Too often, when we think about Tax-Free Savings Accounts, we focus on the "savings account" element and overlook the "tax-free" part.
As of June, Canadians had opened just over 6 million TFSAs worth $29.8-billion, with most of that money going into safe products with little return on investment, says Carlos Cardone, senior consultant at Investor Economics. Of the money Canadians contributed to TFSAs, 71 per cent was booked with retail banks, with 57.3 per cent deposited in premium savings accounts, 30 per cent in term deposits and the rest in mutual funds and other holdings.
You can contribute up to $5,000 annually to a TFSA. Investment income earned in a TFSA is tax-free, as are withdrawals from the account.
Gordon Pape, author of The Ultimate TFSA Guide, says unless you need quick access to your TFSA money, you owe it to yourself to invest aggressively and take advantage of the tax savings.
"If you're only getting a 2- or 3-per-cent return on what's in the account, you're not saving much tax," Mr. Pape says.
Before you move your TFSA money from a savings account to a brokerage account, however, make sure you understand the rules and have contribution room, so you won't end up in the same boat as the 70,000 taxpayers who received TFSA over-contribution notices from the Canada Revenue Agency this past summer.
"In many cases, the problem was a misunderstanding of the rules," Mr. Pape says. "You are allowed to re-contribute any withdrawals you make from a plan - but only in the following year. If you put the money back before year-end, you may be in over-contribution territory."
Also, don't withdraw money from one plan to open another. If you want to switch plans, you need to open the new one and then have the money transferred directly to it from your existing plan.
"This was another trap people fell into during the 2009 tax year. They decided they didn't like their original TFSA, perhaps because it was a low-interest savings plan, so they drew the money out to use for opening a different type of account. The CRA considered that to be a new contribution."
Mr. Pape offers these additional tips for taking advantage of a TFSA:
Don't contribute losing securities.
If you have a self-directed plan, you are allowed to make "contributions in kind" instead of cash. That means you can put securities into the plan at fair market value. Such contributions can trigger a taxable capital gain in the case of a profitable security. If the security has dropped in value, no capital loss is allowed. You should sell the security first, which will result in an allowable capital loss, and then contribute the cash.
Make your RRSP contribution first.
In most, but not all, cases, it's better to make a maximum RRSP contribution before considering a TFSA. That's because you get an immediate tax deduction for the RRSP contribution, which a TFSA does not offer. Exceptions are people who expect their tax rate in retirement to be higher than it is now; those with no earned income (so no RRSP contribution room); and those who are likely to be eligible for income-tested government benefits and tax credits, such as the guaranteed income supplement. TFSA withdrawals do not count as income for those benefits and credits, whereas payments from an RRSP or RRIF do.
Name your spouse or partner as successor account holder.
Naming a successor ensures a smooth transfer of the assets with no probate fees in the event of your death. Heirs can be named as beneficiaries but only a spouse or partner can be a successor holder. If you are unsure of whether this was done when the account was opened, check with the financial institution that holds it.
Give your spouse money for his or her plan.
Unlike RRSPs, there is no such thing as a spousal TFSA. But you are allowed to give a spouse or partner the money to contribute to their own plan with no income attribution rules. It's an excellent form of income-splitting.
Use TFSAs to shelter RRIF income.
Some retirees complain about the high taxes they have to pay on RRIF withdrawals. There is nothing that can be done about that, but if the income isn't needed immediately, invest the net proceeds in a TFSA so as to shelter future investment growth from tax.