The ins and outs of tax free savings accounts (TFSAs)

The Canada Revenue Agency recently advised more than 70,000 Canadians that they must pay penalties for over-contributing to their tax free savings accounts in 2009.

You can make tax-free withdrawals from your TFSA at any time. You can put the money back in, as well, but the main limitation here is that you have to wait until the next calendar year to do so. That’s where many of these 70,000 investors ran afoul of the TFSA rules.

Penalties stem from confusion about rules surrounding tax free savings accounts

The federal government first made TFSAs available to investors in January 2009. These accounts let you earn investment income — including interest, dividends and capital gains — tax free. However, you could only contribute $5,000 in 2009 to start your tax free savings account.

Every year, you gain an additional $5,000 of contribution room in your TFSA. That means you have $10,000 of contribution room in 2010, rising to $15,000 in 2011, $20,000 in 2012 and so on. You also get to carry forward unused contribution room from previous years.

In the over-contribution example, say you made the maximum $5,000 contribution when TFSAs were first introduced in January 2009. Three months later, in April 2009, you withdrew $2,500 to pay for a family vacation. The earliest you could have put this $2,500 back into your TFSA would have been January 1, 2010. If you put it back sooner, you would have to pay a 1% per month penalty, even if you stayed below your 2009 contribution limit of $5,000.

To take this example further, you could put a total of $7,500 into your TFSA after January 1, 2010 ($5,000 for your annual 2010 contribution and the $2,500 withdrawal you made in 2009).

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Use caution when transferring funds between tax-free savings accounts

Another condition that trapped many investors is that, under the current TFSA rules, you can’t withdraw money from one TFSA and use this cash to open another TFSA at another bank or financial institution within the same year. If you do, the amount you contribute to the new plan is also considered an over-contribution.

In order to avoid a penalty, you must ensure that your financial institution transfers your funds from one TFSA to another directly.

Look to lower-risk investments for TFSA investing

Despite the confusion, we continue to think TFSAs are well worth investing in. To make the most of your TFSA investing, we think you are best to hold lower-risk investments in these accounts. That’s because you don’t want to suffer big losses in your TFSA. If you do, you can’t use those losses to offset capital gains. You’ll also lose the main advantage of a TFSA: sheltering gains from tax. You won’t have gains to shelter if the value of your investments falls.

Even though you have $10,000 of contribution room in 2010, it’s still difficult to build a diversified portfolio within your tax free savings account. Instead, we continue to recommend that you look to index funds, like the iShares Cdn Large Cap 60 Index Fund (Toronto symbol XIU), for TFSA investing.

The fund is a recommendation of our Canadian Wealth Advisor newsletter. Its units are made up of stocks that represent the S&P/TSX 60 Index, which consists of the 60 largest, most heavily traded stocks on the exchange. Most of the stocks in the index are high-quality companies.

The units trade on the Toronto exchange, just like stocks. Prices are quoted in newspaper stock tables and online. You’ll have to pay brokerage commissions to buy and sell them. However, the fund’s management expense ratio (MER) is just 0.17% of its assets.

Over the years, as the value of your TFSA increases, you could switch to a well-diversified portfolio of conservative, mostly dividend-paying stocks.

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