Everyone know that a TFSA allows for withdrawals free of any taxes but did you know that you don’t even need cash to make a contribution, or that many people aren’t taking advantage of their full TFSA potential?
Advantage: RRSP Transfers
One possible strategy with a TFSA is to trade equities for the short term in the hopes that they will gain a significant amount over a short period of time. This involves more risk than investing in companies that pay dividends over the long term. So what happens if you invest in a company for the short term in the hopes it will go up and instead it drops?
Stocks held in a TFSA can be transferred to your RRSP account – giving you a RRSP contribution for that year. The amount of the contribution is the current value of the shares. So if you bought a stock at $5/share and it drops to $3/share but you don’t want to sell for a loss, you can simply transfer it to your RRSP account and get the deduction. The transfer would be done at the current value of the shares (in this case $3/share).
This strategy is useful for a few reasons:
– It allows someone to transfer over a stock that may increase over time, but is low for the short term
– It gives you a contribution for that year towards your RRSP which would reduce your taxable income (and your taxes payable)
– At year end if you transferred an amount over to your RRSP from your TFSA, the amount of the transfer would be carried over as available TFSA contribution room for the following year
Advantage: Gains are carried forward
Any withdrawals made from a TFSA are carried forward to the following year – including any amounts above your contribution room.
Let’s say you invested $25,500 which was your maximum contribution amount. You did well on your investments and ended the year with a balance of $35,000. If you withdrew the entire $35,000, the following year your available contribution room would be $40,500 ($35,000 that you withdrew and $5,500 for the new year).
Many people think that the contribution room is capped at the annual dollar limit, which is currently $10,000. But what they don’t realize is that the contribution room does not include any earnings made within the fund.
A study by BMO showed that in 2012, 82% of the account holdings in a TFSA are fixed-income investments.
Personally, I see this as a wasted opportunity because of the potential gains within a TFSA. Fixed-income investments such as GICs will never have huge gains and therefore the tax savings will be much less.
Maybe you are saving for a large purchase such as a vehicle, down payment on a house or an extended vacation. The TFSA allows you to earn income tax free within the account which would help increase your savings.
When you do finally take the money out to make the purchase, the amount withdrawn gets carried forward towards your contribution room for next year.
Example: Dave is saving for a vehicle he will need to buy in a couple years. At the beginning of 2013, he didn’t have a TFSA. He opened a TFSA in May 2013 and contributed $25,500. Then in 2014 he contributed another $5,500. His investments did well and in late 2014, he withdrew $42,000 to spend on a vehicle. Beginning in 2015, his contribution room will be $47,000 ($42,000 + $5,500). Update: the annual TFSA contribution limit has been increased to $10,000 per year.
Advantage: Contributions in Kind
Did you know that you don’t even need cash to contribute to a TFSA? You can contribute to your TFSA ‘in kind’ by using investments (equities, GICs, etc) that you already have – it is simply a transfer from one account to another.
The rules for in kind contributions are the same as RRSPs – any equities are considered to be sold when transferred which could trigger capital gains.
On the flip side, if you hold equities that are below cost it would not trigger a capital loss. You’re likely better off to sell any equities below cost, claim the capital loss and then contribute to your TFSA (using the cash from the sale).
For GICs, it is important to calculate the total value of the GIC when transferred (principal amount and any accrued interest) as if this amount goes above your contribution limit, you could risk having an overcontribution. It should be noted that you can’t make contributions directly from an RRSP to a TFSA, only from non-registered accounts.
Advantage: Income splitting
Many people don’t realize that a TFSA can also be used to split their investment income. Normally when someone gives money to their spouse to open an investment account (assuming it is non-registered) there are no tax consequences.
But the income generated in the investment account is taxed in the hands of the spouse who loaned the money. This is called income ‘attribution’ and CRA says the rule is there to avoid people paying less taxes than they should.
With a TFSA this rule doesn’t apply and spouses are free to pool their money together and contribute to each other’s TFSAs with no tax consequences. Over the long term if someone had a higher income than their spouse and contributed to their TFSA the tax savings could be huge because the income generated in the account would not be attributed back to the higher income spouse.
Conclusion: TFSAs are a great tool for saving with many advantages: contributions in kind (no cash needed), RRSP transfers, gains are carried forward to future years and income splitting of investment income is allowed.