When you invest in a Tax-Free Savings Account (TFSA), you don’t expect to be taxed.
It’s in the name, after all: Tax-Free Savings Account.
And it’s true that if you follow the account rules, you will not be taxed while holding investments inside a TFSA. However, there are some ways in which you can be taxed in a TFSA. Chiefly, by running afoul of the account’s regulations. In this article I will explore two ways in which you can be taxed on TFSA investments.
Overcontributing
The easiest way to get taxed on TFSA investments is to contribute too much to your account. Every Canadian has a maximum amount of money they can contribute to a TFSA. If you were 18 or older in 2009, your maximum is 88,000. If you’ve already made contributions, subtract them from $88,000 to get your remaining space. If you were younger than 18 in 2009, you’ll have an amount that depends on the contribution room added during your adult life.
If you contribute more to your TFSA than you are allowed to, you’ll pay a 1% per month tax on the excess amount. Let’s say that your maximum is $88,000 and you contribute $89,000, putting you $1,000 above your limit. In this scenario, you’d be assessed a $10-per-month tax on that $1,000 as long as it remains in the account.
Day trading
Another way you can get taxed in a TFSA is by day trading. If you realize huge profits in a TFSA by trading frequently, then the Canada Revenue Agency (CRA) may decide that you are running a business and tax you accordingly. You are particularly at risk of having this happen to you if you do not have a full-time job and are day trading options. There was a recent case where a Canadian man realized over $1 million in profits in a TFSA only to be taxed on the earnings by the CRA. He appealed the tax assessment but lost in court.
How can day trading get you taxed in your TFSA?
Let’s imagine that you are swing trading Shopify (TSX:SHOP) stock in a tax-free account. Shopify stock is very volatile, so there are many opportunities to profit on its up and down swings. If you simply buy and hold a stock like Shopify in your TFSA, you won’t be taxed. Shopify is exactly the kind of Canadian company that the government wants Canadians invested in.
But if you’re a day trader buying and selling SHOP options and raking in millions of dollars in profits, you’ll probably get taxed. If you make such trades full time, you’re at very high risk of being classified as a business. Once you receive that classification, taxation is just around the corner.
What to do instead
If you’re worried about being taxed in your TFSA, you should opt for a buy-and-hold investment strategy. Trading Shopify options might sound like fun, but it’s very risky and could get you taxed. Instead of doing that, you should own a diversified portfolio, with Shopify stock being just one position among dozens. That way, you will not run afoul of TFSA regulations.
