You’ve probably heard about Tax-free Savings Accounts, or TFSAs, but if you’re still struggling to get out of debt, this kind of saving vehicle might be beyond the scope of your current plans.
Still, it’s important to understand what it is and how it can help you, even while you’re in debt.
Introduced in 2009, the original contribution amount limit was $5,000 per year. Starting in 2013, this limit is being raised to $5,500 to account for inflation.
Setting up one or more TFSA accounts is simple. You can set up a TFSA that’s like a regular savings account, or you can create one that holds GICs and/or mutual funds.
Regardless, the whole point of a TFSA is the TF, or Tax-free part. Money that you earn inside your TFSA grows tax-free, meaning when you withdraw it you won’t pay anything in taxes. That means if you contribute $5,000 this year and in 20 years it’s worth $16,000, you won’t pay anything in taxes on the $11,000 you earned.
Compare this to an RRSP. RRSP contributions are made with pre-tax dollars, which means you don’t pay income tax on the money you use to contribute. For example, if you make $60,000 a year and are in a 30% tax bracket (for easy math), you’ll pay $18,000 in taxes. But if you contribute $10,000 to your RRSP, you will only pay 30% on $50,000, or $15,000. So not only are you putting $10,000 in savings for your future, you’re also saving $3,000 right now on your tax bill.
The problem with RRSP’s is that when it comes time to withdraw, you’ll pay taxes on that money as if it’s income. We’ll talk in a later article about choosing which vehicle is right for you.
Back to TFSAs. Whereas RRSPs restrict when you can withdraw from them, a TFSA can be accessed at any time. Once you withdraw some or all of the money in it, you can’t put that money back in the same year, but you CAN put it back in any later year without penalty. This makes it a much better option for mid-range savings goals like saving for a down-payment on your home or starting a business.
Even better, your unused contribution room accumulates, so if you haven’t touched your TFSA room yet, you have a maximum allowance of $25,500 right now (4 years at $5,000 and 2013 at $5,500).
Two more quick points. Unlike an RRSP, the only condition you have to meet to open a TFSA is being 18 years or older. Also, contributions into a TFSA or withdrawals affect your eligibility for federal income benefits like Old Age Security, the Guaranteed Income Supplement, or the Child Tax Benefit.
We’ll talk more about TFSAs and RRSPs soon.