The 2008 Federal budget introduced the new investment vehicle called the “Tax Free Savings Account.”  It allows Canadians aged 18 and over to contribute the dollar limit for the year, plus any unused contribution room from previous years and any amount you withdrew the year before.

Starting in 2009, contribution room accumulates every year.  The annual amounts are as follows:

  • 2009 to 2012 – $5,000 each year
  • 2013 to 2014 – $5,500 each year

So, as of 2014, the total contribution limit is $31,000.

Related: Ways to save inside your TFSA

It sounds quite simple, but it is one the of most misunderstood savings/investment vehicle around.  Entire books have been written on this one topic.

How well do you know how Tax Free Savings Accounts operate?  These are some of the most common misconceptions I have run across.  For fun, I’ll turn it into a quiz.

True or False?

Deposits to a TFSA:

  • Aaron is 16-year-old high school student who has scored a well paying job this summer.  He will earn at least $5,000 that he can contribute to a new TFSA to enable him to save for university.
  • 21-year-old Brigit received an inheritance from her aunt.  She will deposit $31,000 into her TFSA.
  • Her 28-year-old brother, Conrad, also inherited.  He had not previously opened a TFSA so this year he can contribute only $5,500 and must wait till January 2015 to deposit a further $5,500.
  • 71-year-old Dick must stop contributing to his TFSA.

All these situations are false.

Related: Using TFSAs in retirement

Aaron must wait until he turns 18 on May 13, 2016 before he can open a TFSA. He can then make the full contribution amount allowed for that year.

Brigit can only contribute $21,000.  She turned 18 in 2011 and makes her calculations from that date.

Conrad can contribute the full $31,000 limit for this year even if he is just opening his account now.

There is no age limit on TFSA contributions (unlike RRSPs) so Dick can deposit for as long as he is able to.

Withdrawals from your TFSA:

  • Zander contributed the maximum allowed each year for a total of $31,000.  He withdrew $20,000 last month to purchase a car.  He is expecting a large bonus in the fall and can redeposit the entire withdrawal amount at that time.
  • Yasmin has also contributed $31,000.  Her investments have grown to a total of $55,000.  She withdraws the full amount.  Next year she will be able to redeposit the original $31,000 plus the new annual amount of $5,500.
  • Xena has managed to contribute a total of $15,000 since 2009.  She withdraws $10,000.  She will have to wait until 2015 before she can replace the withdrawal amount to avoid penalty.

Again, these statements are all false.

Related: Where to invest for short term goals

Zander must wait until January 2015 to redeposit the amount he withdrew.

Yasmin can replace the full withdrawal amount of $55,000 in 2015.

Xena has unused contribution room of $16,000 so she can redeposit her $10,000 this year.  She should keep careful records if this becomes a regular occurrence.

Other misconceptions:

  • Logan assumes that the term “Tax Free Savings Account” means that he can only open a savings account at his bank or credit union.  He feels it is useless to open an account given the low interest rates available on savings accounts.
  • Marissa purchased some shares in EFG Company that have since dropped considerably in price.  She sells the shares and takes a capital loss.
  • Nolan carefully purchases a portfolio of U.S. Dividend stocks in his TFSA because non-resident withholding tax is waived on registered accounts.
  • Oscar wants to transfer his account.  He can withdraw his funds and redeposit them at another financial institution without penalty.
  • Penelope is told that any investment growth in her account will be favorably taxed.

False, again.

Related: TFSA versus non-registered account

Logan is not limited to a cash account.  He can invest in various vehicles such as GIC’s, bonds, mutual funds, stocks and ETF’s.

Since the account is tax-free and capital gains are not taxed, capital losses cannot be used to offset income.  If Marissa sells her losing shares she will have to hope that she can make up the loss with better investing.

U.S. withholding tax on dividends is only waived on U.S. stocks held in an RRSPNolan will receive a reduced dividend amount.

Oscar must use the required transfer forms to switch his TFSA to a different financial institution to avoid penalty.

The Tax-Free Savings Account is just as it says.  Deposits are made with Penelope’s after tax money and all returns generated – interest, dividends, capital gains – are tax free and government benefits or assistance programs are not affected by income earned within.

Conclusion

You can find more information on Tax Free Savings Accounts at www.cra-arc.gc.ca/tfsa/

If you want to avoid confusing “government-speak,” I recommend Gordon Pape’s excellent revised and updated book on the topic – “Tax-Free Savings Account – How TFSAs Can Make You Rich.”


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