There are few free rides in personal finance, but Canada’s tax-free savings account (TFSA) is one of the most generous to investors: interest, dividends and capital gains can grow tax-exempt, and there’s no tax on withdrawals.
However, some TFSA blunders will trigger harsh penalties from the Canada Revenue Agency (CRA), or at least unravel the benefits of tax-free investing.
Here are the eight most costly TFSA mistakes to avoid.
1. Over-contributing, by accident
The CRA keeps close tabs on every penny moving in and out of your TFSA. If you inadvertently contribute more than your allowable limit, expect what’s known as an “excess amount letter.” This provides information about TFSA rules and what you need to do to resolve the issue. You could be penalized with a tax of 1% per month on the excess amount until it is withdrawn. For instance, a $10,000 over-contribution over 12 months could be subject to a $1,200 tax penalty. You can request a review of this fee and possibly have it waived or cancelled, but the process is not free of hassles.
2. Over-contributing, on purpose
Don’t do it! The CRA does not look well upon those who deliberately bend rules to try and gain advantage. Say, for instance, a TFSA holder intentionally over-contributed with a view to generating a rate of return that outweighs the cost of that 1% penalty. The rules allow the CRA to impose the harsh penalty of a 100% tax on the benefit (i.e., the income) attributable to the over-contribution.
3. Withdrawals and deposits between institutions
You may have any number of TFSA accounts across multiple institutions. But if you withdraw money from one to put into another, be aware that this counts as a TFSA contribution. Yes, the withdrawal increases your TFSA room — but not until the following year, so you could be over-contributing. If you need to move money between financial institutions, ask for a direct transfer — it won’t count as a TFSA withdrawal or impact your contribution room. It might make sense to consolidate with one provider to more easily manage your TFSA account, as well as coordinate your financial planning and investments.
4. Contributions made while outside Canada
It’s OK to maintain investments inside a TFSA account in Canada if you opt to live, work or study medicine abroad, but be aware that any new contributions made while you are considered a non-resident may be subject to a tax penalty of 1% per month. If you withdraw money from a TFSA while residing abroad, there’s no penalty in Canada — but you may be subject to foreign taxation.
Note that any amount withdrawn while you were a non-resident will be added back to your TFSA contribution room in the following year, but won’t be available until you re-establish Canadian residency.
5. Prohibited and non-qualified investments
TFSAs allow a wide range of qualified investments, but there are some general restrictions. For instance, prohibited investments include any property that you’re closely connected to — say, shares of a company or a partnership in which you have a significant interest (10% or more). This can trigger not one but two special taxes: 50% on the value of the investment; and 100% on any income or capital gains derived from the investment. The issuer of your TFSA must take reasonable care to ensure that the account does not hold non-qualified investments, but investors should still exercise caution and monitor their TFSAs.
6. Foreign dividend earners
There may be tax implications if you allocate an outsized proportion of assets to foreign-dividend-paying stocks inside a TFSA, as this dividend income may be subject to withholding taxes by foreign governments. For example, the Internal Revenue Service levies a withholding tax on dividends from U.S. companies held by Canadian resident investors within a TFSA, and this tax cannot be recovered
7. Too many low-yield investments
Despite the name, it’s better not to think of the TFSA as a “savings account.” To enjoy the tax savings of a TFSA, your investments need to have meaningful growth. If instead your TFSA mostly holds cash and other low-interest-bearing investments, you erode the main benefit of investing in a TFSA
8. Day trading in a TFSA
It is perfectly OK to build and manage your own investment portfolio in a self-directed TFSA account if you prefer to, but be aware that high-frequency or aggressive day trading may draw the attention of CRA auditors. If a TFSA account is determined to be used for “carrying on a business,” all gains could end up being taxed as business income. So if you dream of hanging up your scrubs to trade full time, chat with a tax professional first.
Guard your tax savings, today and in the future, with a solid plan
Whether you like to invest on your own or work with an advisor, you can minimize the tax you pay by including a TFSA in your financial plan. An MD Advisor* can help you make the most of your TFSA contributions and find the best combination of RRSPs and TFSAs to save more of your money. Let’s make sure your TFSA is in line to bring the greatest possible tax savings, now and in the future.
* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec), or an MD Private Investment Counsel Portfolio Manager.
The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.