TFSAs- Tips And Traps

Although a relatively new financial product, tax-free savings accounts are well-utilized and have become a mainstay in many financial plans. The annual contribution room is indexed to inflation (rounded to the nearest $500) and the additional 2018 room is $5,500. This means that anyone who was eighteen in 2009 and has been a Canadian resident for the last ten years could have made total TFSA contributions of $57,500 as of 2018. A couple could have a combined total of $115,000.

As is always the case, finance has made the TFSA rules complicated and there are tricky spots. Hopefully the following will help guide you through without any unpleasant surprises.

Track Your Own TFSA Contribution Room

CRA closely monitors TFSA contributions and taxpayers’ available contribution room. As many know, TFSA contribution room can be accessed on-line. However, that information is not up to date so it is often not reliable. Be skeptical of the numbers if you have recent withdrawals or contributions (see below) or hold TFSA’s with more than one institution.

If you want to make a contribution and your spouse has unused room, consider a contribution to his or her TFSA. There are no income tax implications for the contributing spouse. On marriage breakdown, amounts can be transferred directly between the former partners’ TFSA’s without affecting the contribution room.

Be Careful Making A Withdrawal And Re-Contribution

Some make the mistake of withdrawing funds from one TFSA and redepositing the funds in another account. Intuitively you would think that is allowed. Unfortunately, however, the TFSA withdrawal does not increase the contribution room until the next calendar year.

That is difficult to understand, so to provide an example. Kevin never made TFSA contributions but wanted to catch up and contributed $52,000 in January 2017. However, in June 2017, he decides to move his TFSA to another institution. Kevin withdraws the $52K from the one institution and then redeposits it in another TFSA at a different bank. Unfortunately, even after the withdrawal, Kevin’s 2017 contribution room is zero. He will be over-contributed for six months in 2017 and will have to pay over $3,000 penalty tax.

As of January 2018, Kevin’s contribution room will be restored for the $52,000 withdrawal so he will no longer be over-contributed. His TFSA contribution room as of January 1, 2018 will be $5,500 (at time of publication).

The penalty tax could have been avoided if the original TFSA issuer just transferred the funds to a new TFSA at the second institution, completed a direct transfer form, and filed that with CRA. But the investor needs to be proactive to ensure the right steps are taken and paperwork filed. My experience is that otherwise it will be assumed that the taxpayer is simply withdrawing the TFSA funds.

If You Have A Spouse Or Common-Law Partner, Designate Him Or Her As A Successor Holder To Your TFSA

“Successor holder” means that on your death, the TFSA can transfer directly to your spouse without tax consequences. The TFSA will continue to exist and both the value and any subsequent income will continue to be sheltered. It should also not affect the receiving spouse’s TFSA contribution room. This is subject to provincial legislation so check out your province’s rules.

Again an example may help clarify. David, an Alberta resident, has $50,000 in his TFSA when he passes away. He has designated his wife Susan as successor holder. Therefore, on David’s death, Susan becomes the new holder of his $50,000 TFSA. The principal and any resulting income continue to accumulate tax-free as long as Susan maintains the TFSA. Susan can also make tax-free withdrawals from this account. If she has her own TFSA, she can maintain two separate TFSA accounts or transfer the TFSA that was previously David’s to her own account (on a tax-free basis).

If a successor holder designation is not in place, a surviving spouse or common-law partner can also designate an exempt contribution. This allows him or her to receive their deceased partner’s TFSA without affecting their own TFSA contribution room. However, there are time limits and paperwork so the successor holder designation is preferable.

Leaving A TFSA To Another Designated Beneficiary

The rules are not as generous if the TFSA is left to another beneficiary, i.e. son or daughter. The designated beneficiary can receive the proceeds from the TFSA tax-free, but all income earned after the holder’s death is taxable. The designated beneficiary can however contribute any amount received to their own TFSA as long as they have contribution room.

Investing Within A TFSA

The types of TFSA investments are generally the same as those permitted as Registered Retirement Savings Plan (RRSP) investments. When TFSA’s were first introduced, the conventional wisdom was that they were best suited to interest-generating products such as money market funds, bonds or GICs. Although we all know that interest rate returns have been minimal over the last nine years, my research indicated that significant TFSA investments are still held in cash or money market funds.

No one has accumulated $1M in their TFSA without a lot of active trading (see below), but those who have invested in good dividend-paying securities have probably done reasonably well. Some argue that dividend-paying investments are wasted in a TFSA because they lose the advantage of the dividend tax credit. That is true but in my view, investment growth, not income tax savings, is the priority. The dividend income is of course tax-free as are any capital gains from selling the securities. The downside is that any capital loss inside a TFSA is basically lost so it is wise to avoid any high-risk investments. CRA has indicated that they are looking at TFSAs with high dollar amounts and large numbers of trades. Their position is that frequently trading securities within a TFSA is essentially operating a stock-trading business. This is not allowed and could lead to substantial reassessments depending on how it plays out. It also bears mention that foreign dividends received in TFSAs are subject to withholding tax, unlike RRSPs. This means the withholding tax is lost so that is a definite consideration when deciding on asset allocation.

Because any income earned within the TFSA is non-taxable, any related investment management fees are non-deductible. Be careful here – some investment companies will deduct TFSA management fees out of the investor’s non-registered account. If these are deducted for tax purposes, the taxpayer is subject to reassessment.

TFSAs are a very important and effective financial planning tool. I hope the above will give you some ideas for using them to your best advantage.

David A. Townsend, C.A., C.F.P. has been providing accounting and tax services in Calgary since 1990. Clients include a wide variety of individuals, trusts, estates and private companies.

For further information, check out www.datownsend.com