productive lifetime of 45 year (age 20 to 65) is $225,000.
  • Add a compounding rate of return of 5% to this invested inside a tax-sheltered plan and that TFSA investment will grow to $838,426 inside the plan. By comparison, if this deposit had been invested outside the TFSA the amount would be only $547,420. The tax-free savings therefore are just over $290,000 or over twice as much more!
  • At a 3% compounding interest rate, the accumulated capital would be $547,420 inside the TFSA, and only $376,253 outside of it, not as good, but still over $170,000 or 45% more in tax-free savings.

Here are some additional TFSA rules of note:

  • Basic investor profile: Contributions can be made by/for those who have attained 18 years of age and are residents of Canada. There is no upper income limitation.
  • Earned income limitation: There is no earned income limitation.
  • TFSA contribution room: Every TFSA holder can contribute a maximum of $5000 per year, and this amount will be indexed after 2009, with rounding to the nearest $500.
  • Contribution deductibility: Contributions to the account are not deductible.
  • Excess contributions: These are subject to a 1% per month penalty until the amounts are removed.
  • Withdrawals (distributions) of both earnings and principal are tax exempt.
  • Withdraw for any reason: Withdrawals (distributions) from the plan will create new TFSA contribution room. Take the money out - principal and earnings - for what ever purpose you wish. Then you can put it back to grow again - you don't lose TFSA room once it is created.
  • Carry forward room: Unused contribution room can be carried forward on an indefinite basis.
  • Income testing not affected: Income-tested tax preferences like Child Tax Benefits, Employment Insurance Benefits or Old Age Security pension are not affected by earnings in the plan.
  • Attribution rules: There is no attribution rule attached to the TFSA, allowing parents and grandparents to transfer $5000 per year to each adult child in the family - for the rest of their lives. In addition, one spouse may transfer property into the TFSA of the other spouse without incurring attribution.
  • TFSA eligible investments: The same eligible investments as allowed within an RRSP will apply to the TFSA. A special rule will prohibit a TFSA from making an investment in any entity with which the account holder does not deal at arm's length.
  • Interest deductibility: Interest paid on money borrowed to invest in the TFSA is not deductible.
  • Stop Loss Rules: A capital loss is denied when assets are disposed to a trust governed by an RRSP or RRIF. The same rule will be extended to investments disposed to a TFSA.
  • Use TFSA as security: A TFSA may be used as security for a loan or other indebtedness.
  • Departure tax: The TFSA is not caught by the departure tax rules. No TSFA contribution room is earned for those years where a person is non-resident and any withdrawals while non-resident cannot be replaced. The US does not recognize the TFSA, therefore any realized income should be non-taxable when removed after emigration. However, any capital appreciation will be taxable. Therefore it will make sense to remove capital properties from the TFSA on a tax-free basis immediately prior to emigrating to trigger the deemed disposition on a nominal gain on departure.
  • Marriage breakdown: Upon breakdown of a marriage or common-law partnership, the funds from one party's TFSA may be transferred tax-free to the other party's TFSA. This will have no effect on the contribution room of either of the parties.
  • Death of a TFSA holder: The funds within the account may be rolled over into their spouse's TFSA or they may be withdrawn tax-free. Any amounts earned within a TSFA after the death of the taxpayer are taxable to the estate.


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