What is a Tax-Free Savings Account (TFSA)?
In Canada, a tax-free savings account (TFSA) is a federal program that allows Canadians to avoid paying taxes on interest earned in specific savings accounts.
How Does a Tax-Free Savings Account (TFSA) Work?
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 Does a Tax-Free Savings Account (TFSA) Matter?
Any finance professor will tell you about the power of compound interest -- that notion of earning interest on your interest. It's the phenomenon that allows wealth to grow exponentially.
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.