The Tax-Free Savings Account (TFSA) is one of the best ways for Canadians to save and invest their money. Over time, the tax-free investment gains can really add up! However, there are some common mistakes people make when using their TFSA. Here are the top four mistakes to avoid to ensure you’re making the most of this popular investment vehicle.
Mistake 1: Using your TFSA as a Savings Account, Not an Investing Account
This is a common misconception – after all, it’s called a “tax-free savings” account, not a “tax-free investment account.” But using your TFSA as a savings account instead of an investment vehicle is not ideal. Yet according to a 2020 Bank of Montreal Survey, the average TFSA contained 38% in cash. What’s more, a 2022 BMO survey found, “While 73 per cent of Canadians consider themselves knowledgeable about TFSAs, only half (49 per cent) of Canadians are aware that a TFSA account can hold both cash and at least one of the other investments.”
The bottom line is that you should not use your TFSA as a savings account if you are looking to maximize your returns. Instead, you should invest your money so that it grows over time.
Mistake 2: Contributing and Withdrawing
The second mistake people make is withdrawing and contributing to a TFSA in the same year. You are allowed to contribute $6,000 per year (2022) to your TFSA. If you withdrew money in the past, you may be able to re-contribute that amount plus any unused contribution room from previous years.
However, if you withdraw money from a maxed out TFSA and then immediately re-contribute it, you will trigger a penalty. The Canada Revenue Agency (CRA) considers this to be an over-contribution, and you may be required to pay a penalty of 1% per month on the excess amount.
For example, if you were to withdraw $6,000 from your maxed-out TFSA today, you wouldn’t be allowed to recontribute that $6,000 until January 1 of the next calendar year – at which point you could add $6,000 to your account, plus the annual TFSA limit.
Mistake 3: Overcontributing
The third TFSA mistake to avoid is overcontributing. If you over-contribute to your TFSA, the CRA will charge you a penalty of one percent per month on the excess amount (as previously stated). It is important to keep track of your contributions so that you do not overcontribute and trigger this penalty. The best way to do this is to keep records of all your deposits and withdrawals. If you do make an overcontribution the process to fix an over-contribution is quite simple: reach out to your financial institution and request they withdraw the extra funds immediately. If you received a TFSA Excess Amount letter, it would include a cover letter which states general information about TFSA rules and instructions regarding what you need to do to respond to the proposed return. You will also receive an RC243-P, Proposed Tax-Free Savings Account (TFSA) Return. This proposed TFSA return shows the taxes the CRA has calculated and is based on the information it received from your financial institution. Pay the penalty and make sure you do your best to avoid making this mistake again
TFSA Mistake 4: Overtrading
The final mistake people make in their TFSAs is overtrading. In 2018, The Globe & Mail reported the CRA was looking for $110 million in unpaid taxes from TFSA holders, stemming from audits conducted over seven years. Some of the factors they considered in deciding whether a taxpayer was liable for taxes in a TFSA were the frequency of transactions, period of ownership, knowledge of the market, time spent, and financing.
The CRA’s interpretation of tax liability would not catch a TFSA that made $1 million dollars buying and selling securities twice in five years. But another, equally sophisticated, investor – who bought and sold a security 500 times in the same period, and also made $1 million dollars – could be taxable in the CRA’s view.
Should you, as an average long-term TFSA investor, worry about being audited? Probably not. Those who are successful at generating unusually high balances in their TFSAs might expect to hear from the CRA at some point, but most ordinary investors who hold ETFs, pooled funds or a handful of blue-chip stocks are not the CRAs definition of an abuser.
A TFSA is a great long-term investment tool, but there are some mistakes that people make which can trigger penalties or make it less effective. Leaving your money dormant in the account, withdrawing and contributing in the same year, overcontributing, and overtrading are all mistakes to avoid. If you can stay mindful of these things, your TFSA will be much more effective.