Five TFSA traps to avoid

Avoid these mistakes when managing your TFSA

A Tax-Free Savings Account comes with some attractive benefits – tax-sheltered growth, tax-free withdrawals, and savings flexibility that’s hard to beat. But there are some pitfalls to be aware of.

Taking full advantage of your TFSA isn’t always simple. Like many Canadians, you could be making mistakes that are costing you money in penalties and unnecessary taxes, or causing you to miss opportunities to grow your wealth.

Here are five mistakes to avoid when managing your TFSA.

1. Overcontributing to your account

Overcontributing is one of the most common errors people make with TFSAs. Doing so will trigger a penalty from the Canada Revenue Agency come tax time. That can add up quickly – you are charged 1% of the overcontribution amount for every month you’re over the limit. To curb the penalty you must withdraw the excess funds or wait for enough contribution room to be created the next year (or in later years) to absorb the overcontribution.

You can overcontribute to your TFSA in two ways. First, you can simply put too much money into your account. How much is too much? That depends on how actively you’ve contributed to your TFSA. If you were at least 18 years old in 2009 but never had a TFSA until now, you can contribute as much as $95,000 through 2024. If you’ve maxed out your contribution room every year, your limit is $7,000 for 2024.

The most frequent cause of overcontributing stems from misunderstanding how TFSA withdrawals work. When you withdraw funds, if you recontribute or “replace” them in the same calendar year it is considered a fresh deposit against your contribution room.

For example, let’s say you’ve maximized your TFSA contributions, including a $6,000 contribution at the beginning of the year. You withdraw $2,000 over the summer and then replace the money a few weeks later. According to tax rules, the amount of a withdrawal doesn’t get added to your TFSA contribution room until the next calendar year. So although recontributing the $2,000 only restores your TFSA to where it was, in the CRA’s eyes you’ve now contributed $8,000 for the year – your original $6,000 deposit plus the $2,000 re-contribution. For 2024, that leaves you $1,000 offside and facing a penalty on the excess funds.

Avoid overcontributing by following these tips:

• If you maximize your TFSA contributions each year, 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; you won’t have to wait as long for the calendar to flip to the next year and have the withdrawn amount added to your TFSA contribution room.
• As with an RRSP, 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 own contribution room instead of relying on the CRA to do it for you. Your information on file may not capture your most recent contributions and its accuracy depends on how quickly your financial institution reports client TFSA contribution information after year-end. Keep your own records and be confident you are contributing the right amount.
• If you’re moving TFSA funds from one financial institution to another, transfer, don’t withdraw. Withdrawn funds that are then deposited to a new account could be counted by the CRA as a new contribution. Follow the required procedures and have the account transferred properly.

2. Naming spouse a beneficiary instead of successor holder

Do you intend to leave your TFSA to your spouse after your death? If so, it’s often better to name them the successor holder of your account rather than the beneficiary.

Why? When you designate your spouse as the successor holder, he or she becomes the new owner of your TFSA after your death and its tax-free status is automatically preserved.

If you name your spouse as the beneficiary instead, they can still receive the TFSA’s assets tax-free. But, they’ll have to contend with 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, such as your children, grandchildren, or a charitable organization.

3. Holding investments that produce foreign income

Although TFSAs and RRSPs are both tax shelters, it doesn’t mean they treat all investment income the same way.

An RRSP is considered a retirement savings plan under the Income Tax Act. This means if you receive dividends in your RRSP from companies registered in countries that share a tax treaty with Canada (the United States, for example), that income is free of withholding tax typically assessed by foreign jurisdictions on Canadian investors. That’s good news if you hold foreign investments as part of a balanced portfolio.

A TFSA, on the other hand, doesn’t share the same exempt status as an RRSP, leaving foreign dividends paid into a TFSA subject to withholding tax.

A non-registered account is often a better choice for foreign dividend-paying investments; you can claim a foreign tax credit to offset withholding tax deducted. In a TFSA these taxes are not recoverable.

4. Not recognizing how market gains and losses impact your future contribution room

How your TFSA changes in value can make a significant difference in how much, or how little, you’ll be able to contribute in the future. A drop in value leaves less capital to withdraw. And, because you can’t recontribute more than you withdraw, a market loss essentially shrinks your future contribution room. Let’s use an example to explain.

Assume you put $6,000 into your TFSA and over time the market value of that contribution falls to $5,000. If you withdraw the remaining value, you’re eligible to recontribute only $5,000 – not the $6,000 you originally put in.

Luckily the opposite is true when your TFSA outperforms. If the value of your original contribution rises to, say, $7,000, you can withdraw and recontribute that higher amount, so market gains raise future contribution room. For the same reason income received raises a TFSA’s value and contribution room.

The lesson is if you’re likely to withdraw from your TFSA, consider the effect market moves can have on your future contribution room. Then carefully decide which investments have the right amount of risk. If you’re a conservative investor you might want to think twice about holding volatile investments in a TFSA that could hold back how much you contribute.

5. Choosing non-qualified investments

Securities that are not traded through a recognized stock exchange run the risk of being deemed ineligible for a TFSA. That’s important to know if you’re an investor who seeks out opportunities in off-the-radar companies.

The costs of holding a non-qualified investment in your TFSA are steep: a penalty equaling 50% of the non-qualified investment’s value, plus, loss of the TFSA’s usual tax-sheltering for that investment. There are further tax implications around prohibited investment rules which are complex and vary depending on the scenario. The best course of action is to consult with a tax specialist to ensure you're covered no matter what the situation. Think about holding more speculative securities outside a tax-sheltered account where you can claim losses and enjoy preferential tax treatment on capital gains.

No matter what you’re saving for – a new home, that special vacation, or retirement – using a Tax-Free Savings Account is a smart choice to reach your goals. And when you avoid common mistakes that can hurt your efforts, you’ll get there that much sooner.

Want to explore more ways to put your TFSA to work and achieve financial wellness? Arrange a review with your BlueShore Financial advisor today and get started on building your plan for tomorrow.