Canada Revenue Agency: This TFSA Mistake Could Land You With a $34,750 Tax Bill!

If you want to avoid a $34,750 tax for prohibited investments, consider holding index funds like the iShares S&P TSX 60 Index Fund (TSX:XIU).

| More on:

You’re reading a free article with opinions that may differ from The Motley Fool’s premium investing services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Did you know that you could be taxed $34,750 or more in your “Tax-Free” Savings Account (TFSA)?

It might sound unbelievable, but it’s true.

In 2020, the total TFSA contribution room you can have is $69,500, and there’s a tax mistake that can get you taxed at 50% — or $34,750. In fact, if you’ve seen capital gains in your TFSA, this tax could go even higher, because it’s based on the value of your investments rather than contribution amounts.

While this little-known tax rule is hard to break, it could be absolutely devastating if you do run afoul of it. In fact, it could totally negate all the benefits of having opened a TFSA in the first place. So, what is this little-known TFSA no-no?

Holding prohibited investments

Holding prohibited investments is probably the costliest TFSA mistake you can make. Over-contributing will put you on the hook for a 1% monthly tax, and day trading could get you paying income taxes in your TFSA. But neither of those can compare to the sheer destructive power of holding prohibited investments in your TFSA.

If you do that and get caught, expect to pony up 50% of your holdings’ value to the Canada Revenue Agency.

What is a prohibited investment?

According to the Canada Revenue Agency, three specific items are prohibited in TFSAs:

  1.  Your personal debts.
  2.  A company you own a 10% or more stake in.
  3.  A publicly traded company that you do not deal with at arm’s length.

You might think that these would be difficult rules to run afoul of, but something as simple as putting shares in a private company into a TFSA could put you at risk. You don’t want to get slapped with a 50% tax for doing something as silly as that. So, here’s what to do instead.

Do this instead

If you want to be absolutely sure that your TFSA investments are non-prohibited, you should consider holding highly liquid index ETFs in the account. There are two reasons for this:

  1. Most of them have huge market caps, so you’re unlikely to own 10% or more of one.
  2. These funds are operated by huge asset management companies, so unless you’re a finance kingpin, you can be fairly certain you’re more than an arm’s length away.

Not only that, but low-fee index ETFs are generally some of the best investments around. Offering nearly guaranteed market average returns, they ensure both safety and reasonably solid gains.

Consider iShares S&P/TSX 60 Index Fund (TSX:XIU) for example.

This is a low-fee index fund based on the TSX 60, the largest 60 stocks in Canada by market cap. By buying this fund, you get built-in diversification, which minimizes risk. You also get exposure to only large-cap stocks, so you avoid the risks inherent in some small-cap TSX equities.

To be sure, XIU won’t become a 10-bagger overnight. However, it does have a historical tendency to outperform the TSX composite, which is the primary benchmark by which Canadian portfolios are measured. It also has a solid dividend yield of around 2.8%, which provides you with an income stream and a buffer against capital losses. It’s simply a great way to get exposure to a diversified basket of Canadian stocks.

For a little extra diversification and some exposure to U.S. markets, you could also throw in the Vanguard S&P 500 Index Fund for good measure. It has even better historical returns than XIU and adds some geographic diversification to your portfolio.

Should you invest $1,000 in Vanguard S&p 500 Index Etf right now?

Before you buy stock in Vanguard S&p 500 Index Etf, consider this:

The Motley Fool Stock Advisor Canada analyst team just identified what they believe are the Top Stocks for 2025 and Beyond for investors to buy now… and Vanguard S&p 500 Index Etf wasn’t one of them. The Top Stocks that made the cut could potentially produce monster returns in the coming years.

Consider MercadoLibre, which we first recommended on January 8, 2014 ... if you invested $1,000 in the “eBay of Latin America” at the time of our recommendation, you’d have $20,697.16!*

Stock Advisor Canada provides investors with an easy-to-follow blueprint for success, including guidance on building a portfolio, regular updates from analysts, and two new stock picks each month – one from Canada and one from the U.S. The Stock Advisor Canada service has outperformed the return of S&P/TSX Composite Index by 29 percentage points since 2013*.

See the Top Stocks * Returns as of 3/20/25

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 Andrew Button owns shares of iSHARES SP TSX 60 INDEX FUND.

Confidently Navigate Market Volatility: Claim Your Free Report!

Feeling uneasy about the ups and downs of the stock market lately? You’re not alone. At The Motley Fool Canada, we get it — and we’re here to help. We’ve crafted an essential guide designed to help you through these uncertain times: "5-Step Checklist: How to Prepare Your Portfolio for Volatility."

Don't miss out on this opportunity for peace of mind. Just click below to learn how to receive your complimentary report today!

Get Our Free Report Today

More on Dividend Stocks

A worker gives a business presentation.
Dividend Stocks

Market Dip: Opportunity or Risk This April?

This market dip might have investors worried, but should they be excited instead?

Read more »

Blocks conceptualizing Canada's Tax Free Savings Account
Dividend Stocks

Why I’d Add This Top TSX Dividend Stock to My TFSA During the Current Dip

The market is full of volatility right now. Fortunately, this top TSX dividend trades at a discount and pays a…

Read more »

Pile of Canadian dollar bills in various denominations
Dividend Stocks

Invest $20,000 in 2 TSX Stocks for $1,421.09 in Passive Income

Are you looking to bump up your passive income? Then consider these two TSX stocks.

Read more »

A plant grows from coins.
Dividend Stocks

Where I’d Invest in Canadian Value Stocks for Long-Term Compounding

When markets plunge, Warren Buffett's wisdom shines: Get greedy when others are fearful. Canadian value stocks like Scotiabank await patient…

Read more »

analyze data
Dividend Stocks

How I’d Invest $28,000 in Canadian Natural Resource Stock to Amass Personal Wealth

Investing in TSX dividend stocks such as Enbridge can help you earn a passive-income stream in 2025.

Read more »

hand stacks coins
Dividend Stocks

Got $400? How I’d Start Building Income With 3 High-Yield Stocks for the Long Term

These high-yield dividend stocks have a solid payout history, making them compelling investments to generate passive income.

Read more »

A close up color image of a small green plant sprouting out of a pile of Canadian dollar coins "loonies."
Dividend Stocks

I’d Put $15,000 in These 3 Dividend-Growth Champions for Increasing Income Potential

Want to offset some volatility? Here are three defensive dividend-growth champions that can generate a juicy yield right now.

Read more »

Blocks conceptualizing Canada's Tax Free Savings Account
Dividend Stocks

Transform Your TFSA Into a Cash-Creating Machine With $7,000

Discover how the Tax-Free Savings Account can be your golden goose for generating cash without losing your investment.

Read more »