Disadvantages of Using a TFSA
While TFSAs have many advantages and it’s hard to knock their usefulness, there are instances where it is not the best investment option.
Taxable income and refunds
The most obvious disadvantage of a TFSA is the lack of an immediate reduction of your taxable income. With an RRSP you at least get to claim it as an income deduction. With a TFSA you don’t get to do this. The advantage only comes in on the other end (tax-free withdrawals) so if you are looking to lower your taxable income, this isn’t the way to go.
Another often-overlooked aspect is that unlike an RRSP, a TFSA doesn’t contribute towards a tax refund. Because of this, you don’t have the option of immediately investing that refund and enjoying compound interest.
Contribution limit confusion
One of the most common problems with owning a TFSA is the confusion surrounding contribution limits. People constantly over-contribute and end up getting penalized by the CRA. In the early years of the TFSA these “accidents” were often forgiven by the CRA, provided you could prove no malicious intent, but since the program has been around for several years now the CRA is less lenient. So make sure you understand the rules and to be safe, never withdraw and then re-contribute money to your TFSA in the same calendar year. Wait until the next year to be safe!
Contribution limit not enough for you?
The TFSA has a current annual contribution limit of $6500. However, if you have lots of income to potentially invest, you may find this rather restrictive. With an RRSP you can contribute potentially more (18% of your income) up to about $30,000. And if you want to invest oodles of money in a non-registered plan there is no limit at all (although you’ll pay tax on it).
This is related to the confusion surrounding contribution limits. Basically every time you do a transfer between multiple TFSAs, you will be eating into your annual contribution limit. To avoid this, you must do what’s called a direct transfer, where the bank (or whomever is your TFSA issuer) does the transfer for you. Only in this way can you avoid the accidental over-contribution scenario!
When the investments inside your TFSA do well, you make money. That capital gain is tax-free. However you can’t claim a capital loss if you lose money inside the TFSA. That money is lost forever, you can’t claim it back by subtracting it from a well-performing (taxable) investment outside your TFSA. And you also can’t claim this loss against increasing your contribution room…once you contribute your annual designated amount, that’s it.
US dividend stocks and withholding tax
If you have foreign stock inside your TFSA, you will have to pay a withholding tax. Normally when you have to pay a withholding tax you get to claim the equivalent in a foreign tax credit, essentially cancelling each other out. However the foreign tax credit is not available on TFSA earnings so you have to eat this extra expense. There is a special exemption in place for US dividends going into retirement vehicles such as the RRSP or RRIF, but this does not exist for TFSAs.
While a TFSA can be a great way to earn tax-free income, if you put that money in the wrong type of investments you could end up losing money over the long term. Mutual funds can especially eat into TFSA income if you invest in ones with high MERs. And if you like to make numerous trades you could be hit with lots of commission fees or transaction fees. Do your homework to make sure you are investing in the right sort of funds for your financial situation!