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TFSA Investors: 40% of You Could Be Making This Giant Mistake

Many people mistake a TFSA for an ordinary savings account — a misconception prevents them from fully utilizing the potential of a TFSA and the power of compounding interest.

Even you aren’t one of them, and you’re using TFSA as an investment account to build your wealth, you might still be one of the 40% of TFSA holders who are making another giant mistake: not understanding overcontribution.

The tax penalty for overcontributing to your TFSA

BMO’s annual TFSA report revealed some curious facts about how Canadians are using TFSAs. One of the facts is that almost 40% of people didn’t properly understand the TFSA contribution limit, and didn’t even know that there is a tax penalty for overcontribution.

Let’s make it easy to understand. Know your contribution limit for the year because, throughout the year, your contribution limit can only decrease.

For example, if you have $57,500 in your TFSA and your contribution limit for 2019 is $6,000, you can contribute only $6,000 in your TFSA for the full year 2019.

Even if you take $25,000 out of your TFSA in mid-2019 for an emergency, you can’t just put it back in without facing the penalty because your limit for the year 2019 is only $6,000. If you do, you’ll be charged 1% per month for the excess amount as long as it’s in your TFSA.

Thus, if you took $25,000 out in June and put it back in August 2019, your overcontribution is $19,000. That’s $25,000-$6,000 allowable for the year.

Your tax penalty for the year 2019 will be $950 ($190 times five months) and you won’t face any tax penalty when you enter 2020. As each New Year’s contribution limit is the addition of any unused contribution from last year (which you don’t have), any withdrawals you made ($25,000) and New Year’s contribution room ($6,000). So in 2020, your contribution limit is $31,000.

However, you can contribute just $12,000 in 2020 because your last year’s excess of $19,000 is subtracted from your new contribution limit of $31,000.

A good stock for your TFSA

While overcontribution should be avoided, maxing out your TFSA for a good investment is a great idea, especially if you’re investing in a dividend emperor like Fortis (TSX:FTS)(NYSE:FTS).

With a powerful history of increasing dividends for 45 years, Fortis is one of the most desirable stocks to fill your TFSA with. The current yield is a juicy 3.6%.

Fortis is a dependable utility company that has not been operating successfully for decades. The company is currently trading at a monthly low of $52.43 per share at writing, a 38.5% increase in the last five years.

The company is profitable and stable. Apart from generous dividend payouts that you can reinvest to build a giant nest egg with your TFSA, the company has the potential of doubling up your capital gains in a decade or so.

Foolish takeaway

If you’re a careful value investor, a TFSA can help you in wealth building. But just as analyzing and picking the right stock is essential, so too is understanding the TFSA. Overcontribution is a simple mistake to avoid. And, sadly, about 40% of people don’t understand this and get taxed on their TFSA as a penalty.

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Fool contributor Adam Othman has no position in any of the stocks mentioned.

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