As the name suggests, a Tax-Free Savings Account (TFSA) is an account that enjoys a tax-sheltered status from the government. This means that taxes are not applied on contributions, dividends, interest earned, capital gains or withdrawals. You can use a TFSA as an emergency fund, to save for retirement or to meet any other financial goal. Individuals aged 18 and above in Montreal are eligible to open a TFSA account.
However, despite all the advantages that this account offers, many Canadians make costly mistakes with their TFSAs that end up hurting them.
Here are 6 TFSA blunders to avoid at all costs:
- Naming spouse a beneficiary
If you are planning to leave your TFSA to your husband or wife after your demise, don’t add them as a beneficiary. Instead, you should name them the successor holder of the TFSA account. When your spouse is the successor holder, the tax free status of the account will be automatically preserved. A beneficiary designation should be used for TFSA recipients such as your children, grandchildren or preferred charities.
- Over-contributing to the account
One common blunder TFSA owners make is over-contributing. Every year, the Canada Revenue Agency sends out letters to thousands of people who have exceeded contribution limits. Don’t over-contribute and think that they’ll turn a blind eye. All excess contributions incur a penalty of 1% per month. For instance, if you contribute an excess of $2,000 in January, you will pay $240 in taxes at the end of the year. To avoid such penalties, always keep track of your contributions. Any excess contribution should be withdrawn immediately.
- Selecting non-qualified investments
If a security is not traded through a well-known stock exchange, it is likely to be considered ineligible for a TFSA. Having a non-qualified investment in your TFSA could result in a loss of the tax shelter for that investment, plus a penalty equivalent to 50% of the investment’s value. In addition, there will be other tax implications which will vary depending on the situation.
- Holding foreign dividend stocks
When held inside a TFSA, foreign dividend stocks are subject to a withholding tax which is not recoverable. For U.S. dividend stocks, the withholding tax is 15%. However, this tax does not apply when foreign assets are held in a Registered Retirement Savings Plan (RRSP). Therefore, foreign dividend stocks should be allocated to your RRSP or other non-registered investment accounts.
- Limiting your TFSA to savings
Many people wrongly assume that a TFSA is simply a savings account. As a result, they save GICs (Guaranteed Investment Certificate) and cash in their TFSA and make withdrawals anytime they are in need. However, the TFSA should be managed just like any other investment account, especially for long-term retirement savings.
- Being too risk averse
If your TFSA is comprised of GICs and cash only, your portfolio is considered very conservative. Such a portfolio only makes sense for short-term goals such as a wedding, home down payment, car purchase or vacation. However, if you are saving towards a long-term goal, you will need to take more risks. A TFSA can hold a wide range of investment assets including gold and silver bars, mutual funds, bonds and stocks.
Regardless of what you are saving for –a special vacation or a new home – using a Tax-Free Savings Account might be a wise idea for attaining your goals. If you avoid the common mistakes that will frustrate your efforts, you will get to your destination much sooner.