Tuesday, February 1, 2011

Avoid TFSA Penalties and Shelter Your Largest Gains From Taxes.

TFSA's, or tax-free savings accounts, are a great option for Canadian investors. With the ability to contribute $5000 every calendar year, they are fantastic ways for young Canadians to begin saving for retirement, or large purchases that they may make in the future. It is important, however, to use them wisely. 

Remember not to violate the rules governing the accounts that have been placed there by the government. 72,000 Canadians have already been hit this year with tax penalties for violating one basic rule... you can NOT put money in, take it out, and then put it in again in the same year. Many people, because of the titles of the accounts, are using them for plain vanilla savings, but that is not what they are designed for. If money is going in, you should leave it there for the year... unless you are sure you are not going to put it back in again.

Basically, TFSA's allow account holders to invest up to $5,000 a year in the accounts, and the gains therein can grow tax-free. They have been very popular, with more than five million opened since 2009. But the average penalty for those who "over-contributed" to the accounts by taking money out and then putting it back in again was $179.10. The Federal Government's Revenue Minister Keith Ashfield said in a statement last June that "We understand that it may take time for some Canadians to learn about the program and for some financial institutions to properly inform their clients about this product. ... We have taken the decision to be as flexible as possible in cases where a genuine misunderstanding of the TFSA contribution rules occurred." And thus the government has granted relief to most of those who complained about the penalty.

To be sure, the rules are not being explained to most Canadians when they open the accounts. The information is located in the fine print of most of the account opening documents. For Scotiabank it states; "The amount you withdraw can be put back in your TFSA starting the following year without impacting your contribution room." It also notes that a one per cent per month over-contribution penalty will be levied by the CRA to any excess contributions, similar to the rules for an RRSP.

In addition, the major banks are advertising the TFSA's as savings accounts, when in actuality they are more like Tax-Free Investment Accounts. Money should not be taken in and out like with a conventional savings account. Rather, since stocks and other investments may be held within them, the TFSA's should be used to generate longer-term income through the use of dividend paying stocks or mutual funds. A couple high-quality long-term stocks, such as Imperial Oil (TSE:IMO) and Scotiabank(TSE:BNS), would be great names for inclusion in a Canadian's TFSA. The intelligent investor will put something in their TFSA that they might otherwise have had to actually pay tax on... and since most banks do not pay you enough interest on your GIC's or cash savings, you will often not need to shelter that income from taxation. You want to shelter your largest potential gains from taxation, and most often those gains will arise from high-quality, dividend paying stocks. So take a look at your TFSA and ensure that it has the right investments inside it because, more often than not, the banks have been not giving the best advice on these accounts.

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