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Published July 19, 2021
Updated July 21, 2021

What Is a TFSA and How Does It Work?

Since tax is not applied to interest and investment income inside a Tax-Free Savings Account (TFSA), you can grow your money faster. Contribute up to $6,000 this year.

Back in 2009, the federal government introduced Tax-Free Savings Accounts (TFSAs). This account quickly became popular with investors since it was another savings vehicle that allowed people to tax-shelter their money. However, the name is a bit misleading, and many people still don’t understand how TFSA limits and contribution rules work. Here’s everything you need to know about TFSAs.

What is a TFSA?

A TFSA is an account that allows people who are 18 or older and have a valid Social Insurance Number (SIN) to save up to a certain amount of money each year without paying taxes on the earnings.

Despite the name, you can use your TFSA for more than just savings. You can invest in mutual funds, stocks, bonds, guaranteed investment certificates and more. Although you don’t get a tax break when you contribute, you won’t pay any taxes on capital gains. All of your savings and investments are entirely tax-free when inside a TFSA.

Your TFSA is similar to other accounts, such as a Registered Retirement Savings Plan (RRSP). You’ll deposit money into the account, purchase investment products, and hopefully watch your balance grow. The main difference with TFSAs is that when you withdraw your money, you don’t pay any capital gains to the Canada Revenue Agency (CRA).

What you do with your TFSA is up to you. Some people use it for short-term savings, such as an emergency fund or a down payment. Others use it for retirement savings, while some people purchase high-risk stocks in their TFSAs, hoping to strike it rich.

How TFSA contributions work

TFSA contributions can be tricky as various factors depend on your individual situation. First off, there’s a yearly contribution limit. For 2021, the TFSA contribution room is $6,000.

Your contribution room also carries forward from previous years. That means that if you were eligible to contribute in previous years but didn’t have the cash, that unused room gets added to the current year’s room. For reference, here’s how much TFSA contribution room there has been in each year since the account’s debut:

  • 2009: $5,000
  • 2010: $5,000
  • 2011: $5,000
  • 2012: $5,000
  • 2013: $5,500
  • 2014: $5,500
  • 2015: $10,000
  • 2016: $5,500
  • 2017: $5,500
  • 2018: $5,500
  • 2019: $6,000
  • 2020: $6,000
  • 2021: $6,000

As of 2021, that’s a total of $75,500. However, if you’ve deposited money in previous years or made withdrawals, you’ll need to factor in those amounts to calculate how much you can deposit into a TFSA. In other words, to find out your actual contribution room for the year, you can use the following formula:

Current year contribution limit + unused contribution room from previous years + withdrawals made in previous years = Current available TFSA room

You can also check your CRA MyAccount for your TFSA room. However, since financial institutions typically only report your contributions once a year, the number displayed in your CRA MyAccount may not be accurate. It’s a good idea to keep your own records so you know exactly how much room you have, as you’ll pay a penalty of 1% for each month that overcontributions stay in your account.

How to withdraw money from a TFSA

Withdrawing money from your TFSA is easy, and you can do it at any time if you hold cash in your TFSA. However, some investment products may have restrictions, such as term deposits that have a maturity date. Also, keep in mind that withdrawals only apply when you actually take money out of your account. For example, if you decide to sell a bunch of stock in your TFSA so you can purchase a different stock within your TFSA, no withdrawal has occurred.

What’s excellent about TFSA withdrawals is that the amount is added back to your contribution room on January 1 of the following year. For example, say you had maxed out your TFSA in August 2020 and then withdrew $10,000 in November. On January 2, 2021, you’d be able to contribute $16,000: your $6,000 contribution for 2021 and $10,000 to make up for your withdrawal.

What you can’t do is withdraw money and then add it back in the same calendar year (unless you have available contribution room). To continue our example above, let’s say you withdrew $10,000 from your maxed-out TFSA in November 2020. You couldn’t re-contribute the money in December 2020; instead, you’d have to wait for the following year to begin.

Also, note that transferring your TFSA from one financial institution to another doesn’t count as a withdrawal. You just need to make sure it’s done correctly by asking your new financial institution to initiate the transfer. Your old bank may charge a fee to transfer your account, but some financial institutions will cover the cost for you.

Pros and cons of TFSAs

Once you understand how a TFSA works, you’ll quickly realize the benefits. Even though a TFSA can be great for many people, there are still some drawbacks to consider.

Pros of TFSAs

  • Tax-free earnings. All of your capital gains are tax-free. When it’s time to make a withdrawal, you don’t have to pay the CRA.
  • Easy withdrawals. Withdrawals can be made anytime, and you get the contribution room back the following year.
  • Equal contribution room. Regardless of your income, everyone gets the same TFSA contribution room.
  • Flexible. You can purchase different investment products, including bonds, stocks and exchange traded funds (ETFs), in your TFSA.

Cons of TFSAs

  • No immediate tax break. Unlike when you make RRSP contributions, you don’t get a tax break when contributing to your TFSA.
  • Complicated rules. Many people don’t understand the TFSA rules, which prevents them from using their account to its maximum potential.
  • Tracking contribution room is important. Since the CRA doesn’t track your contributions and withdrawals in real time, you need to track things independently. Disorganization could lead to overcontributions and penalties.
  • Day trading isn’t allowed. The CRA considers day trading to be business income, so it’s not allowed in your TFSA.

The best way to use your TFSA effectively is to have a goal in mind for the savings. This strategy allows you to purchase investment products within your TFSA that line up with your goal’s timeline and potential for risk. For example, if you’re saving up a down payment and plan to buy a house in five years, your strategy would be different than if you’re saving for retirement in 30 years.

How to open a TFSA

Opening a TFSA is easy, as most financial institutions, insurance companies and investment firms offer them. Self-directed TFSAs are also an option. However, before you open a TFSA, there are some basic criteria that you need to meet:

  • You must be a resident of Canada.
  • You must be 18 years or older.
  • You must have a valid SIN.

The age rule is based on your actual birthday, not the calendar year. Let’s say you’re turning 18 on November 1, 2021. You’d be able to open a TFSA and contribute the full amount for the year ($6,000) on that date.

That said, in Newfoundland and Labrador, New Brunswick, Nova Scotia, British Columbia, Northwest Territories, Yukon and Nunavut, the age of majority is 19. That means you may be able to open a TFSA until you turn 19. Fortunately, the contribution room for the year you turned 18 will carry over.

You’re allowed to have more than one TFSA, but your total contribution room doesn’t change. It’s shared between all of your accounts. Regardless of your goals, a TFSA is just one account that can help you reach them. Understanding the rules is vital as you’ll be able to use your TFSA to your advantage while avoiding any penalties.

» MORE: How a TFSA compares to an RRSP

About the Author

Barry Choi
Barry Choi

Barry Choi is a personal finance and travel expert. His website moneywehave.com is one of Canada's most trusted sites when it comes to all things related to money and travel. You can reach him on Twitter: @barrychoi.

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