Wednesday, March 10, 2010

Thinking About TFSAs

I just wrote about my TFSA last week here on my blog and then I got into talking about them over on Trent's blog too.  In fact, I had to deal with a commenter who both twisted what I said and told everybody I was wrong!  Uh, no.  Actually I wasn't.

In case you don't want to go over there and poke around the comments, here's the story.  Trent responded to someone who asked him about opening a Roth IRA and using it as an Emergency Fund.  He was against it, because the Roth has a $5,000/yr limit that expires at the end of each year (instead of being carried forward like a TFSA).  Trent's point was that if you deposit $5k and then use it for an emergency you can't put it back.  You've lost that year's contribution and that $5k is gone from your retirement account forever.

Several others pointed out that you might not have an emergency, and then you'd be ahead whereas if you had the emergency you wouldn't be any worse off than if you hadn't opened a Roth and had just put the money in an Emergency Fund.  I chimed in to talk about how a Roth and a TFSA are similar but different, and how you can take money out and put it back into a TFSA.

I used the example of someone with a $5,000 contribution limit depositing $2,500 then withdrawing $2,000 for an emergency.  I said this person could replace the $2k this year.

Kevin then jumped in to say:

In the interest of avoiding any confusion, I just wanted to correct Shevy’s inaccurate information regarding the Canadian TFSA accounts. Some of his information is completely wrong.

The TFSA does indeed have a $5,000/year contribution limit, and any gains in the account are tax-free, like a Roth IRA. Contributions are not tax-deductible. Shevy is correct that you can take money out, without penalty. Where his information goes off the rails, however, is his suggestion that you have to put the money back in that same year. In fact, it’s exactly the opposite. You CAN’T re-contribute the money that same year. You can put it back, but you have to wait until the next year to do so. Money you withdraw is added to next year’s contribution limit. Unused contribution room rolls forward.

Thus, to correct Shevy’s example, say you contributed $2,500 to your TFSA in year 1, then had an emergency that required you to take out $2,000. Assuming you don’t do anything else in year 1, then next year, your limit will be $9,500 ($2,500 unused contribution room from year 1, plus the $2,000 you took out in year 1, plus your new, $5,000 limit for year 2).

So, of course, I went back to correct all of his errors, starting with where he mistook me for a guy!

First of all, there's a world of difference between being able to do something and being required to do it.  I never said the person had to replace the money that same year but they could if they wanted to.  Why?  Because the person still had enough contribution room to be able to do it.  In my example the person would have used $4,500 out of his or her $5,000 contribution room (and would have had $2,500 in the account at the end of the year).  There are lots of good reasons for wanting to put the money back as soon as possible, interest being only one.  Perhaps the person had to pay for something and then got reimbursed by insurance.  So it really should go back in and, if it doesn't, maybe it will end up getting spent on something else.  It's a way of focusing on savings and making them a priority.

Kevin is only right that you can't repay the money in the case where you've already used up all your contribution room.  For example, if you put $400/mo into your TFSA and then have an emergency in October that costs $2,000 you won't be able to repay it until next year.  Why?  In October you have $4,000 in the account and you have another $800 that is scheduled to go in over the next 2 months.  If you put the $2,000 in you would be over the limit for the year by $1,000 right away and by $1,800 by the end of the year.  CRA charges 1% tax per month on the overlimit amount so that's a very bad idea.

You could put $200 back (bringing you right up to the $5,000 limit) and put the other $1,800 back at the beginning of the next calendar year or you could just wait until January to redeposit the whole $2,000.  In January there's another $5,000 limit, plus anything you didn't use from a previous year, plus the amount of any withdrawal you made.  So, every year the amount people can have in their TFSAs grows by $5,000 and in 10 years time everybody will be entitled to have $50,000 in their account (regardless of how much they actually deposited or withdrew during that decade).

The thing is, how many people are really fully funding their TFSAs?  In fact, how many people even opened one in 2009 when they first became available?  As I mentioned last week, I'm certainly not fully funding mine with $50 per pay period, especially when you consider that I'm one of the ones who didn't open the account until 2010 (so my contribution limit for this year is $10,000).  I think a lot of people who are struggling aren't able to fully fund anything, whether it's 18% to their RRSP or $5,000 to a TFSA or whatever the current maximum to receive the full government match is in an RESP, or even the 1/3/6 or more months we're all encouraged to have in an Emergency Fund.

So what's an average Joe or Jane to do in this circumstance?  I think the first thing is to start paying down debt.  Then open a TFSA and put whatever you can in there.  It could be $10 per week or $416.66 per month or anywhere in between.  If you have a baby, open an RESP right away and start putting something into it.  I pay $50/month into an RESP.  If you've fully funded your TFSA for the year and you have contribution room left over from a previous year, I'd keep going with that.  Otherwise you should start a separate Emergency Fund.  Once there's $1,000 in the Emergency Fund (and your TFSA is still fully funded) you can split the deposits that were going into the EF in half.  Half still goes into the EF, the rest can go into an RRSP.  As you finish paying off each debt, snowball it into the remaining debt.  When you have no debt other than mortgage you can split the debt repayment money between paying down principal and adding to your RRSP (up to your contribution limit, of course).

Sounds so easy, doesn't it?  But I'm still in the very early stages.  I'm paying down debt.  I have a small TFSA and a smaller Emergency Fund.  I have an RESP for my daughter.  I have RRSPs but I'm not putting anything into them at this point in time.  The money in them is still earning interest though.  I prefer the TFSA to the RRSP because of the flexibility inherent in it but I think each has a place in my retirement plans.


Adam said...

Sounds like you have it down pat. :)

I love my TFSA. I use it as a monthly property tax shelter. I pay my property taxes monthly into it, make some tax free returns, and then pay out my property taxes in July.

The bank used to take my money, use it for a year and give me nothing in return other than paying my property taxes on my behalf in July.

Thumbs up to the TFSA.


Grace. said...

I didn't understand a word of that, except that I may want to move to Canada!

Revanche said...

...I think I get it. I don't think I'll ever need it, but your explanation with examples is pretty clear for the subject matter.