Do you think your Tax-Free Savings Account (TFSA) won’t be taxed?
Think again.
Although TFSAs are designed to be tax-free, there are ways that you can end up being taxed on funds held within a TFSA — namely, by breaking the account’s rules. TFSAs don’t let you hold just anything, and they don’t let you contribute an unlimited amount of money. Run afoul of your TFSA’s rules, and you may find yourself getting handed a tax bill. In this article, I will explore three ways your TFSA can be taxed and how to avoid them.
Three ways TFSAs can be taxed
There are basically three ways that your TFSA can be taxed:
- Overcontributing. Everybody has a maximum amount of funds that they can contribute to a TFSA. If you contribute beyond your maximum, you’ll pay a 1% monthly tax on the amount in excess of your limit.
- Holding unapproved investments. The TFSA is designed to hold publicly traded securities, Guaranteed Investment Certificates and cash. If you try to put shares in a private company into your TFSA, you’ll be taxed.
- Day trading. Day trading can be considered a business. If the Canada Revenue Agency (CRA) catches you day trading and finds that you are doing it as a full-time job, it will tax you. Here, the tax benefits of the TFSA are more than negated, because the income taxes you’ll pay on your TFSA funds will be greater than dividend and/or capital gain tax.
How to avoid being taxed
As we’ve seen, there are three main ways you can get taxed in a TFSA. Knowing this, we can move on to the more important question: How do you not get taxed in your TFSA?
As far as avoiding overcontributing and unapproved investments, that’s mainly just a matter of paying attention. Check your TFSA limit regularly to see if you’re still allowed to add more funds. Check to see whether the investments you hold in your TFSA are allowed.
Avoiding the day trading violation is trickier. Basically, anybody who trades frequently could be investigated by the CRA for this one. Certainly, running up an enormous account balance or being a financial adviser will make you more likely to be investigated. Either way, the solution is simple.
Invest for the long term and don’t day trade. By holding stocks and other approved investments for the long term, you increase your odds of avoiding the CRA’s wrath.
Consider Royal Bank of Canada (TSX:RY) stock, for example. It’s an established Canadian bank stock of the sort that the government wants you to hold in your TFSA. If you simply buy RY shares and sit on them, you’ll collect a 4.91% dividend each and every year and maybe realize a capital gain, too. Compared to trying your luck day trading options, such an investment is very sensible.
RY stock has rewarded investors handsomely over the years. Over the last 10 years, its stock has risen 80%, paying sizable dividends all along the way. If you buy RY stock today, you’ll be buying it on a significant dip and with a very big dividend yield. Most likely, you’ll achieve a satisfactory result with your investment. And you won’t get taxed in your TFSA.
