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How can you get the most out of your TFSA without risking any penalties? - DFSIN - SFL

How can you get the most out of your TFSA without risking any penalties?

Putting money into a tax-free savings account (TFSA) is simple, and so is withdrawing it. As things go along, however, the timing of your deposits and withdrawals can get complicated and make you lose track of the prescribed limits. A quick reference guide to get your bearings and avoid expensive mistakes.

April 26, 2023

The TFSA is a flexible savings solution that lets your money grow in a tax-sheltered environment where you can access it at any time. TFSA withdrawals are not taxable and, since they’re not deemed to be income, they don’t affect your eligibility for any income-tested tax credits or benefits. However, these withdrawals can have an impact on your future TFSA contribution room and, in spite of yourself, you might end up with an over-contribution – which could result in penalty taxes on some portions of your TFSA.  

A few guidelines. 

Start of a 4-point infographic explaining the rules for TFSA deposits and withdrawals. Point 1. What is the maximum amount you can contribute to a TFSA? Your maximum cumulative contribution is equal to the sum of these two amounts: first, either your cumulative contribution room since the first year TFSAs were available, or your cumulative contribution room since you turned 18, whichever is less, plus the current year's contribution room. The cumulative contribution room since TFSAs first became available amounts to:$5,000 from 2009 to 2012 for a total of $20,000; $5,500 in 2013 and 2014 for a total of $11,000; $10,000 in 2015; $5,500 from 2016 to 2018 for a total of $16,500; $6,000 from 2019 to 2022 for a total of $24,000 and, finally, $6,500 in 2023.  In 2023, anyone who was an adult in 2009 and has never contributed to a TFSA will have contribution room of $88,000.

Point 2. How are contributions and withdrawals connected? The general concept is that a withdrawal will free up the equivalent amount of contribution room in the following year.   For example, if you withdraw $3,000 from your TFSA in 2023, your limit will increase by $3,000 in 2024.   To do the math, use this equation: add your cumulative contribution room to your dollar limit for the current year, subtract your previous contributions and add your withdrawals in prior years. The answer will be your contribution room for this year. An example: You opened a TFSA in 2016, when you turned 18. You have contributed $5,000 per year.  In 2022, you withdrew $3,000 to go on a trip.    Your contribution room for 2023 would be calculated as follows: Your cumulative contribution room: $5,500/year from 2016 to 2018 and $6,000/year from 2019 to 2022, for a total of $40,500; plus your TFSA dollar limit for 2023, i.e., $6,500; minus the contributions you made from 2016 to 2022, i.e., $5,000/year, for a total of $35,000; plus the $3,000 withdrawal made in 2022. Your contribution room in 2023 is $15,000.

Point 3. How might you find yourself with excess TFSA contributions? By contributing more than the prescribed limit for a given year, or by mistiming contributions and withdrawals. An example:At the beginning of the year, your contribution room is $15,000. In February, you deposit $15,000. In June, you withdraw $8,000 for a project. But in July, you change your plans and redeposit the $8,000. You will end up with an innocent over-contribution. Here's why. At the beginning of the year, your available contribution room is $15,000.  In February, your $15,000 deposit brings this limit to $0.In June, you withdraw $8,000, but your contribution room remains $0 because the withdrawal amount won't apply to the TFSA until 2024.In July, your $8,000 deposit puts you in the position of having excess contributions: you put $8,000 too much in your TFSA in 2023.

Point 4: How can you avoid an innocent over-contribution to your TFSA? Four things to never forget. First, that withdrawals made during a given year do not increase your contribution room for that same year. Second, to plan the timing of your withdrawals. In our example, if you had made your $8,000 withdrawal in December 2022 instead of June 2023, you would have freed up contribution room in your TFSA as of 2023.Third, that your TFSA contribution room is divided among all of your TFSA accounts. Fourth, that it is not permitted to make a deliberate over-contribution to a TFSA with the idea that the tax-sheltered returns will offset the penalty. The Canada Revenue Agency (ARC) imposes a penalty tax of 1% per month on excess contributions until the situation is rectified.

Talk to your advisor about the best options for getting the most out of your TFSA.

The following sources were used to prepare this article: 
Canada Revenue Agency, “Tax-Free Savings Account (TFSA), Guide for Individuals.” 
CPA, “Over-contributed to your RRSP or TFSA? Here’s what to do.” 
Desjardins, “FAQ – TFSAs.”