3 Traps to Avoid in Your TFSA

Take a look at the TFSA traps you should avoid and a high-quality stock you should not sell out of such as Brookfield Asset Management Inc. (TSX:BAM.A)(NYSE:BAM).

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As an investor who wants to become wealthy in the long run, you must understand the benefits of Tax-Free Savings Accounts (TFSAs). A TFSA is an investment account that allows you to make gains on your investments without the need to pay taxes on them. You can use your TFSA to meet your savings goals, and your withdrawals from the TFSA will be free of any charges.

Of course, reaping all the benefits of TFSAs is not as easy as it might seem. People make all kinds of mistakes with their TFSAs, which can make it difficult for them to make the most of the account. Canadians make common errors that result in them having to pay penalties, incur unnecessary taxes, or miss out on great opportunities to grow their wealth.

If you are thinking of opening a TFSA, you should know that there are dangerous pitfalls you need to avoid to make the most of your TFSA. Here are three mistakes you should avoid while managing your TFSA.

Holding assets that produce foreign income

TFSAs are known for being tax shelters, which is the reason why Canadians consider them to be great tools for accumulating wealth. A common mistake that investors make is that they do not realize TFSAs treat all the investment income in the same manner.

There is a slight confusion investors make with TFSAs and RRSPs. An RRSP is a retirement savings plan. Any income you receive in your RRSP from companies that produce foreign income and share a tax treaty with Canada is not subject to withholding tax. You can typically expect withholding tax to be applied to income from foreign income assets in Canada.

In stark contrast to RRSPs, your TFSA does not enjoy this tax-exempt status. If you hold assets in foreign income in your TFSA, the dividend income will be subjected to withholding tax. You cannot recover these taxes in a TFSA. If you want to go for foreign dividend-paying investments, you are better off going for a non-registered account.

Not understanding the impact of market gains and losses on your contribution room

How the value of your TFSA changes can make a huge difference in how much you can contribute to the account in the future. If the TFSA drops in value, you have lower capital available for withdrawal. You cannot contribute an amount more significant than your withdrawal amount, which is why a decline in the market can reduce your room for contributing to your TFSA.

Let us look at an example. Suppose you have put $6,000 in your TFSA. Over time, the market value of your contribution drops to $4,000. If you withdraw the amount of $4,000, you can only re-contribute the $4,000 — not the $6,000 you initially contributed to the TFSA.

At the same time, an increase in the market value of your contribution means you can withdraw and increase your contribution room. If your original contribution climbs up to $7,000, you can withdraw the amount and re-contribute the higher amount into your TFSA.

If you are going to withdraw from your TFSA, make sure you consider the effects of the market trends on your contribution room before you go through with the decision.

Sell out of your high-quality dividend-growth stocks

Investors who understand what they stand to gain from TFSAs know that the most significant gains you can make through the account are from long-term investments in high-quality stocks. One of the biggest mistakes that investors make is that they sell out their high-quality dividend-growth stocks for short-term gains.

Brookfield Asset Management is the perfect example of such a high-quality company. Investors who got in the game early on with Brookfield are enjoying meteoric gains. If you invested $10,000 in the company at the turn of the millennium, your investment would be worth $225,000 right now.

The company dipped in the recession 10 years ago, but the company keeps climbing back up. The demand for alternative asset investing is increasing, and Brookfield is a company well suited to enjoy a secular growth trend.

Foolish takeaway

To make the most of your TFSA, make sure you avoid holding foreign income assets in the account and that you understand the impact of market movements in how much you can contribute after withdrawals. Also, do not sell your high-quality assets. Following this advice might help you accomplish your goals as a TFSA investor.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Adam Othman has no position in any of the stocks mentioned. The Motley Fool owns shares of Brookfield Asset Management and BROOKFIELD ASSET MANAGEMENT INC. CL.A LV. Brookfield Asset Management is a recommendation of Stock Advisor Canada.

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