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TFSA: How does it work?

A self-managed TFSA allows you to invest in a wide variety of investment solutions and take advantage of their tax-free growth. You can contribute up to $5,500 starting in 2016, per year per person to that account, regardless of your income*. While your contributions are not deductible from your income taxes, the earnings on your investments are not taxable, even after withdrawal.

Moreover, your unused contribution rights can be carried forward to subsequent years. As such, if you haven’t yet contributed to a TFSA, you can do so by using the rights you have acquired since 2009 (the maximum allowed contribution from 2009 to 2012 was $5,000 per year. The contribution room was increased to $5,500 per year in 2013 and to $10,000 in 2015.).

The TFSA is one of the most flexible instruments available today. It allows you to withdraw any amount, whenever you want and for any reason. You will then be granted the right to contribute this amount back to your account as of January 1st of the year following the withdrawal, in addition to the maximum annual contribution. Amounts earned in or withdrawn from a TFSA do not affect your eligibility for income-tested benefits and federal credits.

You cannot contribute to your spouse's TFSA, but assets held in the account can be transferred to your spouse after your death and remain tax-exempt. However, in such a case, it is impossible for your spouse to use your remaining contributions.

There is no age limit for contributions and no expiry date for the plan. However, you must be at least 18 years of age to open a TFSA.

This account available in Canadian or American currency.

In-kind contributions

You can also contribute to the account in kind (for instance, by contributing securities held in one of your non-registered accounts), as long as the investments you transfer are eligible. Doing so will allow you to maximize your TFSA contributions with existing securities without having to liquidate them.

On a tax level, these investments are however considered as having been liquidated at their fair market value at the time of the contribution. If that value exceeds the acquisition cost of the securities, you must declare a capital gain in your income tax declaration. However, it is not possible to declare a loss if the acquisition cost exceeds the current market value. The amount of the contribution is calculated according to the current fair market value.

TFSA benefits

Since a TFSA does not take into account your income level and that unused contribution rights can be cumulated, it can be used to protect assets you want to shelter from taxes.

Furthermore, since withdrawing from a TFSA frees up a contribution room of equal value, with no refund obligation, young couples saving for a first home purchase or those who want to finance a return to school are given an additional option to existing programs such as the HBP and the RESP.

A TFSA can also be used as part of an income splitting strategy, in conjunction with spousal RRSP contributions and the pension income splitting rules. Because TFSA withdrawals are entirely tax-free and not subject to attribution rules, it brings great flexibility to an income splitting strategy.

Because it is not associated with your income level, a TFSA is a great way to transfer money to children and grandchildren. For instance, a grandfather can give his 25 year-old grandson $20,000 to contribute to his TFSA to help him plan for a future home purchase or to start saving for retirement. The only requirement is that the child must be at least 18 years of age and must have accumulated contribution rights. Since the TFSA was created in 2009, the beneficiary presented in this example must have been 18 years old in 2010 at the latest.

A TFSA can also serve to reduce the limiting effect of your pension adjustment (PA). If you contribute to a pension plan with your employer, you already know that this plan is associated to a PA that limits the amount you are allowed to contribute to your RRSP each year. A TFSA allows you to bypass this obstacle by investing an additional CDN $5,500 starting in 2016 per year in a tax-sheltered vehicle, and therefore grow more of your savings free of taxes.

Legal note:

* Contributions exceeding the maximum allowed contribution are subject to a 1% penalty per month. The maximum amount will be indexed annually, based on the consumer price index, and rounded off to the nearest CDN $500.

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