How to avoid running afoul of TFSA rules

There's more to staying onside than keeping to the $5,500 limit.

Matthew Elder 3 November, 2017 | 5:00PM

Unlike its considerably older cousin, the registered retirement savings plan, a tax-free savings account has no contribution deadline or mandatory termination date, and generally has fewer restrictions. But there are some points to consider before the end of the year in order to abide by the TFSA rules.

First, a review of how this tax-friendly vehicle works. You may contribute up to $5,500 to a TFSA each calendar year. As is the case with an RRSP, you can carry forward unused contribution room for future use. For example, if you have never contributed to a TFSA, as of 2017 you can immediately put in as much as $52,000 into an account, assuming you were 18 or over when the program was introduced in 2009. That total is based on annual limits of $5,000 from 2009 through 2012, $5,500 in 2013-2014, $10,000 in 2015, and $5,500 since 2016.

As with RRSPs, income earned within the account is sheltered from tax -- although within an RRSP, this is only a deferral, whereas in a TFSA it is a permanent tax break. Interest on loans taken out to fund a contribution are not tax-deductible. Eligible investments, for the most part, are the same for TFSAs as for RRSPs. Basically, these are stocks and other equity securities, bonds and other fixed-income securities, mutual funds, exchange-traded funds, cash and equivalents, and, in some cases, shares of private companies.

You also are permitted to make contributions in kind using eligible securities you already own in other accounts. And at death -- as with an RRSP or its post-retirement successor, a registered retirement income fund (RRIF) -- the assets within a TFSA can be transferred to your spouse without tax implications, and the spouse's lifetime contribution room is unaffected.

But that's where the similarities end. TFSA contributions are not tax deductible. However, nothing is taxed upon withdrawal, so there's no nasty tax hit as when you remove both capital and income from a TFSA.

What's more, when you remove capital from a TFSA, your lifetime contribution room is replenished by that amount. So, if your current contribution room stands at, say, $20,000, and you withdraw $5,000, your cumulative limit will increase to $25,000.

There can be a catch, though, which brings up the aforementioned year-end element. When you withdraw money from a TFSA, you must wait until the following calendar year to put that money back into your account. If you had made the maximum contribution during the current year and you don't wait until the new year to replace that money in your TFSA, you will be deemed to have made an excess contribution, and be subject to a penalty tax. That penalty is 1% of the excess amount for every month that you are offside. (The amount on which the penalty is based is the highest balance during the month.)

There are some additional restrictions to bear in mind when staying onside with a TFSA:

Spousal loans: Your spouse can give or lend you money for a TFSA contribution. This amount, together with any contributions made from your own resources, cannot exceed your contribution limit. Loaned or gifted amounts can grow tax-free within your TFSA, and may be withdrawn free of tax. However, if you were to reinvest any of this capital in a non-registered account, it would become taxable under the general income-attribution rules. It's better to use this money for a non-investment purpose, such as a major purchase or to pay down a mortgage. The bottom line is that, if you use money from your spouse to make a TFSA contribution, avoid reinvesting any withdrawn amounts in another, taxable account.

If you leave Canada: As a non-resident, you are permitted to retain a TFSA, but no additional contributions can be made. While income earned within the account will continue to be tax-free for Canadian tax purposes, this income may be taxed by your new country of residence, such as the United States.

Making TFSA fees tax-deductible: Some investors arrange with their investment advisor to pay account-management fees on their TFSA, RRSP or other registered account from a taxable account, thus making the fee tax-deductible. The CRA was to have clamped down on this tactic as of the beginning of next year, but recently delayed any action to 2019.

If you trade your portfolio heavily: Active and high-risk trading within a TFSA could be considered by the CRA to be business activity. In fact, the tax department has reassessed TFSA investors for $75 million during the program's eight years of existence. Among the red flags the CRA looks for are high trading volume, how long securities are held, the investor's profession, time spent researching and trading securities, and his or her market expertise. The TFSA is intended to assist individual taxpayers, not professional investors.

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Matthew Elder

Matthew Elder