Withdrawing Cash From a TFSA?

With back to school just around the corner and other money spending opportunities on the horizon, we thought it would be worthwhile to review the Tax-Free Savings Account (TFSA) rules to determine if it is worthwhile raiding the account for those upcoming cash requirements.

Here are the top 6 questions we receive regarding TFSA's:

1. What is a TFSA and Who Can Contribute To It?

Available since January 1, 2009, the new Tax-Free Savings Account (TFSA) is a registered account in which investment earnings, including interest, dividends and capital gains accumulate within the account on a tax free basis. Contributions up to an annual maximum of $5000 can be made by/for those who have reached 18 years of age and are residents of Canada. There is no maximum contribution age (you can be 92, for example!), however a tax return must be filed to build "TFSA Contribution Roomî. This $5000 annual maximum amount will be indexed after 2009, with rounding to the nearest $500. The annual maximum remains at $5,000 for 2010 contributions.

2. How is TFSA Contribution Room Calculated? The TFSA contribution room is made up of:

∑ annual TFSA dollar limit ($5,000peryear plus indexation, if applicable);

∑ any unused TFSA contribution room in the previous year; and

∑ any withdrawals made from the TFSA in the previous year, excluding qualifying transfers.

3. Can unused contribution room be carried forward to future years?

Unused contribution room can be carried forward on an indefinite carry forward basis. This means two things: first if you have unused TFSA contribution room of $10,000, you can in fact carry that unused contribution room forward indefinitely to fund when you have the money. Secondly once you build contribution room, you can't lose it. That is, you can take the principal and earnings out of your TFSAóon a tax free basis--and spend it on whatever you want; then put it back ñ as long as you wait until you have the contribution room.

4. How can I keep track of my TFSA Contribution Room?

Based on information provided by the issuers, the Canada Revenue Agency (CRA) will determine the TFSA contribution room for each eligible individual and report this on the Notice of Assessment. Withdrawals, excluding qualifying transfers, made from a TFSA in the year will be added back to TFSA contribution room at the beginning of the following year.

5. What happens when I make an overcontribution?

Taxpayers cannot contribute more than their available TFSA contribution room in a given year, even if they make withdrawals from the account during the year. If they do, a penalty tax of 1% of the highest excess amount in the plan during the month, is charged, for each month you are in an overcontribution position. Discrepancies in contribution room limit or excess contributions, must be reported to the TFSA issuer. In addition, after October 16, 2009, any income earned resulting from an overcontribution, or a contribution to a prohibited or non-qualifying investment will be taxed at 100%.

For example, let's take Paul who contributed $5,000 to his TFSA in 2009, and another $5,000 in 2010. In mid 2010 he decided to take out $4,000 from his TFSA to put a deposit on a sports car he saw for sale on e-Bay. When Paul found out he couldn't import the sports car into Canada, he backed out of the sale and received his deposit back. Unfortunately, as Paul has already put his full TFSA maximum into the account, he no longer has contribution room. He will have to wait until 2011 to re-contribute all or part of the $4,000 withdrawal. If he does re-contribute during 2010 he would be subject to the penalty tax of 1% a month for each month the excess contribution is in the account.

6. What income sources should be earned from the TFSA account?

That largely depends on age and sources of other income. Those sources of income subject to the highest marginal tax rates (such as interest) or dividends, (which artificially inflate net income, thereby decreasing social benefits payments), should perhaps be earned within a TFSA. Capital gains and losses should perhaps be incurred outside the TFSA for better tax results, particularly if planned in combination with a charitable giving strategy. But if you are looking for the power of real tax free growth, the TFSA should contain a diversified set of investments, including equities.