One of the key financial concepts you’ll likely be teaching your kids is to save for a rainy day – to establish an emergency fund. A great way to encourage them to do that is by setting an example and opening a Tax-Free Savings Account (TFSA). Not only does a TFSA provide an easy way to put money aside for unexpected expenses, it also can be used to save for long or short-term goals – tax-free. And when your child turns 18, they can follow your lead and open their own.

How it works

With a TFSA you can:

•    Contribute up to $5,000 annually with no tax payable on interest, dividends or capital gains earned.
•    Accumulate contribution room every year. For example, if you are taking advantage of tax-free savings for the first time in 2011, you would have a $15,000 contribution limit across all the TFSA options – $5,000 per year since the launch of the TFSA in 2009. Carry forward unused contribution room indefinitely.
•    Withdraw from your TFSA without tax consequences or any impact on government benefits and tax credits. Note: Funds withdrawn in a given calendar year cannot be replaced until the following year.
•    Transfer TFSA funds to an RRSP or RESP (Registered Education Savings Account.) Such transfers count as a withdrawal, however.

When you withdraw

If you take money out of your TFSA, make sure you have some contribution room left before you re-contribute that amount in the same calendar year. Otherwise you may face penalties from the Canadian Revenue Agency – 1% for each month the over-contribution remains in your account. 

• Example 1: You deposited $5,000 in 2011 and withdrew $5,000 later in the year. Because you have no contribution room left for 2011, you can’t replace the withdrawal this year unless you hadn’t taken advantage of depositing $5,000 in 2009 and 2010. However the entire withdrawal will be added to your 2012 contribution room of $5,000, meaning you can deposit $10,000 next year.

• Example 2: Assuming you have taken advantage of TFSA deposits in 2009 and 2010, deposited $3,000 in 2011 and withdrew the same amount later. You can’t replace the withdrawn $3,000. However, you have $2,000 of contribution room left for 2011 so you can deposit that amount leaving the $3,000 you’ve withdrawn to be added to your 2012 contribution room, meaning you can deposit $8,000 that year.

For more examples of how to determine contribution room and the taxing of over-contributions, visit the Canada Revenue Agency or BMOs websites. 

Tax-free compounding

BMO also has a handy TFSA calculator showing the impact of tax-free compounding. Let’s say your income is $39,000 and you contribute the maximum to your TFSA annually. Over 10 years, assuming a return of 2%, you will save $1,377 in tax. If your income is $50,000 the savings jumps to $2,007. Actual savings levels will depend on which province you live in as the provincial tax rates vary.