Withdrawal Penalties in a Tax Free Savings Account

by Leslie McClintock

The tax-free savings account, or TFSA, is a savings program allowed under Canadian law that allows workers to set money aside each year for a variety of objectives. You don't get to deduct your contributions, but once money is committed to a TFSA, you never have to pay income or capital gains taxes on those funds. Once contributed, TFSA funds can be withdrawn at any time, without penalty.

Mechanics of TFSAs

TFSAs work similarly to American Roth IRAs. If you are a resident of Canada over the age of 18, you can contribute up to $5,000 to a TFSA for each year. However, unlike Roth IRAs in the U.S., the TFSA allows you to make up for contributions you missed in prior years. If you contribute too much, however, you may have to pay a penalty tax of 1 percent for each month you have too much money your TFSA account.

Types of Investments Allowed

TFSAs allow the investor a good deal of latitude as to the types of assets that may be held in the account. Popular choices include mutual funds, stocks, bonds, annuities and real estate investment trusts, or REITs.

Alternatives

For Canadians, the chief alternative tax-advantaged long-term savings program is the RRSP, or Registered Retirement Savings Plan. These plans do allow you to take a current year tax deduction, but withdrawals are taxable as income. Withdrawals from RRSPs may reduce allowable welfare benefits in your retirement years, since many of these benefits are means-tested. As of 2011, workers can contribute up to $22,000 per year into an RRSP.

Conisderations

If you believe that your income tax bracket will be higher in retirement than it is now, you may want to lean more toward contribution to a TFSA, rather than a RRSP account. Also, you must either withdraw your entire RRSP balance by the time you turn 71, or transfer it into a registered retirement income fund. No such requirement exists with the TFSA.