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Beware of These TFSA Pitfalls

Common mistakes to avoid with this unique type of savings account.



Since they were first introduced in 2009, millions of Canadians have enjoyed the benefits of having a Tax-Free Savings Account (TFSA). This flexible, general-purpose savings vehicle allows for annual contributions that can be withdrawn at any time down the road. And investment growth that accumulates each year can be withdrawn tax free. Unlike a Registered Retirement Savings Plan (RRSP), you can’t claim a tax deduction for contributions made to your TFSA – and withdrawals are added back to your contribution room for the following year. There are also a few things to keep in mind regarding this straightforward type of savings account. The following guide can help you avoid making mistakes or missing opportunities that could cost you money.


Overcontributions

Every year, there is a set amount that you can contribute to your TFSA, with the added bonus that any unused contribution room is carried forward. The contribution amount for 2021 is $6,000. If you’ve never contributed before, you could have as much as $75,500 in room dating back to when the TFSA was first introduced.


It’s important to contribute no more than the amount that is available to you, because overcontributions are subject to a penalty. Canada’s Income Tax Act imposes a penalty of one per cent per month on the highest excess contribution amount at any time during the month. If you do contribute too much, the excess amount can be withdrawn to eliminate the penalty tax for subsequent months.


One or more …

Sometimes two is better than one, and you may have set up a second TFSA. There is no restriction on how many TFSAs you have. However, if you are contributing to more than one, keeping track of your deposits is vital to avoid overcontributing and the penalties that go with it. (See the section above.)

Why would you want two TFSAs? Maybe you have very specific savings goals that you want to keep separate, such as a vacation fund and a renovation fund. Or sometimes it’s a case of wanting to get a better deal with another financial institution. Refer to this example from the Canada Revenue Agency.



Withdraw or transfer?

If you have made the decision to open a second TFSA, you can transfer money from one account to another without affecting your contribution limits. However, if the funds are paid to you first, it will be considered a withdrawal and your TFSA room for the withdrawal amount won’t be reinstated until the next calendar year. Recontributing to any TFSA in the same year as the withdrawal runs the risk of overcontribution and the penalties that go with that.


TFSAs and retirement

Unlike an RRSP, when you retire you can withdraw the proceeds of a TFSA tax free. Since you have already paid tax on the contributions, they compound tax free inside of the TFSA, and can be withdrawn at any time. The rules around withdrawing from an RRSP are different, and the income is taxable.


What’s interesting to note in using a TFSA for retirement planning is that withdrawals do not count as taxable income, so they don’t affect income-tested benefits such as Canada Pension Plan (CPP) and Old Age Security (OAS). In contrast, income from a Registered Retirement Income Fund (RRIF) or Life Income Fund (LIF) will count as taxable income and may result in a clawback of CPP or OAS. It’s always wise to speak with your advisor about all possible options.