Q – I’ve heard that a Tax-Free Savings Account is a good way to set aside money for things like a down payment on a home or a new car. But I’m not sure I really understand what makes it such a good deal. Can you explain? – Steve Y., Toronto, Ontario
A – It’s simple: A Tax-Free Savings Account (TFSA) is quite possibly the best tax shelter now available to Canadians. Contributions made to a TFSA grow tax-free within the plan, and all withdrawals from the plan are tax-free. Almost everyone is eligible to open a TFSA. But there are a few rules and regulations you need to know to make the most of this amazing investment vehicle.
You can contribute a maximum $5,500 annually to a TFSA, regardless of your income or pension plan or anything else. There’s no cutoff date – you can contribute any amount at any time you want through the year, as long as you don’t exceed the maximum. You have to be over 18 and a have a valid Canadian Social Insurance Number. That’s it.
If you don’t contribute to your TFSA in a given year, you may carry that unused “contribution room” forward to be used in future years to use above and beyond maximum contributions. There’s no tax deduction for contributions, but the whole beauty of the TFSA is that investment income generated within the plan – whether interest, dividends, or capital gains – is completely tax-free.
TFSA investment power
If you haven’t opened a TFSA, and you’re eligible to do so now, you may in 2014 immediately contribute your entire accumulated contribution room since 2009 – that’s $31,000. And the next year, you’ll be able to add another $5,500. And so on. And so on.
Let’s say you are 30 years old today, you make $50,000 a year, and you are able to contribute $31,000 to your TFSA right away. If you continue to contribute $5,500 every year until you retire at age 65 (that’s $458.33 per month), at an average compounded annual rate of return of 8%, your TFSA would grow to $1,446,666! That’s entirely tax-free (except for your total $223, 498 in deposits, on which you’ve already paid tax). That’s the real power of a TFSA!
Follow the rules
TFSAs are lovely tax-free investment vehicles. But the rules and regulations can get complicated.
First, there’s wide latitude in what you can invest in. Qualified investments are very much like those allowed for RRSPs: cash, stocks listed on designated exchanges, mutual funds and ETFS, bonds, GICs, and certain shares of small business corporations. Shares traded “over-the-counter” on dealer networks or exchanges are not qualified TFSA investments.
“In kind” contributions of qualified investments are also allowed (for example, stocks transferred from a non-registered account) in your TFSA. But any in-kind transfer will trigger a deemed disposition of the security at its fair market value, which will be considered as the amount of your contribution. If there’s a capital gain, you will have to take 50% of the gain into income for tax purposes. But if there’s a loss on the disposition, you cannot use it to offset other gains.
Remember, too, that as in other registered plans, various investment tax benefits won’t apply, such as preferred tax rates on dividends and capital gains, as well as the ability to use capital losses to offset gains.
Mostly, people who come to me with TFSA problems have run afoul of the rules related to withdrawals and contributions.
This happens if you start using your TFSA like a piggy bank or a daily interest savings account, dipping into it when you’re short of funds, and then topping up again when you’re flush. If you’re prone to doing this, you could end up in a confusing cycle of contributing, withdrawing, and re-contributing so that you end up with what the Canada Revenue Agency calls “excess amounts” in your TFSA – that is, over and above the $5,500 annual contribution limit for the year.
The CRA levies a tax penalty of 1% per month based on the highest excess TFSA amount in your account for each month in which an excess exists. This means that the 1% tax applies for a particular month even if an excess amount was contributed and withdrawn later during the same month. The excess-amount tax kicks in on the first dollar of excess contributions.
High net worth investors should seek advice
You see what I mean about complicated rules? Qualified investments, excess amounts, qualifying portion of withdrawals, exempt contributions, and so on can make for some dangerous hidden traps and pitfalls in what seems like a straightforward TFSA investment. To avoid falling into them, and paying the often hefty taxes and penalties that result, be sure to consult with a qualified financial advisor if you are a high net worth investor and your TFSA strategy goes beyond anything but the simplest investment allocations. – Robyn
Robyn Thompson, CFP, CIM, FCSI, is the founder of Castlemark Wealth Management, a boutique financial advisory firm specializing in wealth management for high net worth individuals and families. Contact her directly by phone at 416-828-7159, or by email at email@example.com for a confidential planning consultation. Follow Robyn on Twitter and Facebook.
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The foregoing is for general information purposes only and is the opinion of the writer. No guarantee of investment performance is made or implied. It is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. Please contact the author to discuss your particular circumstances.
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