Money often costs too much.

~Ralph Waldo Emerson


As if earning enough money to live wasn't hard enough, we have to figure out a way to put enough aside for the days when we are no longer earning income. Even more arduous is the task of finding the best vehicle for growing that money. And then there are the taxes . . .

In Canada, we have a new product that is supposed to help defray some of our tax burden. The Tax Free Savings Account became available in 2009 and was considered to be a simple, efficient way for Canadians to save money and avoid paying taxes on the growth of that money. I love TFSAs and I think they're a great product for everyone. They do seem pretty simple on the surface, but, as always, the devil is in the details.

Capital Growth, Withdrawals, and Contribution Limits

Last year I wrote about TFSA Withdrawal Rules, giving some examples of how they work. In the last couple of weeks, however, I've received a lot of questions from readers on how capital growth affects your TFSA contribution room. One reader asked this question:

If I contribute in 2009 – $5000.00 and in 2010 $5000.00 and in 2011 – $5000.00 for a total of $15,000.00 and say this summer of 2011 it has grown to $75,000.00 and I take out the $75000.00. Is it true that in January 2012 that I can put back $75, the 2012 $5000.00 for a total of $80,000.00.

Another reader had a similar question:

I am also curious about something about gains. I contributed the max $10K in the first two years but doubled it through investing. If I withdraw $20K in 2010, does that mean I can contribute back the $20K in 2011? Someone told me that even if the max contribution over the next 5yrs is $25K, if you build the account to $100K then that is the limit of the account. In other words, if I withdraw $100K in year 6, I can contribute back $105K in year 7. Does this make sense? (naturally the growth numbers are fictional)

When I tried to verify the answers to these questions, I realized why so many people were asking them. None of the examples on the CRA (Canada Revenue Agency) website address this directly. So I called CRA. The gentleman I spoke to basically looked up the information in the TFSA guide and said that the best way to figure out your contribution room is to just follow the formula given by CRA:

The TFSA contribution room is made up of:

•    your TFSA dollar limit ($5,000 per year 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.

The $5,000 TFSA dollar limit is indexed based on the inflation rate. The indexed amount will be rounded to the nearest $500. For example, assuming that the inflation rate is 2% for 2009 to 2011, the TFSA dollar limit would be $5,000 for 2009, 2010 and 2011, but would increase to $5,500 for 2012.

Doing the Math

Scenario #1: Investment Gains

Taking the first reader's scenario into account, the contribution room calculation for 2012 would look like this:

2012 TFSA Limit: .     .     .     .     .     .     .     .   $  5500 (Remember the inflation indexing kicks in in 2012, hence the extra $500)

Unused Contribution Room from 2011: .    .  + $       0 (Note that unused contribution room can be negative if you over-contributed in previous years.)

2011 Withdrawals: .     .     .     .     .     .     .  + $75 000

2012 Contribution Room: .     .     .     .      .     $80 500

In terms of the second reader's question, he is correct. If you contributed a total of $10 000 in the first two years (2009 and 2010) and by tremendous skill or luck doubled that money, you could withdraw the $20 000 at the end of 2010 and contribute back the $20 000 plus your $5000 for 2011. He is also correct, in theory, that if you grew the account to $100 000 in 5 years, you could take that $100K out at the end of the 5 years and recontribute it starting the following January.

I qualified this explanation with “in theory” because this scenario assumes that there were no other withdrawals and no over-contributions. Also, it may not be entirely correct to say that your contribution limit has permanently grown to $100 000 because you could sustain investment losses down the road that would reduce the size of the TFSA. Let's look at an example that includes some investment losses:

Scenario #2: Investment Losses

Suppose, as in Scenario #1, that you had contributed $5000 per year in each of the first 3 years (2009, 2010, & 2011) for a total of $15 000 in contributions. However, instead of growing the account by 5 fold as in our extremely optimistic first case study, you sustained a substantial 33% loss. Ouch. Your TFSA would then be worth about $10 000 instead of $15 000. If you withdrew the entire $10 000 in 2011, here's what your 2012 contribution limit calculation would look like:

2012 TFSA Limit: .     .     .     .     .     .     .     .   $  5500

Unused Contribution Room from 2011: .   .   +  $       0

2011 Withdrawals: .     .     .     .     .     .     .  + $10 000

2012 Contribution Room: .     .      .     .     .     $15 500

Note that this contribution room limit is lower than what your limit would have been if you had not sustained any losses. An investor who had contributed the maximum $5000 in the first three years and (in theory) incurred neither gains nor losses would have $20 500 in contribution room: $5000 for 2009-2011 plus the inflation indexed $5500 for 2012.

Final Thoughts

The examples above are very simple. Your personal scenario may be more complicated if you have done any transfers or over-contributed at any time. If you really want to know what your contribution room is, you're best to just do the math following the CRA formula. You can also get TFSA contribution room information from your My Account page on the CRA website or from the CRA's T.I.P.S. telephone service at 1-800-267-6999. From the CRA website:

The Canada Revenue Agency (CRA) will determine the TFSA contribution room for each eligible individual based on information provided by you and the TFSA issuers. Your TFSA contribution room will be shown on your income tax notice of assessment or reassessment.

You could just look for your contribution room on your notice of assessment, but if you want to do some planning ahead based on different scenarios, it's good to have an understanding of how these limits are calculated. If you want more information, you can find the TFSA pamphlet on the CRA's site in HTML or PDF format. I hope this helps those who have been wondering about this.

Here's a look at how capital gains, investment losses, and withdrawals affect your TFSA contribution room.