Solving TFSA confusion

The tax-free savings account is the best shot most Canadians have for sheltering their investment income from the taxman. It’s simple, accessible and flexible. So why are tens of thousands still getting tripped up over technicalities?

The rule is simple enough. If you have maxed out your annual contribution and withdraw money from a TFSA today or anytime this year (2014), you can’t put it back until the next calendar year: i.e. 2015. Basically, if you decide to replace or re-contribute all or a portion of your withdrawals into your TFSA in the same year, you can only do so if you have available TFSA contribution room. If you re-contribute but do not have room, you will have over- contributed to your TFSA in the year and you’ll get dinged with a penalty.

More than 100,000 Canadians fell afoul of this in 2010: understandable because the program became operational only early in 2009. But much ink and airtime has been expended about TFSAs since then so you’d think the problem would have vanished by now. But according to the Canada Revenue Agency, al- most 55,000 taxpayers still fell afoul of this rule for the 2013 tax year.

The pity is this is so easily avoided. Frequent withdrawals from these plans

don’t make much sense, but if you’re forced to do so, it’s best to wait until the end of any calendar year before making withdrawals. If you took out $5,000 around Christmas, you could repay it early in the New Year, along with making your next $5,500 TFSA contribution for calendar 2015. Pulling it out late in December means you’d lose only a few weeks of tax-deferred growth on the underlying investments.

But it’s that same powerful taxdeferred growth that makes me loath to tap a TFSA for any purpose other than building a giant pot of tax-free money after you stop working.

Advantage No. 1 is this maximizes long-term wealth. Advantage No. 2 is you don’t have to worry about this silly technicality on withdrawals and repayments.

I have read that the TFSAs “cost” Ottawa a cumulative billion dollars over its first five years. I look at it the other way round. Without TFSAs, it would “cost” investors millions in unnecessary tax on interest, dividends and capital gains. Remember TFSA investments are made with money that’s already been taxed once. To come up with $5,500 for a TFSA contribution, you have to earn roughly $7,000, on which top-bracket taxpayers would pay maybe $1,500 in income tax. So Ottawa has already received its due: let’s not bleat about how much TFSAs are “costing” the federal treasury. TFSAs merely prevent double taxation (or triple, if you consider that whenever you do spend the money, you’ll pay consumption taxes on it).

There has also been mention of the Finance Department finding TFSAs are more popular with older, higher-income Canadians. Certainly, “wealthy Boomers” should bend over backwards to max out TFSAs. But if anything, TFSAs are more of a no-brainer for younger, less affluent Canadians.

The power of tax-free compounding is so compelling I’d urge anyone 18 or over to move heaven and earth to contribute at the earliest opportunity, even if they have to convince parents to “match” a half-contribution. A half-century of maxing out TFSAs and investing it wisely should generate a million-dollar nest egg (or more), even if no other money was contributed to RRSPs, employer pensions or non-registered accounts. At retirement, there would be no clawback of OAS or GIS or certain means-tested benefits.

Now that’s something that WILL “cost” Ottawa big time down the road. Little wonder the feds and Ontario want to backtrack by setting up new pension schemes that resemble RRSPs rather than TFSAs, so they can continue to generate taxable income on withdrawals in old age.

But that’s a column for another day.