The government can use taxes to discourage behaviour, or give tax breaks to encourage it. Several years ago, the Government of Canada decided to encourage saving by creating a Tax Free Savings Account (TFSA).
Tax-Free Savings Accounts (TFSA) operate in the following manner. One first earns income from various sources that is taxed. Then, this after-tax income can be put in a special account, the TFSA, where capital gains, income, and dividends are not taxed. The catch? There are contribution limits that you need to be aware of. Read on for details...
How contribution room works
Many securities can be held in a TFSA: cash, most stocks, ETFs and index funds, individual bonds, GICs, and mutual funds. The first year of the program was 2009, in which Canadian residents could contribute up to $5000 to their TFSA. Every calendar year since, another $5000 was added to the contribution room, indexed for inflation. This means that starting in 2013, the contribution room was increased to $5500 per year. If you have never contributed to your TFSA, your 2014 contribution limit would be $31,000.
Any gains or losses to the value of the securities in the account do not count as contributions nor withdrawals. If you put all your money in a security that went bankrupt, you can't claim this as a capital loss, nor can you re-contribute the same money.
The government places no limits to withdrawals. Because contributions were made with after-tax income, the withdrawals are considered also "after-tax" income. If you put all your money in a single security that went up significantly (generally unlikely), you could have hundreds of thousands of dollars of capital gains that would be exempt from tax.
Withdrawals from a TFSA increase the contribution room by the same amount in the subsequent calendar year. For example, if you contributed $20,000 in 2012 (the maximum at the time), you would have a contribution room of $0. In 2013, you would get an additional $5500 of contribution room. If the value of your securities went up, your TFSA could hold $200,000. If you withdraw $100,000, then your contribution room for 2013 is still $5500 - the withdrawal doesn't change the contribution room for the current year. However, your 2014 contribution room is now $111,000 - the unused $5500 from 2013, another $5500 for 2014, plus the withdrawn amount of $100,000 in the previous year.
The government imposes a very high tax on exceeding the contribution room - 1% per month of the excess amount. If you are unsure of your contribution room, it is best to contact the Canada Revenue Agency.
Holding foreign equity in a TFSA
There are few limits imposed by the Government of Canada on what equity can be held in a TFSA. The Department of Finance maintains a list of exchanges on which a stock must be listed to be eligible:
http://www.fin.gc.ca/act/fim-imf/dse-bvd-eng.asp
The financial institution with which you open an account will have its own list of exchanges on which its platform allows trades. The list likely will not be as extensive as the list of eligible exchanges, but it could also contain exchanges, like the Canadian OTC Automated Trading System, which are not eligible.
If you hold foreign equity, there will likely be foreign withholding taxes on any dividends. If the equity is held in a regular, taxable, account and the country has a tax treaty with Canada, then you may be able to claim this tax amount against your income taxes. Similarly, if the equity is held in an RRSP, these foreign withholding taxes can be recovered by filling out an appropriate form. For the United States, this is form W-8BEN, where you can have the foreign withholding tax on dividends reduced to 15%, and recover it from the government.
In contrast, the tax treaty between Canada and the United States does not cover the TFSA, so these foreign withholding taxes on dividends are not recoverable. If you invest in foreign stocks that pay high dividends, it may be best to hold them in your RRSP. If you have maxed out both your RRSP and TFSA, from a tax perspective foreign equity should be the first to end up in a regular, taxable, account.
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