TFSA mistakes you won’t want to make

There’s no such thing as a free lunch for an investor, but the Tax-Free Savings Account (TFSA) comes close. While it’s still up to you to stock your account with winning investments, every cent you earn in the account is yours to keep, tax-free.

Introduced in 2009 by the federal government to help Canadians meet their savings goals, TFSAs are “often the best vehicle we have to grow our funds tax-free,” says Nicole Ewing, Director of Tax and Estate Planning at TD Wealth.

These registered accounts have been steadily gaining popularity. With more than 16 million Canadians holding TFSAs as of 2020, they overtook Registered Retirement Savings Plans (RRSPs) in terms of participation rates beginning in 2013. ¹ Yet Ewing is surprised many people still don’t take advantage of them. “Not utilizing them at all, or to their full capabilities, may be a big, missed opportunity.”

TFSAs have the power to generate substantial savings. For instance, if you invested 2024’s maximum allowable contribution of $7,000 and earned an average annual return of 5%, you could have $18,573 after 20 years, assuming you don’t make any additional contributions or withdrawals. That’s a tax-free gain of more than $11,000. By comparison, if you held that investment outside of a tax-advantaged account, up to 50% of those earnings could be taxed as capital gain at your marginal tax rate. You can calculate the impact of compound growth using TD’s compound interest calculator.

Anyone already using this tax-advantaged account knows it can be a smart way to grow your wealth, but even seasoned TFSA users can make mistakes. Ewing recommends watching out for these common pitfalls.

Overcontributing to your account

The federal government limits the amount TFSA holders can contribute each year — and the Canada Revenue Agency (CRA) pays attention. You’ll pay a penalty of 1% per month on any amount you deposit over the annual limit. “That adds up,” says Ewing, who advises keeping careful records of your deposits to avoid penalties. If you hold TFSAs at different institutions, it’s easy to inadvertently overcontribute.

And if you’re thinking about risking the penalty because an investment you’re eyeing offers returns that would easily offset a 1% tax, hold that thought. The CRA takes a harsh view of intentional overcontributions — and can tax any income or gain you receive at 100%. ²

Not knowing your contribution limit

Unused TFSA contribution room accumulates over the years. If you didn’t make use of the full $6,500 limit last year, it’s not too late. You can add the extra room on top of this year’s limit of $7,000. Even better, you can contribute the maximums for every year you’ve been eligible for a TFSA and a resident in Canada, even if you’re only opening an account now. If you were over 18 in 2009, when TFSAs came on the market, you could claim every year of contribution room since then — which works out to $95,000 over that time frame.

Withdrawing and recontributing too soon

While you can withdraw from your TFSA any time, replacing that money counts as a new deposit. That’s important. You don’t lose the contribution room, but you have to wait until the next year before your contribution room resets. If you don’t wait, you may inadvertently overcontribute if your TFSA was already maxed out before the withdrawal. When Ewing wants to make a temporary withdrawal and the new year is approaching, she often does it at the end of the current year so she can replace the money as early as January when the reset occurs.

Moving money between TFSA accounts

Withdrawing money from one TFSA and depositing it in another still counts toward your annual contribution limit. To avoid having a transaction like this recorded as a TFSA contribution, ask the bank to make a direct transfer rather than doing the withdrawal yourself. Also you can consider streamlining your accounts to make deposits and record-keeping easier.

Naming your spouse beneficiary

In principle, this sounds like a nice idea, but Ewing advises naming your spouse as a successor holder instead. From a legal perspective, when the account is transferred to a beneficiary, the TFSA has to be closed and cashed out. Successor holders, on the other hand, can maintain the TFSA, allowing the funds to remain invested and grow tax-free.

Catching day-trading fever

Yes, it’s tempting to aggressively buy and sell investments to quickly generate hefty returns, but the CRA frowns on investors who treat their TFSA like a business. Some do-it-yourself investors have tried trading frequently in speculative investments, like penny stocks on the TSX Venture exchange, and have run afoul of the CRA rules. While the rules around excessive stock trading — also known as day-trading — are not straightforward, the CRA may regard it as a sign you are not using the TFSA as intended. If your transactions look like day-trading, all your gains will be taxed as business income. ³

Holding the wrong investments

Shares that pay dividends can be a great choice for TFSAs, since those payouts aren’t taxed by the Canadian government, even when you withdraw them. But they may be subject to foreign withholding tax — dividends from U.S. investments, for instance, are taxable by the U.S. Internal Revenue Service (IRS) — so dividend paying foreign securities may not be an ideal choice for some TFSA investors.

You may also want to think carefully about whether your TFSA is the best place to hold volatile investments. If they’re winners, you’ll love your TFSA, but you have fewer options to help you lessen the sting of a loss. If you plan to invest in riskier investments, says Ewing, you could consider holding those assets in a non-registered account, where the losses can be used to offset capital gains. A loss can also impact your contribution room. While there is no tax on any gains you enjoy within the account, the CRA won’t give you any new contribution room if you experience a loss.