Canada Revenue Agency: 2 TFSA Rules To Keep in Mind

TFSA is one of the most powerful investment tools that can help you make a fortune if you use it the right way.

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Until a year ago, about two in every five Tax-Free Savings Account (TFSA) holders used it exclusively to store cash. They might have their reasons for that, but using your TFSA to hold cash is a severe under-utilization of its full potential. Even with the best interest rates, your savings will barely be able to stay ahead of inflation.

Let’s say you fully contribute to your TFSA every year. Assuming the limit is $6,000 every year, at a 2.2% interest rate, you will be sitting at about $392,000 in 40 years; 63% of that sum will be your capital. That shows that there is only so much compounding can do.

While many people don’t use TFSA for investment at all, some go completely overboard with stocks, and in doing so, they make costly mistakes. If you are using your TFSA to keep your securities, there are two rules you need to keep in mind.

Rule number one

Don’t day trade using your TFSA. While its tax-free nature makes it very desirable for day trading, that’s not what it was created for. And CRA keeps a close watch on people who use their TFSA in unconventional ways.

If you are buying and selling stocks in a short amount of time and generating an income based on the short-term fluctuations in share prices, CRA will consider that business and your TFSA will lose its tax-free status.

Any income you have earned in your TFSA while day trading will be taxed as business income, and that can result in a hefty tax bill, especially if you have accumulated a substantial sum in your TFSA. The best-case scenario is to buy and hold good securities for long-term growth.

Rule number two

Don’t exceed your TFSA contribution limit. By now, the total TFSA contribution limit is $69,500, and it typically increases by $6,000 every year. For avid investors, it might seem like a small sum. But if you become overenthusiastic with your investments and contribute over that limit to your TFSA, you won’t only be slapped with a penalty; the exceeding amount will eat into your next year’s contribution limit as well.

And in the right company, $6,000 is a substantial investment. Take FirstService (TSX:FSV)(NASDAQ:FSV) for example. The company is a slow and steady grower and returned over 51% to its investors in the past three years. It also grew its quarterly dividends by 50% in the past five years.

If we consider its three-year CAGR of 14.86%, it can turn your $6,000 into a sum of over $191,000 in 25 years at this pace.

FirstService has two major platforms, Residential and Brands. It’s one of the largest managers of residential properties in North America and a leader in essential property services. The company has grown its revenues by 19% on a year-to-year basis for the past two decades.

Even if the company’s future growth is slower than what you expected it to be, it’s just one year’s TFSA investment. If you invest in one such company every year with your TFSA contribution limit, and just half of them grow as much or better than you expected, you will have accumulated a decent amount of wealth in your TFSA in three decades.

Foolish takeaway

TFSA is a powerful tool, but only when you use it the right way. Invest, but don’t trade, and don’t exceed your contribution room.

You may create additional contribution room by withdrawing a sum from your TFSA, but you will have to wait a year before you can use that additional room.

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 recommends FirstService, SV.

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