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Beware this big TFSA tax trap!

by | Nov 20, 2013 | SELF-PUBLISHED

Quick! What’s the first thing that pops into your head when you hear someone mention “Tax-Free Savings Account”? If you’re completely honest with yourself, deep down inside, it’s not the modifier “tax-free.” Many people I talk to feel all virtuous about their TFSA, taking advantage of the tax-free growth features and so on. But in fact, many of those same people use it as just another savings account – a sort of high-powered ATM to use when we’re running a bit low. Not only does that defeat the purpose of a TFSA, but it could be dangerous to your financial health too.

A TFSA, remember, lets you contribute a maximum $5,500 annually, regardless of your income or pension plan or anything else. You have to be over 18 and a have a valid Canadian Social Insurance Number. That’s it. In addition, 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.

The best thing since sliced bread

TFSAs were started by the federal government in 2009, and if they’re not the best thing in personal financial sliced bread since RRSPs debuted back in 1957, I don’t know what is. 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 and make $50,000 a year. And let’s say you sock away $31,000 in your Tax-Free Savings Account right away (okay, okay, so maybe you got an inheritance or made a smart investment). Now let’s say you’re able to contribute $5,500 every year until you stop working at age 65 (that’s $458.33 per month). And over the long term, your investments might earn an average compounded annual rate of return of 8%.

When you reach age 65, you will have accumulated $1,446,666! Tax-free (except for your total $223, 498 in deposits, on which you’ve already paid tax). Breathtaking, isn’t it? Even with smaller amounts, a lower return, or a shorter period, a TFSA can be breathtaking. But only if you stick with it. And that’s the other side of the coin.

2 really good reasons not to dip into a TFSA

The other major alluring feature of the TFSA is that any withdrawals are completely tax-free too. The point is that you’re contributing to your TFSA in after-tax dollars – so you’ve already paid tax on the income. But it can be far too easy to start looking at your TFSA as a plump, juicy apple, ready for the picking whenever you need it.

Yes, it’s true, withdrawals can be made from a TFSA at any time, and, yes, they are tax-free. But a couple of things happen when you do this. First, you immediately start to lose the benefits of all that tax-free compound growth. If you crack open the TFSA piggy-bank before you’ve
achieved your savings objective, whether it’s three, five, ten, or thirty-five years, you’ll be back to square one in terms of investment returns. Say bye-bye to that million bucks!

Second, you have to take care not to contribute, withdraw, and recontribute to your TFSA in the same year. If you do, you may accidentally overcontribute for a given year, and that means tax penalties.

Monthly tax penalty…with no wiggle room

According to the Canada Revenue Agency, there is a tax of 1% per month that is 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 is like the 1% per month tax levied on excess RRSP contributions with one crucial – and potentially costly – difference: There is no $2,000 “grace” amount, and the excess-amount TFSA tax kicks in on the first dollar
of excess contributions. Ouch!

The whole business of “excess amounts,” “qualifying portion of withdrawals,” and “exempt contributions” can make your head spin – and can shrink your bank account if you trip over the rules. So be sure to check with a financial planner before you start using your TFSA as an everyday savings count. Generally, it’s just better to consider your TFSA as a special, registered tax-sheltered investment vehicle with some lucrative tax benefits, rather than as an everyday account for spending money.

© 2013 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited.

© 2023 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.

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