Thursday, November 21, 2013

Two Common Misconceptions about TFSAs

The name Tax-Free Savings Account does a good job of making it clear that these accounts produce gains that are tax-free. However, the “savings account” part of the name leads to confusion for some Canadians. Here are two common misconceptions about TFSAs.

Misconception #1: TFSAs are just for holding cash like regular savings accounts.

TFSAs can hold a wide range of investments, including stocks, bonds, and cash just like RRSP accounts. It’s common for banks to offer TFSAs that can only hold cash and GICs, but this is the banks’ restriction, not a TFSA restriction. Most banks offer other TFSAs that do permit holding stocks and other investments. Almost all discount brokerages also offer TFSAs that allow the full range of investments.

Misconception #2: TFSAs can be treated like regular savings accounts with many deposits and withdrawals.

Most people are aware that there are limits on the total amount you can contribute to a TFSA. For those who turned 18 in 2009 or earlier, the lifetime contribution maximum is $25,500 in 2013. A nice difference between TFSAs and RRSPs is that if you make a TFSA withdrawal, you get your contribution room back, but not until the next year.

Let that last bit sink in a little: not until the next year. Suppose you opened a TFSA in 2012 and put in the maximum of $20,000. Then this year you put in another $5500. Later this year you took out $5000 and then put it back. It may not seem like you’ve contributed too much, but CRA disagrees. The $5000 withdrawal will give you extra contribution room in 2014, but for 2013 you’ve contributed $5000 too much and will be charged a 1% penalty each month on the excess.

In many ways TFSAs are much simpler than RRSPs, but there are still some rules that Canadians need to know.

6 comments:

  1. The "don't deposit again until next year" rule is probably the worst design flaw in the TFSA. They catch 1000s of people on that one every year. Luckily if the amount is small and it's a "first offense" it may be possible to appeal the interest penalty. Given that most people making the mistake are working with cash account TFSAs paying 3% or less a year, it's horrible to get a 1% a MONTH penalty.

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    1. @Bet Crooks: I suspect that there is some reason for this rule. One possibility is to discourage withdrawals (and thereby encourage saving). Another is to prevent some sort of swapping abuse that shifts assets from some other type of account into a TFSA. In any case, I doubt that this rule is going away, and I'll keep trying to warn people not to get caught.

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  2. This does not relate to your topic, but have you any advice for investors with the market presently at it's highest level in years?
    Should I lock in my investments (ETF's, mutuals, stcoks) in case there is a downturn?

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    1. @Anonymous: One of the most important lessons I've learned about investing is that I don't ever know the answer to that question, and I don't believe that any talking heads on television know either. I just stay invested through thick and thin.

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  3. Another misconception I feel is that your TFSA is for taking big risks because of the tax shelter on capital gains. People forget that you can't claim the loss if you end up losing money.

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    1. @Andrew: That's one that puzzles me. Big risks are usually uncompensated risks which means that you're more likely to underperform than outperform. But some people manage to talk themselves into the crazy idea that they need to try to grow their TFSA wildly. I'm not sure why.

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