What is a Tax-Free Savings Account?
A tax-free savings account (TFSA) is a great way to save money without any risk. This registered account allows you to hold savings at a higher interest rate without paying any tax on your earnings. In addition to savings, you can also place stocks, GICs, mutual funds, ETFs, and bonds inside of a TFSA so long as they are under the yearly limit of $6,000 in contributions.
The bonus of placing your savings or any of these investment products inside the umbrella of your TFSA is that they can grow tax-free. In addition, unlike other savings accounts such as a Registered Retirement Savings account, if you choose to withdraw funds you do not have to pay taxes on any interest earned. Thus, it truly is tax-free in any sense of the word.
Of course, the government isn't going to give you everything for free, which is why there is a yearly maximum contribution. For 2020 that amount is $6,000. You can open as many accounts as you want, but the total you can contribute across all of them is still $6,000. The good news is if you don't make the maximum contribution the unused portion can be rolled over for the following years. This makes it an excellent tool for financially savvy students who can roll over unused portions to take advantage of when they have dependable income as a working professional.
What is the Difference Between High-Interest Savings Accounts and Regular Savings Accounts?
The simple answer is the interest rate. As the name implies, a high-interest savings account offers a better interest rate than a standard savings account. This allows the account holder to earn more on their savings. High-interest savings accounts are designed to be contributed to and left untouched, whereas regular savings accounts can be dipped into from time to time with fewer penalties or banking fees.
What are the Advantages of a TFSA?
The major benefit of using a TFSA over a traditional high-interest savings account is that your earnings are tax-exempt. If you intend to keep your savings account open for a lengthy period of time, this can result in large savings. A TFSA is also beneficial to those who expect to tap into their savings in the future for things such as a home down payment or tuition payments because there are no penalties for withdrawals. In addition, account holders can withdraw funds from a TFSA tax-free. Finally, TFSA's offer rolling contribution limits which mean as long as you have one open you won't face any penalties on the years you cannot afford to contribute while maintaining the option to catch-up later and maintain the same tax-free benefits.
How do Tax-Free Savings Accounts Work?
Tax-free savings accounts are pretty simple. They are simple savings accounts that are encouraged by the government which is why they enjoy tax-free status. The only catch is that they cap your annual maximum contribution at $6,000, but as mentioned any unused portion can be rolled over into future years so long as you hold an open account. The other perk is that you can re-invest any money you take out. For example, if you take out $3,000 this year to pay for a new roof on your home, next year you can contribute your annual $6,000 plus the $3,000 you withdrew.
Are Tax-Free Savings Accounts Taxable?
Nope. That is why they are so highly recommended by most financial experts. Tax-free savings accounts are not taxable while earning interest or when withdrawing funds so long as you adhere to the maximum contribution limits.
TFSAs Vs. RRSPs
Both RRSPs and TFSAs are great long-term saving options for Canadians who are looking for tax protection, but they function in different ways. TFSAs allow you to skip paying taxes on any interest that accrues within the TFSA but still requires you to pay basic income tax on earned income before you deposit it. On the other hand, if you open an RRSP account you are simply choosing to defer your taxes until you access the funds at a later date. In other words, you will have to pay income tax when you withdraw them. The benefit of an RRSP is that most people expect to have a lower income when they retire and thus a lower tax rate. Therefore, you may potentially end up paying less tax by differing taxes until you withdraw it during retirement. However, you will also have to pay taxes on the interest you earn, which is what makes the TFSAs more desirable to those who don't expect their tax bracket to fluctuate too much.
Who Should Open a Tax-Free Savings Account?
Anyone who wants to save money and is over the age of 18 with a valid social insurance number is allowed to open and/or invest in a TFSA. While it is never too late to open a TFSA, it is encouraged that all financially savvy young adults open one so that they can start building their rollover potential for future more financially lucrative years. This said it is never too late to open an account. If you want to save money in high-interest savings account a tax-free savings account is a great low-cost way to start.
How to Choose the Best Tax-Free Savings Account
The goal of a tax-free savings account is to earn money without paying any taxes. This only works if you choose a TFSA with a reasonably high-interest rate attached to it. Therefore, when shopping for a TFSA you need to use an interest rate calculator to look at how marginal fluctuations in interest rates will affect your earning potential. Then, check out the interest rates that your banking institution and other top lending options have to offer you. Your top goal should be to get the best interest rate.
Not only does a higher interest rate help protect you maximize your earnings, but it also protects you against inflation. Inflation reduces the value of money and can hurt your savings account unless it is earning interest at a higher rate. In general, you want an interest rate that is aligned with or above the nationally recognized inflation rate of 2%.
While comparing bank offers, always make sure to read the fine print of promotional offers and assess whether or not they will serve your long-term goals. Many banks offer what is known within the industry as "teaser rates" to get your attention but then drop the interest rate down substantially lower once the original period ends. For instance, a bank might offer you 3.5% for the first six months and then drop their rate down to 1.2%. While this may look attractive at first, another bank that offers you a flat 2% will be the better long-term option.
Finally, you need to also consider how you plan to use and/or access your TFSA. Some accounts charge transaction fees or monthly maintenance fees. Some banks do not allow you to transfer money into a chequing account while others do. In principle, TFSAs allow for unlimited transfers, but banks or credit unions can create their own conditions or fee structures. Thus, you need to consider how often you will be tapping into your TFSA and then weigh interest rate offers against the costs of expected transaction fees to determine the best fit.
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Author Bio
Mohamed Konate is a personal finance expert, blogger, and marketing consultant based in Toronto. He is a former financial services professional who worked at major Canadian financial institutions for many years. He managed the marketing strategy around various financial products ranging from credit cards to lines of credit. Mohamed is passionate about personal finance and holds a Bachelor's in Business Administration from the University of Quebec (Montreal) and a Master's in International Business from the University of Sherbrooke (Quebec). He is also the author of the Canadian Credit Card Guidebook.