3 TFSA Mistakes That Could Cost You Big Time

   Are you making one of the three most common TFSA mistakes?

   For Canadians, the TFSA is one of the best investment style accounts you can hold. But that only applies when you follow some rules. Breaking any one of these rules, and you could be in for a nasty surprise come tax time!

   The Tax Free Savings Account (TFSA) is actually a style of account that allows tax free investment growth. Tax savings? Check. But, there is a specified limit of lifetime contributions that increases every year. The only way to increase the amount of funds covered tax free in this tax advantaged investment account is to let the markets work their magic over time.

   Of course, in times of great opportunity, sometimes impatience starts to rear its head, and people start looking for ways to get ahead of the game. Unfortunately, those activities could actually hurt you more than you’re expecting.

Trading too Often (Day Trading)

   With the increased market volatility during 2020, especially the crash in March, investing into the stock market can produce some wild swings in valuation. For those more involved in short-term trading (defined: gambling), there has presented the opportunity to score some quick returns. Investing for the short term steps a little too close to the vast grey-area that the Canada Revenue Agency refers to as, “investing for business activities”. 

   “Business Activities” as it applies to your TFSA means that you have found yourself in a grey-area of TFSA tax law. Somewhere in that grey area surrounds the frequency of buying and selling transactions. If the CRA determines that the buying and selling of investments is too frequent, those transactions may be disqualified, and therefore not tax-advantaged. You would then be required to pay taxes on those investments.

A note on frequency of trading: 

   Any long term buy and hold strategy will be fine, even if you have weekly or monthly contributions made automatically. This is where the grey-area begins. 

   For example: I might have weekly contributions to my TFSA - resulting in 52 purchase transactions a year. On the other hand, someone else might have bought and sold only a half dozen times throughout the year, playing on the market swings of particularly volatile stocks. While my 52 transactions would be fine, the person with only those half-dozen transactions might still be classified as “business activities”. 

   We saw this a couple of years ago during the weed-stock bubble. Playing the volatility in those stocks resulted in some people walking away with huge gains in their TFSA, ultimately increasing their tax-advantaged investment limits. But, the tax-man always takes his cut. And many people who had tried to “beat” the CRA were ultimately re-assessed and forced to pay tax and penalties, as well as losing that contribution room in their TFSA for the year. 

   As a general rule of thumb; if you think you’re out-smarting the tax office, watch out. They will find a way to get you.  

Buying Certain Foreign Investments

   Another mistake many people make is in which investments they buy for their TFSA. While the list is fairly straight-forward, there are a few areas that still trip people up.

What can you invest in?

  • Cash
  • GIC’s (Guaranteed Investment Certificates)
  • Bonds
  • Mutual Funds
  • Securities listed on a designated stock exchange

   In general, if the investment is traded on a major market like the TSX, NASDAQ, or S&P, your investment qualifies in your TFSA. But, that isn’t the end of the story.

   With the diversity of investments available, you can invest in virtually anything under the sun. There are a few types of investments that don’t qualify for the same levels of tax protection as say your RRSP. The most notable of these investments comes in the form of a REIT. 

   REITs, or Real Estate Investment Trusts, often pay their shareholders an above average dividend yield, which makes them extremely popular. With the international nature of many of these big REITs, the currency of distribution can trip some people up. Some REITs pay their dividend distributions in USD. While that alone is not a problem in a TFSA, the US tax office steps in to ensure they get their piece of the action too. Unfortunately, a TFSA does not provide the same protection from US Withholding taxes as an RRSP would.

   Be sure to know what investments you are holding in your TFSA. If the investment is in a foreign country, the same withholding tax protections might not be available compared to holding those investments in a RRSP.

Over-Contributing to Your TFSA

   The final mistake is far easier to identify and fix. Contributing too much into your TFSA will result in penalties, including additional taxes and charges for each day the TFSA sits in an over-contributed state. 

   Each resident has a contribution limit that increases each year they reside in Canada full-time (more than 183 days/year), and are over the age of 18. The confusion arises when moving money into and out of your TFSA. Withdrawals from your TFSA suffer a timing delay before they can be re-contributed. 

   For example: Assume you have fully maxed out your prior years contributions. Then, in August 2020 you remove $30,000 from your TFSA. Even if by October you have that $30,000 to re-invest, your contribution room doesn’t reset until January 1, 2021. That means, if you put the money back into your TFSA in October, you would be in a state of over-contribution until January 1, 2021. That period from October to January would result in penalties and additional taxes, despite your lifetime contribution limit not changing.

   To see what your contribution limit is for any given year, sign into your myCRA account.

   Remember, your contribution limit for the year is total contributions, and doesn’t add-back in any withdrawals until the following year.

   By adopting a long term buy and hold strategy, and only buying qualifying investments, you will be well positioned to avoid the costly TFSA mistakes mentioned here. Financial freedom is only a few right moves away - avoid these mistakes and you will be well on your way.

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