Tax-Free Savings Accounts
David Stewart, MBA, RFP, CFP
The letters “TFSA” may not lend themselves to becoming an easy acronym, but the Tax-Free Savings Account should soon be a familiar part of anyone’s banking or investment accounts.
While there are already a number of savings or investment vehicles that allow for tax reduction or tax deferral, the TFSA actually allows for no tax to ever be paid on whatever growth is earned in the account. There is every reason to use these accounts to the maximum allowable.
Here are the facts about TFSAs:
Contribution Limits: Up to $5,000 can be contributed each year by anyone aged 18 or over. After 2009, the dollar limit will be inflation adjusted and increases will be rounded to the nearest $500. This means that adjustments will not take place each year but will instead step-up in increments of $500 every few years depending on the inflation rate.
Timing: It would always be better to make the maximum annual contribution as early in the year as possible to benefit from the most tax sheltering. However, if your cash flow does not allow for the maximum to be contributed in any one year, any unused room can be carried forward to a future year and added to the normal maximum for that year.
Flexibility: You can withdraw funds from a TFSA at any time and for any purpose. Also, when cash flow permits, you can re-contribute the amount of any withdrawal back into your TFSA in the next or subsequent years without affecting your normal contribution limit of $5,000 per year. As an example, say you contribute an initial $5,000 in one year and it grows to a value of $7,500. If you need funds for spending, you can withdraw the $7,500 any time. If you then have extra funds available at a future date, you can re-contribute the full $7,500 back into your TFSA in addition to the usual annual limits.
The Catch: You cannot re-contribute a withdrawal in the same calendar year without incurring a 1% per month penalty for the remainder of the year. You can re-contribute in any following year. This would affect anyone who might want to use their TFSA balance to fund some temporary expense. For example, if a withdrawal were made in the month of January, then you would need to wait until the following January to re-contribute. On the other hand, if the withdrawal were made in the month of December, then you could re-contribute the following month.
Taxation: There is no deduction on your tax return for contributions made to a TFSA and there is no income added to your tax return on any withdrawals. All withdrawals are tax-free whether or not the withdrawals represent earnings growth or a return of your contributions. Withdrawals from a TFSA do not affect any income-tested government benefits. Any fees charged to a TFSA and any interest on a loan to invest in a TFSA is not tax deductible.
Keeping Track: You can monitor your own contribution room each year by taking into account the annual limit, any unused room from earlier years as well as any amounts previously withdrawn that can be re-contributed. CRA will calculate your contribution limit each year on your Notice of Assessment from the information they receive from financial institutions. Any contributions to a TFSA that exceed your contribution room will incur a penalty of 1% per month on the excess.
Family Members: TFSAs are a legitimate form of income splitting as contributions can be made on behalf of a spouse, common-law partner or adult children without any income attribution consequences.
Investments: You can open a TFSA through any participating financial institution; however, you may want to base your choice of institution on the type of investments you will want to hold within your TFSA and the amount of professional advice you may want in managing the funds.
You generally have the same wide choice of investments within a TFSA as you would for an RRSP or RRIF account. As you might anyway, you will want to match the type of investments you hold, such as cash, bonds or stocks, to the expected timing of your cash needs.
Those with a longer time horizon may want to invest in stocks in order to protect high potential growth from taxation. However, a loss of capital in your TFSA will reduce the amount of principal that can benefit from tax-free investment growth in future years. If you lose your $5,000 annual contributions to investment losses there is no opportunity to replace previous contributions. Any capital losses realized inside your TFSA cannot be used to offset any taxable capital gains realized outside your TFSA. It should also be remembered that capital gains and dividends are already taxed at a reduced rate in taxable accounts.
A TFSA might best be used for safer investments earning interest income in order to preserve the tax-protected capital and because interest income is otherwise the most highly taxed form of income in taxable accounts.
Income from foreign investments may be subject to withholding tax in the foreign country and may therefore be better held outside of a TFSA so that you can benefit from a foreign tax credit.
Existing investments can be transferred in kind at fair market value to a TFSA but it will trigger a disposition that may result in a taxable capital gain. Any capital loss triggered by a transfer will be denied. If you sell an investment at a loss and then transfer the cash, then the loss will be allowed. However, if you then repurchase the identical investment within 30 days, the loss will be denied under the superficial loss rules.
Non-residents: Anyone becoming a non-resident can continue to keep their TFSA intact and it will remain non-taxable within Canada. Any contributions made to a TFSA while a non-resident will be subject to a 1% per month penalty. The foreign tax jurisdiction that you live in may consider income earned in a TFSA to be taxable.
Odds and Ends:
- TFSAs cannot be held in joint name or in the name of a business.
- You can have multiple accounts in your own name but consideration should be given to any minimum fees being charged by institutions relative to the account size.
- A TFSA can be used to secure a loan.
- You can designate a spouse or common-law partner as beneficiary for your TFSA so that on death it will pass directly and will not be subject to probate fees.
Our recommendation: Everyone 18 and over should consider having a TFSA. While a $5,000 maximum may seem like a small amount at the moment to some, the cumulative contributions of $5,000 each year will soon become sizeable. This will be even more so for a family if contributions are made for both spouses, or common-law partners, and any adult children.
Caveat: Information about TFSAs is based on what is currently available from the Canadian government and could be subject to change.