A TFSA is a type of deferred income plan. Any income earned in the TFSA is completely exempt from tax. Withdrawals from the TFSA are completely exempt from tax. However, unlike RRSPs, you do not get a tax deduction for contributions into the plan.
The TFSA funds can be withdrawn at any time and for any purpose. They are not specifically targeted towards funding retirement or any other life event. Simply put, they allow you to earn taxfree investment income for any purpose.
Like other deferred income plans, there are monetary limits for contributions.
The TFSA rules began in 2009, when the annual limit was $5,000. The limit is increased by inflation but in $500 increments only. Therefore, the annuallimits are:
- $5,000 for 2009 through 2012
- $5,500 for 2013 and 2014
- $10,000 for 2015 (the Conservative government implemented this increase), and
- $5,500 for 2016 and indexed thereafter (the new Liberal government overturned the previous increase, but did not change the figure for 2015).
Any unused contribution room carries forward indefinitely. For example, if you haven’t yet made any contributions, you will have a total contribution room of $46,500 in 2016, provided you were born before 1992 so that you were at least 18 during 2009.
In addition, when you withdraw funds, the amount of the withdrawal adds to your contribution room beginning with the year following the year of withdrawal. This rule allows you to take out funds temporarily and add them back later without detrimental tax consequences. But make sure you don’t try to use the extra contribution room sooner than the next January 1, or you will be hit with penalties!
You have contributed the maximum amount of $46,500 to your TFSA. In September 2016, you withdraw $12,000. Beginning January 2017, your contribution room will be $17,500: the regular $5,500 annual limit plus the amount of the 2016 withdrawal.
The TFSA is available for all Canadian resident individuals 18 years of age or older. Since there is no income inclusion upon the withdrawal of funds from a TFSA, the income attribution rules do not apply. Therefore, for example, you can give funds to your spouse for his or her TFSA and the investment income earned in the TFSA will not be subject to attribution in your hands. However, if your spouse withdraws the funds from the TFSA, attribution may apply to later earnings on those funds.
TFSA vs. RRSP?
One question that often arises is whether you should contribute to your RRSP or TFSA. Of course, if you have sufficient income and funds, you should try to contribute the maximum amount to both.
But what if you have to choose between the two? As a rule of thumb, the two plans will give you the same result if your tax rate is the same in the year of contribution as in the year of withdrawal.
This year you are in a 40% tax bracket. You contribute $100 of your income to your RRSP, which, because of the tax deduction and $40 savings in tax, costs you the net amount of $60. Assume the $100 grows tenfold to $1,000 several years later when you withdraw the amount. If you are in the same 40% tax bracket, you will net $600 ($600 net of $400 tax upon the RRSP withdrawal)
If instead you invest the net amount of $60 in your TFSA (i.e. $100 of your income net of $40 tax paid on that income) and it grows ten-fold to $600 upon withdrawal, you will have the same result as with the RRSP.
It is thus apparent that if you are in a lower tax bracket in the withdrawal year relative to the contribution year, you will come out ahead with an RRSP as compared to a TFSA. Conversely, if your tax bracket is higher in the withdrawal year than in the contribution year, you are better off with a TFSA.
Of course, we typically will not know our future tax rates. If you don’t have a good idea of your future tax rates, you might consider contributing equally to both an RRSP and a TFSA. And, as mentioned, if you can afford to max out both contributions you should do that.
Lastly, in terms of your tax rate in the year of an RRSP withdrawal, if you plan to withdraw funds when you are 65 years or older, you should consider how the resulting income inclusion will affect items like your age credit, which is phased out starting with income over $35,927 (2016 figure, indexed for inflation), or your Old Age Security, which is effectively clawed back and phased out once your income is over $73,756 (2016 amount).
These items can make your effective tax rate upon withdrawal significantly higher than the apparent income tax rate. On the other hand, since withdrawals from a TFSA are not included in income, these items are not affected by TFSA withdrawals.
Depending on your situation and how you will be affected by these items, the decision may tilt a little more towards the TFSA contribution.