Five things you may not know about TFSAs

After taking more than three years to get acquainted, Canadians still don’t know the tax-free savings account (TFSA) as well as they should. The TFSA lets you stash extra cash for just about anything — rainy-day savings, a new house or retirement — without paying any tax on the growth within the account or on withdrawals.

Still, since the TFSA was introduced in 2009, less than one-third of Canadians have opened one. Here are five of the most common misunderstandings about the TFSA.

1. It’s called a savings account, but can hold just about anything

From our earliest days, a “savings account” was where our pennies went when they came out of the piggy bank. The name suggests deposits, safety and low rates. But almost any investment you can hold in a registered retirement savings plan (RRSP) can also go into your TFSA: bonds, stocks, mutual funds, exchange-traded funds, options, etc.

Personal finance expert and author Kelley Keehn is among those who wish the government had chosen a different name for the TFSA. “Many banks and financial institutions advertise a set percentage for their cash TFSAs and it’s very low,” she says. “Canadians see the 2% and think ‘those TFSAs don’t pay much.’ In reality, the TFSA is a savings shelter like an RRSP and you need to choose the investment that goes within it.”

2. You can re-contribute your withdrawals — but not until the next year

In the first years of the TFSA, there were many stories about Canadians accidentally over-contributing and facing penalties from the Canada Revenue Agency (CRA). Most problems came from a simple misunderstanding.

Some early owners used the TFSA like a conventional savings account, making frequent withdrawals and deposits. If the total of all deposits exceeded the $5,000 annual limit ($5,500 as of 2013), they had over-contributed.

In other words, each time you deposit funds it counts as a contribution regardless of the total amount in the account. If you deposit $5,000 and then withdraw it and deposit again in the same year, you are considered to have contributed $10,000. Moving a TFSA from one financial institution to another by withdrawing and then re-depositing may trigger an accidental over-contribution. Making a transfer avoids that problem.

So far, the Canada Revenue Agency has been forgiving, waiving penalties if you say it was an accident and promise not to do it again, but there is no guarantee they will continue to do this in the future.

The CRA tells you your annual contribution limit – just like your RRSP limit — on the notice of assessment it sent you last year after processing your tax return. Each year’s contribution limit is the total of three amounts:

•$5,500 (as of 2013)

•Anything withdrawn the previous year (with the exception of certain qualifying transfers and distributions)

•All unused contribution room from previous years

3. You can’t lose contribution room

If you’ve never opened a TFSA, you can contribute up to $25,500 today — $5,000 for each year from 2009 to 2012 plus $5,500 for 2013. Plus, you never lose contribution room, regardless of your age (unless you are a non-resident of Canada for an entire year, during which time you will not accumulate contribution room).

You may not have money today, but many Canadians will reap a mid-life windfall from an inheritance, downsizing a home, severance or insurance payouts. Putting such proceeds into a TFSA (provided they do not exceed the available contribution room) can help shield their future growth from income tax.

“Unused contributions from each year can be carried forward, and withdrawals will [usually] result in new contribution room,” notes Krystal Yee, personal finance blogger at Give Me Back My Five Bucks. So if you use your $25,500 TFSA for a house down payment, you will have at least $31,000 in contribution room the following year. “It can be really confusing because we’ve never had a savings vehicle like this before.”

4. You don’t have to be a big saver

You can use a TFSA for your existing savings, even if they are relatively modest. So long as you don’t lock the funds into a non-redeemable investment such as a guaranteed investment certificate that can only be redeemed upon maturity, you will be able to access the money at any time. This also makes a TFSA perfect to use as an emergency fund. You will have the security of knowing the money will be available if you need it.

5. You don’t have to choose between a TFSA and an RRSP.

There are many clever ways to make the TFSA and RRSP work together to improve your wealth. As a general rule, RRSPs are a good choice for longer-term goals such as retirement, while TFSAs work better for more immediate objectives, such as a house down payment.