When Tax-Free Savings Accounts (TFSAs) were rolled out in 2009, they came with a lot of fanfare. Earn interest tax-free! Contribute up to $5,000 per year! Take it out whenever you want! The problem is that while TFSAs really do come with all these perks, they also come with complicated fine print and a huge number of options, which has left many prospective investors confused, apathetic and occasionally out of pocket.
But before you write off TFSAs for being too much trouble, we'll let you in on a little investing secret: rules can be your best friend, or your worst enemy. Becoming a good investor is all about learning how to play the game.
Here we'll take a look at some of the most common TFSA traps investors fall into. Learn to avoid these and you'll be able to enjoy all the perks that TFSAs provide — while skipping the pitfalls ...
- Trap #1: No contribution deadline
If you tend to procrastinate, the hard deadline on an RRSP can be a great motivator to get some money stashed away for your retirement. TFSAs, on the other hand, accept contributions at any time during the calendar year. You can even carry unused contribution room forward. Indefinitely. Which means if you're the type of person who puts things off, you can pretty much put off contributing to a TFSA forever. Maybe that's why as of 2012, according to a CIBC poll, only half of Canadians were using this type of account.
How to avoid this trap: Contributing to a TFSA isn't mandatory, but if you're saving money outside of an RRSP, it could be beneficial. (And if you aren't saving money outside of an RRSP, you should probably consider it.) Rather than playing it cool about making a contribution, set up an automatic deposit from your checking account. In this way, you won't even have to think about it.
- Trap #2: Account fees
One of the major benefits of a TFSA is that you can earn interest — and withdraw it — tax free. That means that if you put $5,000 into your account this year and earn a three percent return, you can withdraw any amount of that $5,150 and never get a T4 slip from the government. Unfortunately, if your TFSA account includes high fees, these fees can easily wipe out the benefits of any return. Although 'savings' TFSAs (accounts that act much like a regular savings account) are often free, mutual fund and self-directed TFSAs can include administration, withdrawal and other fees.
How to avoid this trap: Ask questions. Some types of accounts will have fees — especially the self-directed kind. If you think you can generate high returns in your account, these fees may be reasonable. Just be sure to know exactly what you're in for upfront. If you're using a TFSA for savings, it's best to shop around for one that's fee-free, because paying to hold your money in savings just doesn't add up (especially with current low interest rates).
- Trap #3: Confusing overcontribution rules
Okay, listen up, because here's where a lot of people have been tripped up by TFSAs. You probably know that you can contribute up to $5,000 to your TFSA each year. You may also know that you can withdraw that amount and any interest you earn any time you want, right? Good.
Now, here's where things get tricky. You can also put back as much as you've withdrawn (contributions and interest). What you need to avoid is recontributing that money in the same calendar year. Doing so could put you over your contribution limit, making you subject to an overcontribution penalty of 1 percent per month on the amount you've over-contributed.
How to avoid this trap: Let's look at an example. Let's say you're a TFSA superstar. You've contributed $5,000 each year since the program began in 2009, and have already made your full contributions for 2012; you should now have $20,000 plus any returns. Let's also say you made a couple of clever investments, and have banked $5,000 in returns.
Now, suppose that you want to withdraw that money to buy yourself something really nice (or, in a more likely scenario, to pay for some big-ticket item that might be worth thinking twice about...). If you make that withdrawal in 2012, you will be able to recontribute $25,000 to the account. But you must wait until the next calendar year (2013 in this instance) to do it because you've already used all your available contribution room for the current year. Come January 1st, your contribution room will be $30,000 (your $25,000 withdrawal from 2012 + your $5,000 contribution for 2013).
- Trap #4: No capital losses
In investing, you win some and lose some. In a TFSA, the wins — known as "capital gains" - are tax free. If you lose, however, a TFSA has one major drawback compared to an unregistered account; that is, you can't match that loss against a capital gain to reduce your tax liability. This makes investing in a TFSA a matter of balancing the desire to win tax-free gains with the risk of losing money without recourse.
How to avoid this trap: Investors use capital losses to reduce the amount of tax they owe on investments that have performed well. So, while the temptation might be to invest very aggressively in a TFSA for the biggest possible return, most experts recommend being a little more conservative, because there is no consolation prize when you suffer a major loss.
- Trap #5: Tricky transfer rules
Think of a TFSA like a turnstile. Everything that goes through is counted. If it goes through twice, it's double counted. We've already addressed what that can mean if you withdraw and recontribute money in the same year. The same kind of situation can arise if you attempt to transfer funds from one TFSA to another. Why? Because if you do that within the same year, it will count as two contributions, which could put you over your contribution limit and make you subject to a tax penalty.
How to avoid this trap: According to the CRA, if you want to transfer funds from one TFSA to another or from one issuer to another, you can avoid tax consequences by asking for a direct transfer. Do note, however, that some banks charge transfer fees, so be sure to ask questions about this before deciding to make the move.
TFSAs: Choose to win
Savvy investors know the rules of the game and do everything they can to make sure they use them to their advantage. For many people, TFSAs are a great way to save for big purchases, build an emergency fund or sock away extra money for retirement. So they make you tiptoe around a few rules to do it...are you really going to let that stop you?!