This post was updated on April 10, 2013
Canadians 18 or older with a valid Social Insurance Number can save up to $5,000 each year in a Tax-Free Savings Account (TFSA). [Update: Beginning in 2013, the contribution limit is $5,500.] A TFSA is a very flexible savings vehicle. Unlike a Registered Retirement Savings Plan (RRSP), contributions to a TFSA are not tax deductible. The money you put into a TFSA has already been taxed. As a result, you can withdraw your TFSA savings whenever you want for any reason, without any tax consequences. If you take money out, you can deposit it back in the following year, in addition to the annual limit. [Update: Re-contributions for 2009 to 2012 are based on the old limit of $5,000.]
While an RRSP is designed for retirement savings, a TFSA can be used to save for many different types of goals. Its flexibility makes it the ideal vehicle to use as an emergency fund or to save for a down payment on a house. You don’t need earned income to contribute and you don’t have to file a tax return or even set up a TFSA to earn contribution room.
If you are already contributing the full amount to your RRSP each year, you can use a TFSA for additional retirement savings. When you retire, you can withdraw funds from your TFSA tax free. This may allow you to delay taking funds out of your RRSP – and paying tax on that income. Taking income from your TFSA tax free in retirement has other advantages. For example, it may help you stay under the Old Age Security (OAS) repayment threshold of $67,668 (in 2011). [Update: The 2012 repayment threshold is $69,562.] OAS pension payments are subject to an income test and are “clawed back” once your income exceeds this threshold. (If you earned more than $110,123 in 2011, you will actually have all of your OAS benefits clawed back.) [Update: The 2012 clawback threshold is $113,160.]
You can hold many different types of investments in your TFSA, including cash, GICs, bonds, stocks, mutual funds and Exchange Traded Funds (ETFs). All registered accounts, including TFSAs, shelter your investment earnings from tax and provide tax-free compounding. This allows your savings to grow faster than they would if they were held in a taxable account. Because not all types of investment income are taxed in the same way, consider using either of these registered accounts to hold investments that would otherwise be taxed at the highest rates, such as fixed-income investments like bonds and GICs or foreign stocks.
We will look at how different types of investment income are taxed in the next post.