Since their introduction by the federal government in 2009, Tax-Free Savings Accounts (TFSAs) have become a favorite savings option for many Canadians – and with good reason: TFSAs provide tax-free savings growth and easy, tax-free withdrawals at any time for any purpose. Almost anyone can benefit from a TFSA – but if you have one, be careful because there is one not-well-understood re-contribution rule that could cost you an unexpected tax hit. That mistake: Making a withdrawal from your TFSA and replacing the money too early.

Here are some of the basic TFSA rules:

  • Every Canadian over 18 years of age is eligible to save in a TFSA.
  • TFSA investments are the same as those available for RRSPs, including mutual funds, money market funds, Guaranteed Investment Certificates (GICs), publicly traded securities, and government or corporate bonds.
  • Contributions to investments held in a TFSA do not affect RRSP contribution room.
  • TFSA withdrawals do not affect eligibility for income-tested benefits such as Old Age Security (OAS).
  • A TFSA can be a good choice for both short and long term financial goals – providing a ready source of emergency funds, a good way to save for everything from a new car to a down payment on a new home, adding to your retirement savings, and even splitting income with your spouse to minimize taxes.
  • TFSA investments are not tax deductible but they do grow on a tax-free basis.
  • The annual TFSA dollar limit is indexed to inflation in $500 increments and for 2014 the limit is $5,500.
  • If you don’t use your maximum contribution room every year, it accumulates year after year, so you can use it any time you choose.

Let’s take a closer look at TFSAs and how to avoid tax penalties.

  • The maximum amount you can contribute to your TFSA is limited by your TFSA contribution room, which is calculated this way:
    • The annual dollar limit (currently) $5,500.
    • Plus the amount of withdrawals from a previous year (excluding withdrawals of excess contributions, qualifying transfers, or other specified contributions).
    • Plus any unused contribution room from previous years.
  • If you make a withdrawal, the earliest you can ‘earn back’ your TFSA contribution room is the first day of the next year after the TFSA withdrawal was made. And this is where many TFSA-holders are running into unexpected taxes: At any time of the year, if you contribute more than your allowable TFSA contribution room, you will be considered to have over-contributed to your TFSA and you will be subject to a tax equal to 1% of the highest excess TFSA in the month, for each month you are in an excess contribution position*.
  • Here’s an example:
    You have maximized your TFSA contribution room for 2014, but decide to withdraw $4,000 for Christmas shopping. Assuming that you have no additional contribution room from previous years, if you were to re-contribute this $4,000 before the end of 2014, you would be considered to have over-contributed and would incur tax penalties. However, if you wait until January 1, 2015, you would have ‘re-earned’ the $4,000 contribution room and could contribute up to that amount in your TFSA without penalty.

When you know the ‘rules’ and follow them, there are many ways a TFSA could work for you. Your financial planner can help you get the most from your TFSA and every other element in your overall financial plan.

Lynn MacNeil, F.PL. is a local licensed Financial Planner with Investors Group Financial Services Inc., with over 19 years experience working with retirees & pre-retirees. This column is presented as a general source of information only and is not intended as a solicitation to buy or sell investments, nor is it intended to provide legal advice. For a private financial consultation, or more information on this topic or on any other investment or financial matter, please contact Lynn MacNeil at (514) 693-3384 or lynn.macneil@investorsgroup.com

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