The Tax-Free-Savings Account, also known as the TFSA, is my favourite investment account to use in Canada. It’s also Canadians most popular account, with over 57% owning one. Every year, I make sure to max out my account.
But while working as a financial advisor, I’ve seen some major mistakes that people make with their TFSA. Let’s go over those and make sure you know all the TFSA rules and pitfalls:
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Mistake #1: Using Your TFSA Only As A Savings Account
The TFSA was created by Kevin McCarthy, a former Chief of Staff to the Canadian Minister of Finance.
Well, Mr. McCarthy, first of all, thanks for making such an amazing account. But although the TFSA is great, I think Kevin made one huge mistake when naming the TFSA. Instead of Tax-Free-Savings-Account, it should have been named the Tax-Free-Investment-Account. By naming it savings, I believe it has given Canadians a belief that you can only use it for savings.
And it’s reflected in the data; a 2019 survey showed that 42% of holdings inside all of TFSAs across Canada are in cash only, and 15% in GIC’s or term deposits, which means that 57% is in cash or cash equivalents!
The TFSA’s Worst Enemy: Inflation
Now I’ll explain why this is a bad thing, and why you should aim to invest instead, and it’s one word: Inflation. If inflation is higher than the rate of return on your investment, then your money is actually losing value over time!
This is especially the case if you’re depositing your money into a TFSA savings account at one of the big banks, which have shockingly low rates, oftentimes less than 0.10%.
Assuming a 2% inflation rate, this means your money is actually losing almost 2% of value every year! This is why investing is a smarter choice.
With a balanced or growth portfolio of equity and fixed income, it should be able to achieve around 3-5% (that is not guaranteed, and market losses can occur, but it’s a rough estimate), or an even higher return if you’re willing to hold more equity over the long-term.
I’ll share my TFSA strategy – I invest my entire TFSA in stocks and ETFs, and I use an online bank called EQ Bank for an account separate from my TFSA for short-term purchases and my emergency fund. Currently, it’s at a 1.5% rate, which almost keeps pace with inflation, which is way better than anything at a big 5 bank (picture of RBC, TD Logo here). I added a link in the description.
Mistake #2: Investing In Your TFSA if You Have Credit Card Debt
While working as a financial advisor, I noticed something weird that some clients would do. Some clients would have large credit card debt, say $10,000 or more, but they would have $10,000 invested in their TFSA in a something like a balanced mutual fund or “growth” fund.
This is a huge mistake because of the super-high interest rates that credit cards have. If you’re paying 20+% in interest rates for your credit card, but only earning 3-7% from a mutual fund, that means you would basically be guaranteeing yourself a loss of around 15% every year!
It’s better off for you to just pay off the high-interest credit card first, and then start building your investments later.
Mistake #3: Overcontributing
One of my favourite features is that the TFSA limits are the same for every Canadian. Your income level does not matter.
This is great because it provides every Canadian with ample room to start saving. You carry forward the unused TFSA room that you haven’t used in the previous years, so if you miss a year, don’t worry, it will be available for you still.
But if you go over the limit, you will incur a penalty of 1% of the value every month. Make sure you don’t overcontribute and always check your TFSA contribution limit if you’re not sure.
There are a few ways you can check:
- Try out this TFSA Limit Calculator
- Best way: If you have an account, log in to your CRA’s My Account. If you don’t have one, I would highly recommend you open one, as it makes things like filing your taxes way easier. Then navigate to the TFSA section, and find where it says “Contribution Room.” Keep in mind though, this number does NOT contain your contributions or withdrawals this year.
- Old-Fashioned Way: Call the CRA Tax Information Phone Service (TIPS) at 1-800-267-6999 and they can help you find the amount.
- Do-it-yourself (DIY) Way: Check out this table here, your max limit is $69,500 if you were born before 1991 in 2020. If you born after 1991, the calculation gets a little trickier, and I would recommend you using methods 1 or 2 in that case.
Yearly TFSA Contribution Limit Table:
Mistake #4: Withdrawing TFSA and Contributing in the Same Year
I must admit, I made this mistake before. It’s a really tricky one to make because it’s not really logical. If you withdraw from your TFSA, that means you should be able to invest that same amount back right away, right?
Well, no, that’s not the case, and it can lead to overcontribution if you’re at your TFSA investment limit. Here’s an example that shows you how easy it is to make this mistake:
Say you’ve invested the maximum limit in your TFSA this year, but you want to withdraw it to make a purchase. If you withdraw $5,000, but then deposit another $5,000 later that same year, now you’re over your TFSA limit, and you’re subject to 1% penalty every month (1%!) It’s a really easy mistake to make, and one that many Canadians fall victim to every year.
Mistake #5: Overtrading Your TFSA
Do you want to become a day-trader to make some giant tax-free returns inside your TFSA? Think again. If you run your TFSA like a business, the CRA will tax it like one. If you’re trading up a storm in your TFSA, you run the risk of the CRA slapping you with heavy penalties or not only the taxes owed, but potentially more.
The CRA audited TFSAs between 2009 and 2017, and found that $114 million in taxes were owed to the government, some of which was related to TFSAs being found as generating business income instead of normal investment income.
The legislation and rules are vague, but the CRA has mentioned that it looks at things like frequency of trading, specialized knowledge of investment markets, and how much time the TFSA account holder spends researching trades. There are no set guidelines though, so if you’re not sure, it’s better to err on the side of caution.
The CRA is clear, and the TFSA was meant for a savings and investment vehicle for Canadians, not for day traders to turn a profit.
The TFSA is probably the best investment account available to Canadians, but it’s not without its fair share of pitfalls and mistakes. Hopefully, this article has opened your eyes to some of them. Check out this TFSA ultimate guide for more details on the account.