More on Tax-Free Savings Accounts

Understand the Rules so You Can Make the Most of the TFSA

Oct 27, 2008

Let's take a closer look at how these accounts are administered, and what happens to them in the event of the account-holder's death or the breakdown of their marriage.

Read our earlier article for the basics on how the new Tax-Free Savings Accounts for Canadians work, and continue with this article for more in-depth information on this new personal wealth-building opportunity.

Together, these articles will help you understand how to use these new accounts to your personal advantage!

You Must File a Tax Return in Order to Establish Contribution Room for your TFSA

Because the TFSA is a registered savings plan, contribution "room" for the account is calculated by the Canada Revenue Agency upon the processing of yearly tax returns.

So, in order to generate new contribution room each year, you must file a return, even if you have no income and no income tax payable.

You are not required to make a contribution to a TFSA in any given year. Unused contribution room will be carried forward from year to year, as it is with a Registered Retirement Savings Plan (RRSP).

Borrowing to Invest in TFSAs

As with RRSPs, because the income from a Tax-Free Savings Account is not taxable, any interest on funds borrowed to invest in a TFSA is not tax-deductible.

For Canadian investors who would like to borrow to invest, it makes more sense to borrow funds only to invest in accounts which are not registered with the federal government (that is, not RRSPs and not TFSAs).

Interest payable on funds borrowed to invest is only deductible when the investment is made in a non-registered account.

Excess Contribution Penalties for TFSAs

As with RRSPs, there is a penalty levied by the Canada Revenue Agency if contributions are made to a TFSA in excess of the allowable maximum. The maximum is $5,000 per year.

If you contribute more than $5,000 per year to a TFSA, the penalty will be 1% of the excess amount per month.

Your total contribution room for your TFSA will be noted on your Notice of Assessment from the Canada Revenue Agency for each tax year. You will need to read your Notice of Assessment carefully each year to ensure you do not overcontribute to your TFSA.

Estate Planning Considerations for TFSAs

When a TFSA account-holder dies, the account loses its tax-exempt status. This means the investment income becomes taxable. However, it will be possible to roll the account over to a spouse or common-law partner without affecting their contribution room.

If an account-holder dies without a spouse, the plan will need to be collapsed (all funds withdrawn) or the investments transferred to a different, non-TFSA account.

TFSAs and Marriage Breakdown

In the event of a marriage breakdown, a TFSA can be transferred from one spouse to another without penalty.

If one spouse transfers his or her TFSA to the other spouse, that will not create new contribution room for the transferring spouse. The contribution room for the spouse to whom the account is transferred is also not affected by the account transfer.

More information on all aspects of the Tax-Free Savings Account can be found on the Canada Revenue Agency website.

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