What is a TFSA and How Does it Work?

Many Canadians are confused as to what a Tax Free Savings Account (TFSA) is, and how it works exactly.

Here, I'll give you the basic points to help clear the air:

1. Why: The main purpose of a TFSA allows you to save money and not have to claim any interest earned as income. 

For example: If you earn $200 on a normal investment, you would normally have to claim that $200 as income earned on your taxes. Therefore, after you file your taxes, you would be left with far less than $200. However, if your investment is under the TFSA umbrella, you do not have to claim any of your interest earned as income. Therefore, you keep the whole $200. 

This doesn't sound like a big difference, but if you make greater returns using the stock market for example, then it becomes a big deal. Moreover, if you're in a high income tax bracket, you can lose close to half of your interest earned if your investment wasn't in a TFSA.

2. Type: A TFSA can be applied to almost any personal investment. Whether it's a normal savings account, GIC, or invested in the stock market, you can shelter the investment in a TFSA. Just make sure you don't go over your limit between your different TFSAs. Keep in mind a TFSA can't be joint with anyone else. It is a registered product with the Government.

3. Limits: As of 2013, the maximum you can contribute to your TFSA is $25,500. The government will announce how much will be added next year to the total, however it generally increases by about $5000.

4. Contributing: Be sure to understand how contributions work. If you over contribute, you may receive a penalty from the Government. If you open a TFSA this year and have never contributed before, you can contribute the full $25,500 if you have it. You are then allowed to withdrawal some of the funds if you need to during that year, however you can't re-deposit funds until the following year. 

For example: At the end of 2012, you have $20,000 + interest in your TFSA. You then contribute $5,500 to your TFSA in 2013 to top up to the limit of $25,500. Then you withdrawal $8000 due to a family emergency.  You are not allowed to re-deposit that $8000 in 2013. You have to wait until 2014 to re-deposit the $8000. Additionally, you are also allowed to contribute whatever amount the Government raises the limit to.

5. Demographics: You may not be entitled to the same limit as the majority of others depending on your age, and how long you have been a Canadian citizen. As of 2013, if you have been a Canadian citizen for less than 5 years, or are under the age of 23, please check here to view what your contribution limit would be: http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/tfsa-celi/cntrbtn-eng.html

If you have any other questions that I didn't answer here, just leave a comment or go to the Official Government TFSA Page. Hope that helps!