According to the CRA: “Contributions to a TFSA are not deductible for income tax purposes. Any amount contributed as well as any income earned in the account (for example, investment income and capital gains) is generally tax-free, even when it is withdrawn.”
What does this mean exactly? How are the contributions “tax-free” when they are not tax deductible? I’m self-employed and looking for ways to save on my tax bill, will contributing to my TFSA do that for me?
The above quote from the Canada Revenue Agency (CRA) is printed on their website under the heading What is a TFSA? It’s a worthwhile read for people interested in tax-free savings accounts (TFSA).
To answer the questions, first let’s talk about what tax-free and tax deductible mean in terms of investments. When you put money into a TFSA any money the account earns is tax-free. In other words, if your TFSA generates any earnings, you don’t pay tax on those earnings. Likewise, when you withdraw money from your TFSA to use it elsewhere, you don’t pay tax on the withdrawal. Any money generated by your TFSA or withdrawn from your TFSA is not taxed as if it were a source of income. This is what is meant by “tax-free”.
However, you do not get any tax credits when you put money into your TFSA. There are no immediate credits or deductions you can claim on your income taxes when you deposit money into your TFSA. You can’t claim deposits into a TFSA in order to lower your income tax bill. This is what is meant by the phrase “Contributions to a TFSA are not deductible for income tax purposes.”
The behaviour of a TFSA (not giving you a tax credit when you put money in, while also not taxing you when you withdraw funds) is in contrast to another type of investment account – the registered retirement savings plan (RRSP). When you deposit money into your RRSP you get a credit on your income taxes. The more money you put into your RRSP, the greater the benefit for you at tax time. Money deposited into your RRSP gives you a tax deduction.
On the flip side, when you take money out of your RRSP you will be charged income tax on it. The money you put into an RRSP gives you a tax credit, but any money you take out is taxed as income. In other words money going into your RRSP gives you a tax deduction, but money withdrawn is not tax-free.
Since you are looking to save money on your income tax bill, the better short-term option is to contribute to your RRSP. Each year you can contribute into an RRSP 18% of your income from the previous year. So if in 2022 you made $50,000 you could deposit $9,000 into your RRSP account in 2023. If you made $100,000 in 2023 then in 2024 you could deposit $18,000.
Since you get a tax deduction for each dollar you pay into your RRSP, and since most people will find themselves typically paying about a third of their income in taxes, you can estimate that you will get a tax credit equal to a third of your annual RRSP contributions. For instance, if I deposit $9,000 into my RRSP this year, I’ll probably get a tax credit of about $3,000 as tax time. If I contribute $18,000 into my RRSP then I should get a credit at income tax time of about $6,000.
The idea behind RRSP accounts is you pay into them when your income is high and you can benefit the most from a tax credit. After you retire and have little to no income, that’s when you withdraw money. You’ll get taxed as though your RRSP were your employment income.
In contrast, people usually pay into their TFSA when their income is relatively low or when they want to be able to withdraw the money at any time without a tax penalty.
Comments are closed, but trackbacks and pingbacks are open.