The Swiss Army Knife of Registered Accounts – The TFSA
An Introduction to Registered Plans – Part 3
The Tax-Free Savings Account (TFSA) was introduced into law as part of the 2008 federal budget and became a part of the registered plan landscape in 2009. The timing was auspicious as the world economy had fallen into a crisis not seen since the Great Depression. The TFSA has proven to be an innovative and versatile account for savings and investment.
How can a TFSA be used?
As the name implies, the TFSA can be used for savings. When it was introduced, you were only allowed to contribute $5,000 per year in the first four years, so it was not an account into which you could put a lot of money. As an investment vehicle it was not that great an opportunity. Many people opened TFSA savings accounts at their local banks. If you are saving up for the purchase of a home, a new car, or even setting aside money for your emergency fund, a TFSA may be a suitable choice.
As the contribution room accumulated year after year, the TFSA became a more advantageous vehicle for investing purposes. With calculated risk-taking, and some luck, some individuals have grown their TFSAs to large amounts, and all of it is tax-free.
How is the TFSA tax-advantaged?
Unlike a non-registered account, there is no tax on interest, dividends or realized capital gains. Since it is non-taxable you can give money to a family member to invest in a TFSA without having to contend with attribution rules.
Are there any tax disadvantages to a TFSA?
The main disadvantage I have seen over the years is that people will take substantial risks inside a TFSA in the hope of striking it rich with a big winning position that they can then sell and withdraw tax-free. That doesn’t sound like a disadvantage, but if you lose money, you cannot write off the loss, like you can in a non-registered account. Thus, the tax-free element is a double-edged sword.
The TFSA is not a recognized retirement vehicle by the US Internal Revenue Service (IRS). Therefore, if you hold US domiciled securities inside a TFSA, the IRS will withhold tax on any US source dividends. However, unlike in a non-registered account, in a TFSA you cannot claim the foreign tax withholding on your tax return. If US source dividends are received inside an RRSP, an account which is recognized by the IRS, no withholding tax applies. That does not mean you should necessarily avoid investing in US-domiciled securities in a TFSA as US tax laws do not apply to capital gains.
Is a TFSA better than an RRSP?
It depends. Are your goals short-term or long-term? Do you have earned income? How much is your taxable income? Do you only have enough money to contribute to either the TFSA or the RRSP or are you able to maximize contributions to both account types? These are among the primary topics to be investigated before deciding where to put your money.
Very broadly speaking, if your income is at the lower end, you get relatively little in terms of a tax deduction from your RRSP contribution. Furthermore, in later years payments from your RRSP, RRIF or registered annuity are treated as income and are therefore taxable, which may push your income over a threshold for receiving government benefits in retirement (for example the Guaranteed Income Supplement or GIS). In that circumstance, you may be better off using a TFSA as withdrawals are tax-free and are therefore not considered in determining your income.
If your income is in the middle range, from a tax-efficiency standpoint it may not make much difference whether you contribute to the RRSP or TFSA. Finally, if you are earning a higher income the impact of a contribution to your RRSP can be significant in terms of tax deductions so it may be to your advantage to prioritize the RRSP over the TFSA. Having said that, a higher income person is likely able to maximize contributions to both accounts.
What happens if you withdraw money from a TFSA?
Nothing. No tax is withheld, no tax is owing, nothing needs to be reported. If you want to put the withdrawn money back into your TFSA, wait until the following calendar year so that you can contribute the amount withdrawn plus the new contribution room made available at the beginning of the new year. Unlike the RRSP you do not lose your contribution room if you withdraw from a TFSA.
Where do people go wrong when using a TFSA?
The biggest issue I have seen is TFSA holders who have withdrawn funds for a temporary need and then re-contribute those withdrawn funds to the TFSA in the same year. There are at least two ways in which this can have a negative impact.
If you have not used up your contribution room
To illustrate, let’s assume you are eligible to contribute the full $63,500 as of 2019 but have so far only contributed $50,000, including $5,000 that you contributed at the beginning of the year. Earlier this year, you withdrew $10,000 from your TFSA in order to buy a car. When the fall came, you received a bonus from work and put that $10,000 that you had previously withdrawn back into your TFSA. You may see it as only replacing what had been withdrawn, but as far as the CRA is concerned you have made a new contribution. Your contributions for 2019 add up to $15,000, resulting in your total contributions to date equalling $60,000 and a permanent loss of $10,000 in TFSA contribution room. If, on the other hand, you had waited until January 2020 to put that $10,000 back in, your $10,000 withdrawal would have been added to your contribution room. Assuming the regular contribution limit for 2020 is $6,000, and taking into account that you had only contributed $50,000 of the allowable $63,500, you would have had $29,500 in total contribution room for 2020.
If you have used up your contribution room
Imagine the same scenario as above, except that instead of $5,000 you have contributed $18,500, reaching your accumulated contribution limit of $63,500. You then withdraw $10,000 and subsequently return it to your TFSA. Your contributions for 2019 will be recorded as $28,500, bringing your total contributions to $73,500, exceeding your limit by $10,000. What happens? To quote the Government of Canada website: “At any time in the year, if you contribute more than your allowable TFSA contribution room, you will be considered to be over-contributing to your TFSA and you will be subject to a tax equal to 1% of the highest excess TFSA amount in the month, for each month that the excess amount remains in your account.” In this scenario, you are going to be paying 1% of $10,000, or $100 for each month that your overcontribution remains in the account.
In the early years of the TFSA, the CRA was frequently forgiving people for this sort of over-contribution error, but those days are probably gone. If you become aware of your error before the CRA notifies you (typically around June of the following year) get in touch with them immediately and withdraw the excess from your account.
TFSA Annual Contribution Limits and Accumulated Contribution Room
Click here to contact me for an appointment.
Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, accounting or legal decisions.