What is TFSA and how does it work?

The tax free savings account (TFSA) is a new form of savings option for Canadian nationals and residents who have a Social Insurance Number and are at least 18 years old. Individuals who are eligible can make a contribution of up to $5000 during the first year. The amounts that are withdrawn from the account at a later period are tax-free.

One may use the account to split income with a partner. For instance, account holders can give income to their spouses or common law partners so that they contribute to the savings account. If the holder passes away, the accumulated amount will be transferred to oneís spouse or paid to the beneficiary tax-free. Alternatively, oneís spouse may become the successor holder. Penalty tax in the amount of 1 percent per month applies in case of excessive contributions being made. Furthermore, individuals who are not residents of Canada for a certain period are also subject to a special monthly tax of 1 percent.

The difference between a tax free savings account and a registered savings plan is that the first is designed to stimulate savings in general while the second encourages retirement savings. Moreover, the registered savings plan has higher limits on contributions and offers immediate tax savings. Individuals who have limited access to registered savings plans also benefit from TFSA. These are persons with large pension plans, those who donít have earned income (homemakers and young adults), etc. Persons with financial resources may also decide to contribute to both, RRSP and TSFA. TFSAThose who have to choose between the two instruments should consider whether they will need the funds for retirement or prefer to have access to them on a repeated basis.

It should be noted that residents may open more than one tax free savings account, but the total amount of contributions should not exceed the contribution room. It is made up of the dollar limit for the particular year, withdrawals that are made during the previous year, and the contribution room that is left unused during the same year. In the second case, it is better to opt for a TFSA. Amounts withdrawn from the account can be re-contributed, and they do not increase oneís tax liability.

Tax free savings accounts can be transferred to another institution. In some cases, there may be a transfer fee. The transfer is not treated as a contribution or withdrawal if it is processed in the form of direct transfer.

Persons who become non-residents are allowed to maintain their tax free savings account. However, they have to ask a qualified professional in their new country what the status of their TFSA is. Contribution room does not accrue over the period one is a non-resident. Persons who are green card holders and US citizens should also consult with a qualified professional before they decide to open a TFSA.

Persons should bear in mind that tax free savings accounts are not creditor-protected. On the other hand, the assets may be used as collateral when applying for a loan.