The best things in life are nearest: Breath in your nostrils, light in your eyes, flowers at your feet, duties at your hand, the path of right just before you. Then do not grasp at the stars, but do life's plain, common work as it comes, certain that daily duties and daily bread are the sweetest things in life.

~ Robert Louis Stevenson

I love TFSAs. I think they're the best financial “innovation” to hit the market in a long time. Last week, I wrote a lot about the complexities that have built up, wreaked havoc on, and continue to threaten our financial system.

The beauty of Tax Free Savings Accounts (TFSAs) lies not only in their tax sheltering function, but in their simplicity. The rules surrounding this relatively new Canadian savings vehicle are noticeably sparse in comparison to those surrounding RRSPs and the tax code itself. I've previously written about the basics of TFSAs in the context of comparing them to RRSPs. (See TFSA vs. RRSP Duel: Who Wins? for a summary of the basic features of each.)

Today, I'd like to look at the specifics of withdrawing money from TFSAs. Although the rules are pretty simple, things can get a bit confusing, especially if you're used to dealing with the rules of other financial products. I thought we'd look at a few examples to help make things a little clearer.

TFSA Withdrawal Basics

You can withdraw any amount from your TFSA at any time without paying tax on the principal or any accumulated investment gains. It's your responsibility to track your contribution room limits, although the CRA does mention your limit on your Notice of Assessment. You don't have to set up a TFSA or file a tax return in order to start gathering TFSA contribution room. You just have to be at least 18.

The main thing to be aware of when you withdraw money from your TFSA is that you can't put the money back until the following calendar year. If you put it back in before the end of the same calendar year and that causes your total contributions for that year to exceed your contribution room limit for that year, you will have to pay 1% per month tax on the excess contribution amount.

Example 1

John opened a TFSA in 2009, the first year they were available. He contributed the maximum amount ($5000). In 2010, he was eligible to contribute another $5000 and he did so in January of that year. In March of 2010, John learned that he would be temporarily laid off. He withdrew $4000 from his TFSA, anticipating that he would need the money during his layoff.

A few weeks later, John's employer landed a contract that meant he would be called back to work after only 2 weeks off.  John wanted to put $3000 back into his TFSA, but would be unable to do so until January 1, 2011 since he had already contributed his $5000 limit during 2010. If he was unaware of this rule and contributed the $3000 back anyway, he would be subject to the 1% per month tax until the end of 2010.

Assuming he understood the rules and held off on replacing any of the money he withdrew, John's contribution limit for 2011 would be $9000. ($5000 for his regular 2011 contribution amount + $4000 to replace his 2010 withdrawal.)

Example 2

This is an example of how I used the TFSA withdrawal rules to manage our finances recently. If you've been keeping up to date with my quarterly planning reports, you know that we have experienced quite a reduction in our income level over the past 2 years or so due to my husband's recent (and frequent) job changes. As a result of a potential budget shortfall this year, I felt that we might need to draw down some of the savings in our TFSAs.

In anticipation of this, I took some money out of each of our TFSAs at the very end of 2009. I did this to ensure that we could replace the money in 2010 if possible. If I had waited until January of 2010 to take the money out, we might not be able to replace that money until 2011.

For example: At the end of 2009, I took $5000 out of my husband's TFSA, leaving only the accumulated interest in the account. (Note that investment gains and interest are not treated as contributions.) As a result, his new contribution limit for 2010 is $10 000 ($5000 for 2010 + $5000 from the 2009 withdrawal.) If I had waited and withdrawn the $5000 in January, his contribution limit for 2010 would only be $5000.

So technically, if all we wanted to do was to be able to replace the original $5000, we could have done so using 2010's contribution room. However, now we have the option to contribute an extra $5000 if we are able to do so. Who knows? Things are looking a little better for us than they were at the last quarterly update. Tune in at the end of June for more details!

Note that there were some changes proposed in October of 2009 that would make some withdrawals ineligible for replacement in the following calendar year. However, most of these pertain to transactions by more sophisticated investors intended to game the system and take advantage of the relatively low 1% over-contribution tax. Frugal Trader offered a good review of these proposed TFSA changes at Million Dollar Journey.

If you have any questions or comments on TFSA withdrawals, please leave them in the comments section or send me an email.

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