Tax-Free Savings Account (TFSA)
What it is:
How it works/Example:
Canadians with valid Canadian Social Insurance Numbers can open a tax-free savings account (TFSA). Though there are no restrictions on the number of withdrawals or deposits that an accountholder can make in a TFSA, an individual can only contribute up to $5,000 per person per year, regardless of how many TFSA accounts an individual has.
Let's look at an example that illustrates why someone would want to open a TFSA:
Let's say that you open two accounts: One is a TFSA and one is a regular savings account. The interest rate on both accounts is 5%. Your marginal tax rate is 28%. You contribute $5,000 to each account, and after one year each account is worth $5,250.
In the regular, taxable savings account, you would have to pay taxes on the $250 of earned interest, which amounts to $70. If you take that $70 out of your savings account to pay the taxes, your ending account balance is $5,180.
However, in the TFSA, you don't have to pay taxes on the $250 of earnings. So that account balance stays at $5,250.
Why it matters:
Accordingly, when taxes reduce the amount of interest available to continue earning interest, the value of an investment account (such as a savings account) diminishes dramatically compared to the account that is not taxed. Any time investors can find tax-advantaged ways of investing (such as a TFSA), more of their money is available to grow over the long-term.