Tax Free Savings Account year-end tips

The end of the calendar year is a good time to think about Tax Free Savings Accounts (TFSA) for a couple of main reasons:

• You get an extra $5,500 contribution room on January 1, 2013 (up from $5,000 in previous years)
• The end of the year is the best time to withdraw money from a TFSA if you want to minimize the time until the contribution room created from the withdrawal is available again. A more concrete example of this: it is easiest to move money from one TFSA to another TFSA by withdrawing from one TFSA at the end of the year and depositing to another TFSA at the beginning of the next year

Rules

Tax Free Savings Accounts have caused some confusion since they were introduced (as evidenced by some of the posts in this forum). For a comprehensive overview about TFSA rules and benefits, check out the Canada Revenue Agency site.

The biggest confusion around TFSAs is typically regarding withdrawals: you can withdraw money from a Tax Free Savings Account to a non-TFSA account during the year, but that does not create contribution room to deposit money back into a TFSA until the following year. As such, frequent withdrawals and deposits (unless in small amounts) can bring you over your contribution limit.

Technically, your available contribution room (in other words, the amount of money that you can deposit) for the current year remains fixed all year, and is made up of:

1. New contribution room available on January 1 ($5,500 in 2013)
2. Unused contribution room from the previous year
3. Withdrawals made in the previous year (including any interest earned that you withdrew)

A very simple example: Suppose you had never opened a TFSA before, and deposited exactly $20,000 into a TFSA in January 2012, maxing out your contribution room. Then, you withdraw $5,000 in February 2012. You cannot re-deposit that $5,000 into a TFSA without penalty until January 2013.

You can transfer money between Tax Free Savings Accounts at different institutions during the year without adversely affecting your contribution limit, although some institutions will charge a transfer fee.

There are some good example scenarios out there that go beyond the basics, such as here, here and here.

Unfortunately, due to the fact that you can open a TFSA at almost any financial institution, there isn’t an easy way for the government give you a real-time report of your contribution room during the year. (I remember seeing such a report once, and it was inaccurate.) Therefore, you have to keep close track of your contributions and withdrawals yourself.

Beware of teaser interest rates

Because it is not as easy to move money in and out of a TFSA as with other bank accounts, you are slightly more locked in to a financial institution’s TFSA account. Thus, you are more vulnerable to fluctuating interest rates. Some banks have, in my opinion, abused this fact by offering higher rates at the beginning of the year and then dropping the rate a few months later for more reasons than just “market fluctuations”. You and your money are a bit stuck at that point. I am not predicting that this will happen again, but it is definitely something to be suspicious about when you see a higher than usual TFSA rate at the beginning of the year.

Some examples:

• Canadian Tire Financial TFSA:
  January 8, 2010: 3.15%; May 7, 2010: 2.15%
  December 30, 2010: 3.50%; March 31, 2011: 2.50% (even though they had advertised that it was “not a temporary promotional rate”)
  December 29, 2011: 2.75%; March 31, 2012: 2.00%
• ING Direct
  Jan 1, 2010: 3.00% (was 1.20% on Dec 15, 2009); April 28, 2010: 2.00%
  Dec 30, 2010: 2.00% (was 1.50% on Oct 2, 2010); August 20, 2011: 1.50%
  January 1, 2012: 2.00%; April 1, 2012: 1.60%; March 20, 2012: 1.40%

See this comparison chart for some historical data on rates.

More than just a savings account

You can open a TFSA trading account for investments (such as in stocks) and you won’t be taxed on the gains made within the TFSA. However, you are also subject to more volatility compared to investing outside of a TFSA: you aren’t able to deduct capital losses within a TFSA from other taxable gains, while you are able to deduct capital losses outside of a TFSA.

You can also open other accounts, such as a GIC, within a TFSA. See this thread for some discussion around this.

Note: re-posted from here; originally published November 25, 2011; updated December 19, 2012