Do you want to get to a million dollars or more in your Tax-Free Savings Account (TFSA)? It’s a goal many Canadians share, but it’s not without its perils. Although TFSAs are the best accounts ever created for investing, there are some things you can do that can end up getting your account taxed. If you break the TFSA rules too severely, you may even find yourself getting taxed more in your TFSA than in a regular brokerage account.
In this article, I will explore the many ways in which your TFSA can be taxed and what you can do about them.
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Your TFSA CAN be taxed
There are three ways you can find yourself getting taxed in a TFSA, despite the ostensibly “tax free” nature of the account:
- Contributing past your limit. If you contribute more to a TFSA than you’re allowed to, you can find yourself paying a 1% tax per month on the amount over the limit.
- Holding unapproved assets. If you hold unapproved assets, such as shares in a company you control, inside of a TFSA, the Canada Revenue Agency (CRA) may audit your account and determine that you have to pay taxes on your holdings.
- Day trading. If you day trade options in your TFSA, you may find yourself getting taxed. The purpose of the TFSA is to facilitate long-term investing, not options trading. If you run up a multi-million-dollar TFSA balance by trading options frequently, the CRA may deem your trading activities to be a business and tax you accordingly. In this scenario, you’ll pay even more taxes than you would in a normal account, because income taxes are higher than capital gains and dividend taxes.
The perils of day trading and options
The last item on the list above merits further exploration. In addition to potentially exposing you to large taxes in your “Tax-Free” Savings Account, day trading comes with other risks. Studies show that the most frequent traders make the least money out of all market participants.
Long-term investors, however, tend to make the most. When you trade options, there is a serious risk of your “investments” becoming completely worthless. It’s pretty rare for stocks to go to $0, but options very frequently do. If you hold a put/call and the underlying asset doesn’t go below/above the strike price, your entire investment goes to zero.
What to do instead
If you’re worried about getting taxed for day trading in your TFSA, here’s a simple solution for you: invest for the long term instead.
Stock prices are essentially random on a day-to-day basis, but they do tend to go up over long periods of time. If you invest wisely in quality stocks and hold for the long term, you can make a lot of money, and your TFSA probably won’t get taxed.
Consider Canadian National Railway (TSX:CNR), for example. It’s a Canadian railway company that transports over $250 billion worth of goods each and every year. It has only one competitor in Canada and a tiny handful of them in the United States. It’s the only North American railroad to touch three Coasts, giving it an advantage in certain shipping routes.
Since the early 1990s, the stock has risen over 5,000%. If you’d held CNR from three decades ago until today, you’d be sitting on a very profitable investment. CN Railway is a good enough business that it should keep delivering solid results over the long run.
