I’ve had a few people ask about the Tax Free Savings Account, or TFSA. Some get the wrong idea because of the term “savings account”. While you can hold a savings account in the TFSA, you could also use it for stocks, mutual funds, bonds, GICs, and other investments.

In a lot of ways, the TFSA is similar to the RRSP. Both of these accounts allow you to grow your investments with a tax advantage. However, there is a diference in the way you fund the accounts, and when you actually end up paying taxes on the money. With the RRSP, you get a tax refund for money that you put into the plan and then pay tax on the money you withdraw during retirement. With a TFSA you do not get a refund when you put money in, but do not pay any tax when you withdraw money. You also don’t lose your contribution room when you withdraw from a TFSA; you can deposit that amount back in the next year, on top of the “regular” contribution.

Who Can Contribute to a TFSA?

Any Canadian resident with a Social Insurance Number, who is 18 or older can contribute to a TFSA, as long as he or she has reached the age of majority in his or her province. You don’t need earned income to make your contributions, and there are no income limits restricting you can contribute. The great thing about the TFSA is the contribution room. Not only can you withdraw the money and replace it at any time, but your contribution room also carries forward if you don’t contribute the maximum.

Man holds white egg with TFSA written on itTFSA contribution limits are indexed to inflation. For 2013, you are allowed to contribute up to $5,500. If you only contribute $4,500, you have $1,000 of contribution room. This means that you can contribute an extra $1,000 down the road. You could contribute $6,000 next year, and $6,000 the year after to “catch up.” Your contribution room starts when you are eligible for the TFSA, so if you didn’t contribute at all the first year you were able to, you have all of that money as contribution room.

Using Your TFSA to Best Effect

Many Canadians like the idea of using the TFSA as an emergency fund, and we do this with a small portion of my wife’s TFSA. They like the idea of a high yield savings account, or laddered GICs in the TFSA. However, this is not the most efficient use of a TFSA as a tax strategy. The rules of the TFSA mean that there is a lot of potential for tax savings down the road.

Since you do not pay taxes on your withdrawal, it is better to have high yielding investments in your TFSA. The expected larger gains will be tax free. It makes more sense to place lower yielding investments like bonds and GICs into RRSPs.

Divide up your long-term investment portfolio between your RRSP and your TFSA. Put the low-yielders, like GICs and bonds, into the RRSP. The earnings from these investments are generally fairly low, so paying taxes on them later wouldn’t cost you too much. Plus, you get the tax refund for your contributions now.

The TFSA is great as a long-term income tax shelter. If you were to purchase ETFs, stocks and REITs, and other income trusts in your TFSA, you can withdraw the earnings as continual tax-free income. Or you could let it build over time. Either way, these high-yielding investments have a greater chance of providing higher gains, so the tax-free withdrawal aspect is very attractive. Even if you have to pay taxes now, the prospect of avoiding what will, likely, be higher taxes later is a good one.

If you are pushing your contribution limits, though, it might not be best to include dividend paying stocks in your TFSA. They are already quite tax efficient. In fact, you might want to hold dividend paying stocks outside of both RRSPs and TFSAs.

Your best case is to max out both your RRSP and your TFSA if possible, focusing on allocating your assets in a way that provides maximum advantage.

About Tom Drake

Tom Drake is the owner and head writer of the award-winning MapleMoney. With a career as a Financial Analyst and over nine years writing about personal finance, Tom has the knowledge to help you get control of your money and make it work for you.