Written by Jennifer Black, Financial Advisor and Certified Financial Planner, Dedicated Financial Solutions, operating under Manulife Securities Incorporated
Many of you may read in the news that tens of thousands of Canadians get hit with penalties because they didn’t understand the rules surrounding re-contributing funds withdrawn from their Tax Free Savings Account (TFSA). It doesn’t take too many penalties to wipe out any savings advantage you may have gained, so read on to be sure you understand how to keep your TFSA working for you.
What Is a TFSA, Anyway?
First let’s look at what a TFSA is. It’s a registered, all-purpose savings tool that allows us to earn tax-free investment income. That means any interest or investment income earned inside the account is forever free from income tax. In addition, unlike a Registered Retirement Savings Plan (RRSP), you will not be taxed on any funds you withdraw from your TFSA because you will already have paid income tax on that money when you earned it.
TFSAs can be bank savings accounts, mutual funds, bonds, guaranteed investment certificates and more. The federal government limits the amount you can contribute each year. Interest and other investment income earned within the TFSA does not count towards your contribution limit.
It’s also good to know that neither income earned inside a TFSA nor withdrawals from it will alter your eligibility for federal income-linked benefits and credits, such as the Canada Child Tax Benefit, Old Age Security and the Guaranteed Income Supplement.
What Do People Do Wrong?
For the great many Canadians who got hit with a tax penalty on their TFSA repayment, the rule that they misunderstood is this: You can replace funds you withdraw from a TFSA, but only in a later calendar year, if you have already reached your contribution limit for the current year. If you re-contribute the funds in the same calendar year you took the money out, and if you have already contributed the year’s maximum, you will be taxed on an over-contribution, even if you replace only the same amount you withdrew. Any funds you contribute, even if it’s to replace a withdrawal, count as current-year contributions.
So people who have been penalized have simply replaced the funds too early. If you’ve taken some money out, wait until next year to replace it – if you’ve already reached your contribution limit for this year.
Know the Rules
Here are the basic TFSA rules (you can read more here: http://www.tfsa.gc.ca/):
• As of April 24, 2015, Canadian residents 18 and older (19 in some provinces and territories) may expect to contribute up to $10,000 to their TFSA per year (as part of the 2015 Federal Budget Economic Action Plan, this measure is subject to parliamentary approval)*
• The contribution limit may be increased in the future through federal legislation
• Unused TFSA contribution room is carried forward and can be used in future years
• Unused contributions are calculated from the program’s effective date, not by the date you actually open an account. Note: the contribution limit for 2009 – 2012 was $5000 per year, and $5,500 for 2013-2015*
• Contributions are not tax-deductible
• If you re-contribute withdrawn funds the same calendar year you took them out, and if you have already contributed the year’s maximum, you will be taxed on an over-contribution, even if you replace only the funds you withdrew
• TFSA balances can usually be transferred to a spouse (including a common-law spouse) upon death
• You can make contributions at any time of the year, as long as you do not exceed your contribution limit
• Only you can contribute to your TFSA – you cannot have a joint TFSA and you cannot contribute to your spouse’s account
• You can give funds to your spouse or common-law partner for them to invest in their TFSA without having earnings on that money attributed back to you for tax purposes
• If you are absent from Canada for an entire calendar year, you will not be allowed to make contributions for that year
• You are allowed to have more than one TFSA account, but the total amount you are allowed to contribute remains the same. You can transfer funds between your TFSA accounts without affecting your contribution room
• If you have non-registered investment accounts you can transfer those funds to your TFSA – you don’t have to sell the investments first. But talk with your financial advisor because there will likely be tax consequences for this transfer
At the beginning of each year, determine your contribution limit for that year. It’s made up of the following:
• The amount set by the federal government for the year (in 2015, it’s expected to be $10,000 – subject to parliamentary approval)
• Any unused contribution room from previous years
• The amount of any withdrawals you made in the previous year
Financial institutions provide information on TFSA contributions to the Canada Revenue Agency, so you can check your limit on the CRA’s website: My Account. Checking with the CRA is a better bet than asking your bank, because your bank will not know about TFSA accounts you may have with other institutions.
Your contribution room started accumulating in 2009, even if you have not opened a TFSA. If you open your first TFSA in 2014, you will be able to contribute $5,000 for each of 2009¬¬–2012 and $5,500 for both 2013 and 2014, for a total of $31,000
Visit the CRA website for the latest updates on contribution amounts.
Opening and Using a TFSA
To set up a Tax Free Savings Account visit your bank, credit union, trust company, insurance company, or work through your independent financial advisor. You will need to provide your social insurance number and date of birth.
You can set up automatic contributions. For example, you could arrange to automatically transfer funds from one of your investments or accounts to your TFSA each month. This is a great way to “pay yourself first.” You can also make lump-sum contributions. To transfer funds between your TFSA accounts – for example, to move funds from your TFSA deposit account to your mutual fund TFSA – contact your TFSA issuer. There are no tax consequences for this type of transfer. You can also transfer your accounts between financial institutions, though the transfer may be subject to either institution’s transfer fees. Check out the details with your financial advisor before you act.
Be especially careful about re-contributing withdrawals if you have set up automatic contributions – if your automatic contributions will bring you to the year’s limit, do not re-contribute any funds you may have withdrawn during the year; wait until the following year.
You can withdraw as much as you want from your TFSA at any time, but just remember that withdrawing does not reduce the current year’s contribution. Contact your TFSA issuer to withdraw funds.
For more information on TFSAs, or other Canadian savings and investment strategies, contact the advisors at Dedicated Financial Solutions at (905) 896-8373. We’re here to help.