After the excitement of new contribution room in a new year, and before the RRSP season steals the show, now’s a good time to quickly check whether you’ve set your TFSA on the right course for the year.
But first, a refresher. A Tax-Free Savings Account, or TFSA, is a registered plan that allows you to save up to a certain amount of money each year without paying taxes on the earnings.
The TFSA was introduced in 2009, and if you were 18-years old as of that date (and have a valid SIN) you have a lifetime contribution limit of $81,500. The limit for 2022 is $6,000. A lot of people see the word ‘savings’ in TFSAs and the first thing they think is that it’s a place to sock away cash for things like a vacation, or a rainy-day fund. But that’s not a smart idea. The TFSA is an ideal investment account, especially if you want the magic power of compounding interest. In fact, there is no other place you can grow your money tax-free, and also withdraw it tax-free.
But apart from using the TFSA to store cash, some other small mistakes could cost you, mistakes that Adam Bornn, Financial Planner at Parallel Wealth, sees all too often at his office. Bornn, with a fast-rising Canadian Personal Finance presence on YouTube, put together a popular piece that spreads the word on these common pitfalls. We got in touch with him to talk about it, and he highlighted mistakes he thinks you should know about. Here they are, in no particular order:
Mistake #1 – Borrowing to Invest in Your TFSA
Compounding works both ways. Interest compounded that you’re paying to clear debt can cost you as well. A big mistake that Bornn encounters with TFSAs involves investors carrying high interest debt, on their credit cards for example. You might not want to be investing right now. “Let’s eliminate that debt first,” says Bornn. “There’s no point paying 20% on a credit card with a ten thousand dollar balance, and having a ten thousand dollar TFSA account that’s earning, say 5% a year.” That 15% spread, he notes, is costing you a lot of money. $1,500 on that scenario.
Which also answers another thing we often hear from our readers is, “Should I Borrow to Invest?”The idea behind this strategy is that you aim to invest your money so it grows at a greater rate than the interest you pay on the loan you have taken out – which is easier said than done. Christine Benz, director of personal finance at Morningstar, warns that investors should carefully think about they can realistically earn on different types of investments. “In this case, there is a mismatch between a guaranteed obligation (borrowing cost) and the return, which is uncertain regardless of where you invest unless you’re in cash,” she says. “And with cash vehicles you won’t come close to matching your borrowing costs.”
Mistake #2 – Contributing and Withdrawing in the Same Year
Another scenario that could cost you a lot of money is the mistake of contributing and then withdrawing and then contributing again in the same year. The TFSA isn’t quite set up for that. Every time you put money into your TFSA, even if you’re ‘returning’ some money you borrowed previously, you’re still using up contribution room. And that can be a problem.
Bornn provides an example: On January 1st, 2022, you deposit the full amount of contribution room available: $81,500. You keep in cash and then decide to purchase a new sports car, so you take the money out. But because prices rise too much, and you decide to wait, before putting it back into the TFSA that fall. Big mistake. “You can’t do it. You’ve already maxed out for that year,” says Bornn, “You can’t contribute until 2023.”
If you overcontribute, there’s a penalty of one percent per month – not cheap!
Mistake #3 – Incorrectly Listing Your Spouse
(Quebec residents: please skip to #4)
One thing to remember with a TFSA is that you can name a beneficiary, a successor, or both. There’s a difference. A beneficiary would get all of the money in your TFSA, and get it tax-free, and after that, the account would be closed. A successor gets the account and the money.
One of the most common mistakes Bornn sees with clients and their TFSAs has to do with their spouses, and how they’re listed as beneficiaries. “If you have a spouse or common-law partner, make sure to list a successor holder. Not a beneficiary.”
As an example, take a hypothetical couple Jim and Sally. If Jim passes away what happens? “She [Sally] will get the money as a beneficiary, but she could only put that money into her TFSA if she had the contribution room,” adds Bornn, “If Sally was listed as a successor holder on Jim’s TFSA, then she’d actually be able to lump it into her TFSA even if she didn’t have the contribution room.”
The distinction on your TFSA forms can make a difference in the thousands of dollars, explains Bornn, and it could lead to the clawback of your Old Age Security (OAS).
Mistake #4 – No Year-End Tax Plan
A big mistake Bornn encounters with his clients and which he says isn’t talked about enough, are TFSAs that lack an accompanying timeline that fits your financial plan. “Let’s say you knew you needed $25,000 for something in February, and you’ve maxed out your TFSA. We often ask clients to make that $25,000 withdrawal in December, so that come February, we already have that money in the bank account ready to go. Then later in the year, if the client has some money to spare, they can contribute up to that amount back.”
If you need money early in the following calendar year and you’ve maxed out your TFSA, the account can be used as a financial planning tool, says Bornn. It’ll give you the cash you need while providing the flexibility to add it back to the account and earn a higher return, tax-free. Not your everyday savings account!