Pay no tax on investments or withdrawals
The Canada Revenue Agency (CRA) confirmed that the annual contribution limit for Tax-Free Savings Accounts (TFSA) will remain unchanged at $5,500 for 2018, bringing total contribution room available since the introduction of the plan in 2009 to $57,500 for someone who has never contributed to a TFSA.
You can contribute the maximum $5,500 annually, regardless of your income or pension plan or anything else. And there’s no cutoff date – you can contribute any amount at any time you want through the year, as long as you don’t exceed the maximum. You have to be over 18 and a have a valid Canadian Social Insurance Number.
If you don’t make a contribution in the year, you may carry that unused “contribution room” forward to be used in future years to use above and beyond maximum contributions. Of course, there’s no tax deduction for contributions as there is with a Registered Retirement Savings Plan (RRSP), but investment income generated within the plan – whether interest, dividends, or capital gains – is completely tax-free. As with RRSPs, you lose the benefits of the dividend tax credit, the capital gains exemption, and the use of capital losses within the TFSA.
Let’s say you are 30 years old today, you make $60,000 a year, and you are able to contribute $31,000 to your TFSA right away. If you continue to contribute $5,500 every year until you retire at age 65 (that’s $458.33 per month), at an average compounded annual rate of return of 8%, your TFSA would grow to $1,446,666! The interest, dividends, and capital gains generated in the TFSA are tax free. And all withdrawals are tax free. It’s the tradeoff for using after-tax dollars to make contributions.
Like any registered pension or retirement savings plan, the rules and regulations can get complicated.
First, you have to stick to “qualified” investments. Fortunately, there’s wide latitude in what is considered “qualified,” and investments are very much like those allowed for RRSPs: cash, stocks listed on designated exchanges, mutual funds and ETFs, bonds, GICs, and certain shares of small business corporations. Shares traded “over-the-counter” on dealer networks or exchanges are not qualified TFSA investments.
“In kind” contributions of qualified investments are also allowed (for example, stocks transferred from a non-registered account) in your TFSA. But any in-kind transfer will trigger a deemed disposition of the security at its fair market value when you transfer it from its source (e.g., an RRSP), which will be considered as the amount of your contribution. If there’s a capital gain, you will have to take 50% of that gain into income for tax purposes. But if there’s a loss on the disposition, you cannot use it to offset other gains.
While TFSAs are relatively simple on the surface, problems frequently arise if you start using your TFSA like a normal chequing account, dipping into it when you’re short of funds, and then topping up again when you’re flush. If you do this regularly, and don’t keep very close track of your transactions, you could end up with what the CRA calls “excess amounts” in your TFSA – that is, over and above the $5,500 annual contribution limit for the year.
The CRA levies a tax penalty of 1% per month 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 kicks in on the first dollar of excess contributions.
If you’re a high net worth investor and your tax situation is more complicated than normal, or your investment strategy involves anything beyond simple asset allocations, consult with your financial advisor to ensure you make the most of your TFSA and avoid tax penalties.
© 2018 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.