You may have heard someone say that a penny saved is a penny earned, but it’s not true. If you earn a penny, you’ll pay taxes. If you save a penny, you keep the whole thing. In fact, you may never have to pay taxes on that penny ever again. All you need to do is use a TFSA.
TFSAs are the best deal in Canadian investing history. The tax advantages and flexibility are unparalleled.
Once your capital is in a TFSA, it grows tax free forever, no matter how much it eventually becomes. Even if you turn $1,000 into $1 million, you won’t pay a dime to the government.
Additionally, you can take money out of your TFSA at any time. No need to wait until retirement. With this capability, TFSAs should be a core part of your saving strategy.
But it’s not all foolproof. Some simple mistakes can eliminate your tax savings altogether. Others will force you to pay the government.
Succeed with a TFSA by avoiding the following errors.
Know your limit
How much can you contribute to your TFSA? Do you know? This is perhaps the most important number to memorize. If you don’t, the penalty can be severe.
TFSAs have annual contribution limits. For 2020, it’s $6,000. But it’s more complicated than that. Unused contribution room from previous years rolls forward. If you didn’t invest anything in 2019, when the limit was also $6,000, you may be able to add that to this year’s limit.
But it’s even more complicated. Contribution room only starts to accrue when you turn 18; don’t account for any years prior. If you turned 18 in 2009, the year the TFSA was first introduced, you can add each year’s limit together to determine your lifetime contribution maximum, which would be $69,500.
If you run the numbers incorrectly, you’ll pay a 1% monthly fee on any excess contributions. Ouch. To avoid this, simply do the math and know your limit.
Keep a long view
The ability to avoid taxes for life is a power that shouldn’t be thrown away. That’s why it’s a shame that so many Canadians still hold cash in their TFSAs earning little to no interest.
If your money will be invested for five years or more, don’t give up long-term potential for short-term stability. Avoid holding cash, opting instead for a diversified portfolio of stocks and bonds.
Over several decades, or even just a handful of years, the disparity can be sizable. Compound interest allows your money to grow exponentially over time, and even a 1% difference in annual returns can add thousands to your portfolio.
Remain an individual
It’s not well known, but if you day trade in your TFSA, the Canada Revenue Agency may classify your account as an enterprise. This would tax all gains as business income, which can be worse than personal income.
This is yet another reason to take the long view when it comes to TFSAs. It’s simple mistake to avoid — don’t day trade — but not knowing this risk will give many Canadians an unfortunate surprise this year.
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Fool contributor Ryan Vanzo has no position in any stocks mentioned.