One of the main draws of a Tax Free Savings Account, or a TFSA, is the ability to grow your savings and investments tax free, so it’s important to understand the rules around contributions and withdrawals to avoid penalties.
A TFSA is more than just a savings account. It can hold cash, but it can also contain any mix of stocks, bonds, GICs, mutual funds or other eligible investments. Whatever interest, capital gains or dividends you get from these are sheltered from taxes within the account.
TFSAs have annual contribution limits, which vary from year-to-year and have ranged from $5,000 to $10,000 per person per year. You accumulate contribution room every year, and if you don’t max out that room in one calendar year, you carry that unused contribution room forward. If, for example, you only deposited $2,000 into your TFSA when you had a $5,000 limit, then you have room to deposit an additional $3,000 as of January 1st of the following year.
Your income tax statement or notice of assessment will have information about how much contribution room you have.
Any losses incurred on your investments won’t give you any additional contribution room because those aren’t considered withdrawals. The contribution you made is the original amount you put into your TFSA regardless of what happens to the value of the investments once inside your account.
You can withdraw money from a TFSA at any time, for any reason, and all withdrawals are tax free.
But, if you take money out of your TFSA and you’d like to later put it back in, you have to wait until the following year to avoid impacting your contribution room.
That’s because just like investment losses, the money you withdraw from your TFSA doesn’t count against the contributions you made that year. If you put in $2,000 during a particular year, your TFSA considers that $2,000 as “contributed,” even if you take it out a day later.
You only get that $2,000 worth of contribution room back the following year.
What could go wrong?
If you exceed your TFSA contribution limit, you’ll face a tax penalty amounting to one per cent of the highest excess TFSA amount in any month during the calendar year, which you’ll have to pay for each month you’re above the contribution limit.
That means if you went $1,000 over in September, for instance, you’ll have to pay one per cent on that $1,000 for each month until the end of the calendar year, or until you withdraw that excess amount.
But while it’s important to be mindful of timing when it comes to contributions, over-contributing isn’t the main pitfall financial planner Jason Heath sees with TFSAs.
“I often see people with TFSAs earning one per cent in a savings account and they’ve got higher interest debt (and) they’d be better off, in the long run, paying down that instead of building money in a TFSA,” says Heath, an advice-and fee-only certified financial planner at Objective Financial Partners Inc. in Markham, Ont.
Alternatively, he adds, he often seen clients who are focused on saving through a TFSA when they have a high income and would benefit from the tax breaks provided by RRSPs, or they have a group pension or a group RRSP where there’s a matching contribution from their employer, which may be a better investment.
“Some young people in particular tend to gravitate toward TFSAs instead of RRSPs and I think there may be some missed opportunities for young people, whereas there are older people contributing to an RRSP when their income is low and they would be better off contributing to a TFSA or repaying debt,” he says.
“It’s really important to understand the different options and look at it in a broad way in terms of your overall financial plan.”