A tax-Free Savings Account (TFSA) is not necessarily a savings account but is a registered account designed to hold investments and savings. Investors can pick what to put in the account from an array of financial instruments—Exchange-Traded Funds, Guaranteed Investment Certificates, Stocks, Bonds, and actual savings.
The TFSA program began in 2009. It is a way for individuals who are 18 years of age or older and who have a valid social insurance number (SIN) to set money aside tax-free throughout their lifetime.
Contributions to a TFSA are not deductible for income tax purposes. Any amount contributed as well as any income earned in the account (for example, investment income and capital gains) is generally tax-free, even when it is withdrawn.
Moreover, administrative or other fees concerning a TFSA and any interest on money borrowed to contribute to a TFSA are not tax-deductible.
Types of TFSAs
Banks, insurance companies, credit unions, and trust companies can all issue TFSAs. Three types of TFSAs can be offered:
- Deposit TFSA
- Annuity contract TFSA
- Arrangement in trust TFSA
TFSA Contribution Rules
The maximum amount of money that an individual can deposit into TFSA annually currently stands at CA$6,000 – contribution room. However, the total amount that you contribute is cumulative hence, any unused contribution room will carry over from one year to the next.
It is important to know that If the amount of money in an individual’s TFSA rises due to the growth of investments or interest earned on savings, this does not count as part of the individual’s annual contribution. The only amount the Canadian government limits is how much money you put in.
Besides, if an individual contributes more than the allowable TFSA contribution room, the individual will be subject to a tax equal to 1% of the highest excess TFSA amount in the month, for each month that the excess amount remains in the account.
TFSA Stock Trading Rules
Individuals using the TFSA for trading activities can attract taxes because the trading could constitute a business. The tax rules mean that should a TFSA operate like a business then they have to pay income tax.
Recently, the Canada Revenue Agency (CRA) has focused its audits on taxpayers that are actively trading within their TFSA.
The CRA considers several factors when determining whether or not a TFSA is subject to income tax. These include:
- Duration of the holdings
- Frequency of the transaction
- Intention to hold investments for resale at a profit
In situations where one or more TFSA taxes are applicable, a TFSA return must be filled out and sent by June 30 of the year following the calendar year in which the tax arose.
TFSA Investment Rules
Cash, mutual funds, securities listed on a designated stock exchange, guaranteed investment certificates, bonds, and certain shares of small business corporations can go into TFSA.
Investors can also contribute foreign funds but they will be converted to Canadian dollars which cannot exceed your TFSA contribution room.
Any investment losses within a TFSA are not considered a withdrawal and therefore are not part of your TFSA contribution room. However, the dividends of foreign investments held in TFSA are subject to non-resident withholding tax (NRT).
Reg Flags with TFSA
- Overcontributing to the account
Thousands of tax filers still receive letters from the Canada Revenue Agency each year concerning over contributions and research has shown that many people remain unsure of how TFSA contribution limits work.
The penalty for over contributing is 1% of the overcontribution for every month the individual is over the limit. To curb the penalty, the individual must withdraw the excess funds or wait for enough contribution room to be created the next year to absorb the overcontribution.
Tips to avoid overcontributing on TFSA
- Maximize your TFSA contributions each year but wait until the next calendar year to replace any withdrawals.
- If it’s getting late in the year and you’re considering a withdrawal, make it before December 31st of that year.
- The TFSA contribution limit applies per person, not per account or institution. If you have more than one TFSA or deal with multiple institutions make sure your combined contributions don’t go over your limit.
- Track your contribution room instead of relying on the CRA to do it for you.
- If you’re moving TFSA funds from one financial institution to another, transfer them, don’t withdraw. Withdrawn funds that are then deposited to a new account will likely count as a new contribution.
- Beneficiary or successor holder of TFSA
It’s often better to name your spouse the successor holder of your account rather than a beneficiary. When you designate your spouse as successor holder, your spouse becomes the new owner of your TFSA after your death 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 have to do extra paperwork, and 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.
A beneficiary designation is best used to distribute a TFSA to recipients other than your partner: your children, grandchildren, or favorite charities.
- Investments that produce foreign income
Foreign dividends paid into a TFSA are subject to withholding tax. A non-registered account is a better choice for foreign dividend-paying investments – you can claim a foreign tax credit to offset withholding tax deducted.
- Impact of market gains and losses on future contribution room
A drop in the value of your TFSA leaves less capital to withdraw. And, because you can’t recontribute more than you withdraw, a market loss essentially reduces your future contribution room.
- Non-qualified investments
Securities that are not traded through a recognized stock exchange, run the risk of being deemed ineligible for a TFSA.
The costs of holding a non-qualified investment in your TFSA are serious: a penalty equaling 50% of the non-qualified investment’s value, plus, loss of the TFSA’s usual tax-sheltering for that investment.