Investors can now contribute $500 more to their tfsaCanadians will be able to sock away an extra $500 in their Tax Free Savings Account (TFSA) starting in 2013. The federal government announced its first contribution limit rise of $500 indexed with inflation, enabling Canadians to contribute $5,500 a year.

This is great news for the rising number of investors taking advantage of their TFSA – according to the federal government 8.2 million Canadians have opened a TFSA with 2.5 million contributing the maximum of $5,000 in 2011. TFSA accounts were started four years ago in January 2009 – by now, you could have contributed a total of $20,000.

 How do TFSAs Work?

There’s a lot of confusion surrounding the TFSA. A recent survey by CIBC found 41 per cent of respondents had no idea what to invest in. To clear up the confusion, here’s a primer on the TFSA and what makes it the most powerful savings vehicle since RRSPs.

 Investment Types

Don’t let the name fool you – the TFSA isn’t just for savings accounts and GICs. You can hold any number of investments including bonds, mutual funds and stocks. If you’re short of cash you can even make in-kind contributions in the form of shares and mutual funds. With interest rates as low as they are, it’s worthwhile to consider investing in dividend-paying blue-chip stocks. Leave your risky investments outside your TFSA – you can’t claim capital losses if your investments go bust.

 TFSA vs. RRSP

TFSAs are similar to RRSPs – your money will grow tax-free, reaping the rewards of compounding. Unlike RRSPs, TFSA contributions are not tax deductible. While RRSPs provide an immediate benefit – contributions are tax deductible – the power of the TFSA lies in the ability to withdraw money tax-free.  TFSAs are a lot more flexible than RRSPs – you have the freedom to withdraw money at any time without withholding tax.

TFSAs are ideal for any number of savings goals – an emergency fund, a down payment for a house or for retirement savings if you expect to be in a higher tax bracket later on. TFSAs are an added incentive for individuals who expect to be high-earners during retirement – income earned in your TFSA does not affect eligibility for federal income-tested benefits and credits, such as Old Age Security, the Guaranteed Income Supplement and the Canada Child Tax Benefit. TFSAs offer a tax-free safe haven for all Canadians – unlike RRSPs, where you are no longer eligible to contribute after age 71, TFSAs have no upper age limit.

 Rules of the Game

TFSAs are a lot more complicated than they first seem. It’s important not to exceed your contribution limit – you’ll be charged  a hefty one per cent tax on the highest excess TFSA amount in that month, which could very well wipe out any investment gains. Anyone who is a Canadian resident and is at least 18 years of age can to open a TFSA. They’re also the perfect holiday gift – funds can be given to a spouse or partner to invest in their own TFSA without income attribution.

New Contribution Standards

Most of the confusion surrounds over-contributing. Starting in 2013, investors can contribute $5,500 per calendar year (previously $5,000). Similar to RRSPs, unused contribution room is carried forward and accumulates in following years. As mentioned, funds can be withdrawn at any time tax-free during the year and re-contributed in the following year. Just be careful when re-contributing in the same calendar year – if you exceed your total contribution limit you’ll be hit with the above penalty tax. For example if you’ve already contributed the maximum $20,000 in 2012 and you withdraw $4,000 in June 2012, you cannot re-contribute $4,000 until January 2013.