TFSAs make excellent investment accounts — as long as you follow the rules.
You might already be aware of contribution limits, but did you know that trading too frequently using your TFSA can also get you in trouble? In this article, we explain the major rules you should be aware of, so you can avoid making any common (but expensive) mistakes.
What’s a Tax-Free Savings Account?
We’ve already done an entire blog on the benefits of TFSAs, so we’ll just give you the highlights today.
This account is exactly what it sounds like: a savings account with tax-free earnings and withdrawals. But it can be used for more than holding cash — you can also hold investments in a TFSA.
Think of a TFSA like a basket, where you can store stocks, bonds, mutual funds, exchange-traded funds (ETFs), and guaranteed investment certificates (GICs). By keeping your investments in a TFSA, you won't pay tax on the income you earn, like interest, capital gains, or dividends.
You can also withdraw funds from your TFSA at any time without paying fees or taxes. However, there is a contribution limit – this is the maximum amount you can deposit into your TFSA annually. For 2022, the limit is $6,000. The total amount that you can contribute is cumulative, meaning unused contribution room carries over to the next year, indefinitely.
By the way, investment income earned within your TFSA doesn’t count towards your contribution room.
When you fund your Flahmingo account, you’re actually funding a TFSA! After all, we want to help you maximize those investment returns.
Because the tax-saving potential is so high, TFSAs come with some pretty strict rules – especially regarding stock trading. You can avoid the stress of dealing with an audit or paying extra taxes by learning what the CRA does and doesn’t allow.
The CRA only lets you hold qualified investments in a TFSA. Generally, a security is considered a qualified investment if it’s traded on at least one designated stock exchange – these are stock exchanges that meet a list of criteria developed by the Minister of Finance. The Toronto Stock Exchange (TSX) and New York Stock Exchange (NYSE) are both designated exchanges – you can visit the CRA’s website to see the complete list.
Non-qualified investments trade on over-the-counter (OTC) markets instead of stock exchanges – this concept is a little more complicated. Kind of like over-the-counter medications, which anyone can purchase without a prescription, OTC markets aren’t formally regulated. They’re considered decentralized, and usually list stocks from smaller companies. However, it is possible for a stock to trade on both an OTC and designated exchange – in this case, the stock could still be a qualified investment.
Holding non-qualified investments in your TFSA can result in tax penalties, but the good news is only qualified investments are available on Flahmingo.
Yes, foreign investments carry their own set of rules.
While you are allowed to contribute foreign funds to your TFSA, they’ll be converted to Canadian dollars – and the CAD amount can’t exceed your TFSA contribution room.
You’re also allowed to hold foreign investments in your TFSA (as long as they’re qualified investments); however, the income from these investments will be subject to a non-resident withholding tax. For example, dividends paid on U.S. stocks are subject to a 15% withholding tax.
This tax is often applied before you receive your dividends and doesn’t show up on your TFSA statement, so it’s important to take this into account to know exactly how much you’re making on foreign investments. For example, if a U.S. stock in your TFSA pays out $100 in dividends, you’ll receive $85 – which is also the amount that will show up on your statement.
Trading too frequently
TFSAs are meant for investing and growing savings over time – not day trading. If you buy and sell investments too frequently in a TFSA, the CRA may consider your account to be “carrying on a business” and any income or realized gains would be considered business income and subject to income tax.
The CRA, on more than one occasion, has cracked down on day trading in TFSAs through aggressive audit campaigns.
To determine if someone is incorrectly using a TFSA, the CRA reviews circumstances on a case-by-case basis, following a list of criteria that includes:
- Whether the TFSA holder has a history of buying and selling investments rapidly
- How long securities are held for before being sold
- The TFSA holder’s knowledge of – or experience in – the securities market
- The amount of time the TFSA holder spends researching and trading securities
- Whether securities are bought on margin or with other forms of debt
All factors are taken into consideration; you won't be penalized based on just one. However, if the CRA determines that the trading activity within your TFSA breaks their rules, then you may be subject to higher tax rates for business income on the full amount. Some cases even make it to court.
Canadians don’t have to declare their TFSA balance on their tax returns because financial institutions provide that information to the CRA annually. If you’ve been trading a lot of stocks, some questions might be raised by the CRA when they compare your end of the year balance to your TFSA contribution room.
You can still buy and sell stocks using your TFSA – just don’t do it too frequently.
If you contribute more than your allowable TFSA contribution room (remember, that’s $6,000 for 2022), you’ll have to pay a 1% penalty tax per month on the excess amount. This can really add up, so it’s best to keep track of your contribution room if you’re regularly depositing into your TFSA.
Remember: withdrawing from your account won’t add contribution room within that same year, although the amount you withdrew will be added to your room the following year. You also can’t add investment losses to your contribution room, unfortunately.
FYI, you can have multiple TFSAs but your total contributions still can’t exceed your available contribution room for that year.
The CRA will notify you if you’ve over-contributed and tell you to remove the excess if you haven’t already. You might also be sent a proposed TFSA return that shows the amount of tax you’re likely to owe on your over-contribution. If you think the proposed TFSA return is correct, you sign it and pay what you owe.
However, the penalty tax might be fully or partially waived if you can show the CRA your over-contribution was due to a reasonable error and you’ve taken the steps to correct it.
Good news: there are few limits on withdrawing funds from your TFSA.
You don’t have to be a certain age to withdraw and there are no limits on how much money you can withdraw from a TFSA or what you can spend it on.
You also don’t have to pay income tax on a TFSA withdrawal because it’s not counted as taxable income. This also means TFSAs don’t affect any tax credits or benefits you receive.
The cherry on top is, most withdrawals are added back to your contribution room the following year – so you can recontribute amounts you’ve withdrawn, just not right away (unless you already had the contribution room before withdrawing).
Talking to a financial professional is a surefire way to keep track of TFSA rules – but we hope this blog was a helpful start!
Missing out on tax-free benefits because you made a mistake defeats the entire purpose of a TFSA – it’s much better to know the rules ahead of time.