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is a tax-free savings account worth it

Whether you’re looking to grow your savings, invest, or earn more on your money, you might consider a tax-free savings account. A tax-free savings account (TFSA) is a type of savings option that lets you tax-shelter your money and any interest earned.

Tax-free savings plans are a popular way to grow your money. Approximately 58% of Canadians have some type of tax-free savings account, according to a 2023 RBC study. However, there are some drawbacks to TFSAs, such as contribution limits and tracking requirements.

Here’s everything you need to know to decide if a tax-free savings account is right for you.

What is a tax-free savings account?

A tax-free savings account is a type of registered plan that doesn’t require you to pay taxes on your earnings. Both your contributions and interest earned are tax-free. You need to be over eighteen to open a TFSA and must have a valid Social Insurance Number (SIN).

First introduced in 2009, this type of tax-free plan incentivizes savings, but there are contribution limits. Canadians can save up to $7,000 per year in 2024 in a tax-free savings account.

While you don’t receive a tax break when you contribute to a TFSA like you would with another type of registered retirement savings plan, you aren’t taxed when you withdraw your funds, either.

You can use a TFSA like you would a savings account, but it also offers other features. You can keep guaranteed interest certificates in your TFSA. And if you want to grow your money even more and have a higher risk tolerance, you can hold investments in your tax-free savings account.

How does a tax-free savings account work?

The way your tax-free savings account will work depends on the type you open. You might choose to open a TFSA at your regular bank or credit union and use it as a savings account to save for goals like a home down payment, emergency fund, or other short-term savings.

Or, you might choose to use a TFSA as an investment account to hold mutual funds, exchange-traded funds, or other stock market investments. In this case, you might open an investment TFSA with a brokerage instead.

In either case, your TFSA would work like a regular savings or investment account, except that any contributions and interest you earn would be tax-free.

Who should open a tax-free savings account?

Anyone over eighteen with a valid SIN in Canada might consider opening a tax-free savings account. It’s a great way to grow your money while reducing your tax liability. Although the interest you earn in a savings account generally wouldn’t add up to a ton in taxes, every dollar saved can help.

If you’re interested in investing, a tax-free savings account may be particularly appealing because any interest or growth your investment portfolio sees is also protected from taxation. As long as you can abide by the yearly contribution limits, this type of account may make a great primary or secondary investment option.

What is the current contribution room for a TFSA?

The 2024 contribution limit for a tax-free savings account is $7,000. This rate can change annually and is tied to inflation. But your individual contribution room can vary.

If you weren’t able to hit the contribution limit in previous years, the unused “room” in your TFSA carries over. For example, if you opened a TFSA in 2023 and had $2,000 left that you could have contributed, you could contribute up to $9,000 this year.

However, there is a ceiling. Right now, the total contribution limit is set at $95,000.

You’ll need to keep track of your contributions and withdrawals on your own to make sure you know how much room is left in your TFSA.

How to calculate your TFSA contribution room

To figure out the contribution room in your tax-free savings account, you’ll need to know the current annual contribution limit, any withdrawals you made, and unused contribution room from previous years.

Let’s say you had a TSFA for five years.

If you had $3,000 left in contribution room in year one, $1,000 left in year two, $0 in year three, $2,000 in year four, and $0 in year five, you’d have $6,000 plus the $7,000 limit for this year. So you could contribute up to $13,000 before there was no contribution room left.

But if you also made withdrawals, let’s say $1,000 in year two and $1,500 in year three, those withdrawals would also add to your contribution room. So you’d have an additional $2,500 you could then contribute in 2024.

Do TFSA transfers count as withdrawals?

Transferring your tax-free savings account or some of the funds in it to another TFSA at another financial institution does not count as a withdrawal. Therefore, your contribution room will remain the same.

What happens if you over-contribute to a TFSA?

Since you have to manually track your TFSA contributions, you can accidentally contribute more than you’re allowed to in a given year. No matter how the overcontribution happened, you’ll be taxed for this action.

Over contributions to tax-free savings accounts are taxed at 1% of the highest excess transaction within a month for every month that the excess money remains in your tax-free savings account.

Tax-free savings account pros and cons

Before opening a tax-free savings account, consider the pros and cons:

Pros:

  • Tax-free ability to grow your money (no capital gains tax)

  • Easy to open

  • Investment options are available

  • You can withdraw funds at any time

  • If you don’t maximize your contributions, the unused amount rolls over

Cons:

  • No up-front tax breaks like other registered retirement savings plans

  • You have to track your contributions to figure out your contribution room

  • There are yearly contribution limits

Alternative savings accounts to consider

If you’re not sure if a tax-free savings plan is for you, there are other alternative savings options worth considering.

Registered retirement savings plan

Similarly, a registered retirement savings plan is another government-registered savings account that can help you earn interest. You're eligible for a RRSP if you pay taxes in Canada and earn an income.

You can contribute a total of $31,560 per year to a registered retirement savings plan — a much higher amount than tax-free savings accounts allow. This plan also allows a $2,000 excessive contribution amount, which could bring your contributions for 2024 up to $33,560.

Like a tax-free savings account, you can roll over any unused contribution room in your account. But unlike a TFSA, there is no lifetime contribution maximum.

The other major difference is that your contributions are tax-deductible, but your withdrawals are taxed. There’s no “tax-free” benefit with an RRSP. You can also invest and save with both plans.

Traditional brokerage account

If you’re not interested in the $7,000 yearly contribution limit, you might consider opening a brokerage account at an investment firm. While you can invest in many of the same investment types as a tax-free savings plan, you’ll be able to invest more than $7,000 per year.

While there’s no tax-free benefit, you could potentially earn more if you have more than this year's threshold to invest. And unlike tax-free savings accounts, you could grow your money with day trading.

High-interest savings account

A high-interest savings account is a type of account that earns higher than the national savings average. Right now high-interest savings accounts in Canada can earn upwards of 5% to 6% annual percentage yield.

A tax-free savings account, on the other hand, earns interest but typically at a lower rate. You may find some TFSAs that offer rates near high-interest savings accounts, but they’re rare. While TSFAs have contribution limits, high-interest savings accounts do not. You can also contribute more than the $7,000 limit to a high yield savings account.

You will, however, pay taxes on any interest earned in a non-tax-advantaged account.

Guaranteed interest certificate

A guaranteed interest certificate (GIC) lets you lock in a fixed interest rate on your savings in exchange for locking away your money with a bank for a certain period of time. While you can invest in a GIC with a tax-free savings account, you can only contribute up to the $7,000 limit.

If you’re opening a GIC with $7,000 or less, a TFSA makes sense since it protects your interest from taxation. But if you want to open a GIC with a larger sum of money, you’ll need to open one outside of a TFSA — and pay taxes on any interest earned.

Other alternative savings options

Some online financial institutions offer savings alternatives that can help you earn interest while also working on your credit score.

For example, you can build your credit with KOHO while also earning up to 5% back on your savings — a rate on par with some of the top high interest savings accounts’. KOHO offers many of the features you’d look for in a bank, like overdraft protection and no NSF fees, while also providing free access to your credit score. It also offers virtual card access.

How to open a tax-free savings account

You can open a TFSA at most Canadian banks or credit unions. If you’re opening an investment account, most brokerages and some financial institutions offer this option.

You’ll need:

  • Your SIN

  • Proof of residency

  • Proof of age (must be 18 or older)

You can open a TFSA online or in person, depending on your preference and the particular financial institution you choose. The process generally takes less than ten minutes but could take longer if opening an account at a physical location.

Tax-free saving account vs. Roth IRA

A tax-free savings account resembles a US retirement plan option, a Roth individual retirement account (IRA). A Roth IRA also lets you contribute post-tax dollars, letting your balance grow tax-free.

Like a TFSA, a Roth IRA has yearly contribution limits. For 2024, the contribution limit into a Roth IRA is $7,000, though you can contribute $8,000 if you’re 50 or older. This limit tends to go up each year and is tied to inflation.

A Roth IRA has early withdrawal penalties, however, meaning if you pull out your funds before you reach retirement age, which is 59 ½ in the US. You can withdraw your funds before then, but you’ll have to pay the IRS (Internal Revenue Service) an early withdrawal penalty of 10%. In some cases, this penalty may be waived, for instance, if you’re using the funds for a down payment on a home. You can’t withdraw any funds until you’ve owned the account for at least five years.

While a tax-free savings account encourages all types of savings that can be drawn on at any point in your life, a Roth IRA is more geared toward retirement. So, their intent is a bit different.

Is a tax-free savings account right for you?

Even if you can’t save as much as you’d like, taking advantage of the tax benefits of a tax-free savings account can help you stretch the savings you do have a little further. It’s a great way to earn interest on your money without worrying about paying taxes on any returns that accrue in your account.

It’s also a great way to begin investing and growing your money for the future. While a tax-free savings account shouldn’t replace a retirement savings plan, it can serve as a nice supplement, both before and during your retirement years.

It can replace a high interest savings account, in some cases, by offering tax protections. But the interest you earn may be lower than a higher yielding savings account, so do your research when deciding where to hold your money.

You can find tax-free savings accounts with no monthly fees from popular Canadian banks, online banks, credit unions, investment firms, and other financial institutions.

Note: KOHO product information and/or features may have been updated since this blog post was published. Please refer to our KOHO Plans page for our most up to date account information!

Courtney Johnston

Courtney is a professional writer, editor and financial literacy enthusiast. You can find her writing on CNET, Investopedia, The Motley Fool, Yahoo Finance, MSN and The Balance. She spends her free time exploring different cities across the globe or enjoy some downtime with her two cats and one dog.