FIVE TFSA TRAPS TO AVOID
W hile the benefits of a Tax-Free Savings Account are commonly known: tax-sheltered growth, tax-free withdrawals and savings flexibility, taking full advantage of your TFSA isn’t always simple.
You could be making mistakes that are costing you money in penalties and unnecessary taxes, or causing you to miss opportunities to grow your wealth. Here are five traps to avoid when managing your TFSA.
Trap #1: Overcontributing
Perhaps the most common error TFSA owners make is overcontributing. The penalty for overcontributing can add up – one per cent of the overcontribution for every month you’re over the limit. To curb the penalty you must withdraw the excess funds or wait for enough contribution room to be created the next year (or in later years) to absorb the overcontribution.
An overcontribution can occur in two ways. First, you can simply put too much money into your account. Your limit will depend on your personal overall contribution room.
A more subtle cause of overcontributing stems from misunderstanding the consequences of withdrawing from a TFSA and then recontributing the funds in the same calendar year. When you withdraw, a recontribution in the same year is considered a fresh deposit against your contribution room. To avoid over contributing: • Maximize your TFSA contributions each year and wait until the next calendar year to replace any withdrawals. • If you have more than one TFSA make sure your combined contributions don’t go over your limit. Consider consolidating to keep tracking simple. • Track your own contribution room instead of relying on the CRA since the information they have on file may not be completely up to date. • If you’re moving funds from one TFSA to another, transfer, don’t withdraw, so the funds aren’t counted as a new contribution.
Trap #2: Not naming spouse a successor holder
If you intend to leave your TFSA to your spouse after your death, it’s often better to name them the successor holder of your account rather than a beneficiary. Your spouse then becomes the new owner of your TFSA and its tax-free status is automatically preserved.
If you name your spouse beneficiary instead, they can still receive the TFSA’s assets tax-free, but they’ll be liable for tax on any income or gains earned for the period between your death and the date your TFSA is finally wound down.
Trap #3: Holding investments that produce foreign income
Although TFSAs and RRSPs are both tax shelters, it doesn’t mean they treat all investment income the same way.
If you receive dividends in your RRSP from companies domiciled in countries that share a tax treaty with Canada, that income is free of withholding tax typically assessed by foreign jurisdictions on Canadian investors. That’s good news if you hold foreign content as part of a balanced portfolio.
A TFSA, on the other hand, doesn’t share the same exempt status as an RRSP leaving foreign dividends paid into a TFSA subject to withholding tax.
A non-registered account is often a better choice for foreign dividend-paying investments – you can claim a foreign tax credit to offset withholding tax deducted. In a TFSA these taxes are not recoverable.
Trap #4: Not recognizing how market gains and losses impact contribution room
How your TFSA changes in value can make a significant difference in how much, or how little, you’ll be able to contribute in the future. A drop in value leaves less capital to withdraw. And, because you can’t recontribute more than you withdraw, a market loss essentially shrinks your future contribution room.
Luckily the opposite is true. If the value of your original contribution rises, you can withdraw and recontribute the higher amount, so market gains raise future contribution room.
Trap #5: Choosing non-qualified investments
Securities that are not traded through a recognized stock exchange run the risk of being deemed ineligible for a TFSA. That’s important to know if you’re an investor who seeks out off-the-radar companies to own.
The costs of holding a non-qualified investment in your TFSA are steep: a penalty equaling 50 per cent of the non-qualified investment’s value, plus loss of the TFSA’s usual tax-sheltering for that investment. Consider holding more speculative securities outside a tax-sheltered account where you can claim losses and enjoy preferential tax treatment on capital gains.
No matter what you’re saving for – a new home, that special vacation or retirement – using a Tax-Free Savings Account is a smart choice to reach your goals. And when you avoid common traps that can hurt your efforts, you’ll get there that much sooner. Talk to a professional Financial Advisor to learn more.