The tax-free savings account (TFSA) turned 9 years old on January 1, and these flexible investment tools are as popular as ever: According to Statistics Canada, 12.7 million Canadians had opened one by the end of 2015.
It’s easy to see why. As the name says, any investment you hold inside your TFSA grows tax-free. Plus, you can withdraw from these accounts whenever you want — to help pay for a new home, your children’s education or even retirement — and you’re not taxed when you take the money out, either.
For 2018, you can contribute up to $5,500 to your TFSA, and you can carry forward unused contribution room from previous years.
Here’s what that means in dollars and cents: If you were at least 19 in 2009, from then through 2012, you could have contributed a maximum of $5,000 a year. The annual limit jumped to $5,500 for 2013 and 2014, then to $10,000 in 2015. In 2016, the yearly limit dropped back to $5,500, where it remains today.
So if you’ve never contributed to a TFSA, you could open your first TFSA in 2018 with up to $57,500 in current-year and previous-year contributions.
But despite the versatility of TFSAs, there are some potential slip-ups to watch out for. Here are 5, courtesy of Cliff Steele, a certified financial planner with Sun Life Financial.
1. Holding cash in a TFSA
Although they’re called “savings accounts,” TFSAs have little in common with the chequing and savings accounts you use every day. To Steele, that means 1 thing: They’re no place for cash.
“I see a lot of people holding cash in a TFSA, making nothing,” says Steele. “Or in a daily interest account [inside their TFSA], making 0.25% a year or so.”
“They’re getting almost no savings out of that,” he adds, “because if you haven’t earned a meaningful amount of interest, you don’t have to pay tax on it anyway.”
2. Withdrawing cash to set up a new TFSA
If you’re changing financial institutions, you should pay particular attention to your TFSA, because moving cash from an existing TFSA to a new one could affect your contribution room. “Remember that if you make a withdrawal, you can’t recontribute until the following January 1,” says Steele.
“Say you withdraw all the funds from your TFSA, then set up a new TFSA somewhere else and deposit this money into it,” says Steele. “That entire deposit would count as a new contribution for the year and could trigger an over-contribution penalty.”
The solution? Have your new financial institution make a direct transfer on your behalf.
3. Over-contributing to a TFSA
Many people go over their TFSA contribution limit without knowing it. This happens when they withdraw and deposit money in the same year — again, treating their TFSA like an everyday bank account.
“The thing to remember is that on January 1, you gain 2 things: The 1st is $5,500 more in contribution room. The 2nd is that you also get back the room from withdrawals you made in the prior year,” says Steele.
Let’s look at an example: Say you’ve contributed a total of $45,000 to your TFSA since 2009. That means you have $12,500 left in current-year and carried-over contribution room ($57,500 minus $45,000) as of January 2018.
In March 2018, you take out $20,000 to make a big purchase. Then, later in the year, you come into an unexpected windfall and put the full $20,000 back in. But because you didn’t wait until the next calendar year to return the cash, you’ve over-contributed for 2018, by a total of $7,500 ($45,000 plus $20,000 minus $57,500).
The penalty? The Canada Revenue Agency (CRA) charges 1% per month for any amount over your total TFSA limit ($57,500 in 2018) until you take it out. So in the example above, you would pay $75 a month — and it can take the CRA a few months to let you know.
“It can be a bit of a shock to get this letter [from the CRA], but the nice thing is, if it’s a first offence and an honest mistake, the CRA will often waive the penalty if you call and ask,” says Steele.
4. Not paying attention to U.S. investments in your TFSA
“Holding U.S. investments in a TFSA can create problems,” says Steele. If you’re a Canadian citizen with foreign dividend-paying investments in your TFSA, you may have to pay a non-residents’ withholding tax.
If you’re a U.S. citizen, a TFSA likely won’t benefit you, as the IRS will tax the income and gains you make inside the plan, and you’ll have to report them on your U.S. tax return.
5. Not opening a TFSA at all
It’s still a common myth that if you didn’t open a TFSA in 2009, when these accounts first came on the scene, you’ve missed out on all the years of contribution room since. Actually, you’ve missed out on the investment growth you could have realized, but you haven’t missed the contribution room.
“You don’t have to have opened a TFSA to start building your contribution limit,” says Steele. “Anyone who was over 18 in 2009 has a $57,500 limit today.”The bottom line? By offering no-tax growth and the ability to access your cash at any time, TFSAs are a great companion to other investment tools, like RRSPs. To make sure you’re maximizing your TFSA, speak to a financial advisor today.