Are you a Tax-Free Savings Account (TFSA) holder who is worried about being taxed for breaking some arcane account rule?
It’s a valid thing to be concerned about, but the real risks are not those that most people have on their radars. Media coverage of people having their TFSA holdings taxed has tended to focus on day trading. Specifically, countless media articles have highlighted cases where people ran up multiple million-dollar TFSA balances, got on the Canada Revenue Agency’s (CRA) radar, and ended up being taxed on their day trading profits.
It is theoretically possible for this to happen to you, but highly unlikely, as day trading is an extremely unsuccessful “investing” strategy that usually results in losses. However, there is one TFSA account violation that you could easily commit without even knowing it. In this article, I will explore the TFSA red flag that could get you taxed faster than day trading.
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Over-contributing
Over-contributing is quite possibly the easiest way to get yourself taxed on your TFSA holdings. Every TFSA holder has a certain limit. That limit is the sum of all the amounts added in each year in which you were eligible to open an account. If you were 18 or older in 2009, your accumulated contribution room is $102,000. If you were younger than 18 at the end of 2009, then your amount depends on the year in which you turned 18. If you turn 18 this year, you’ll have $7,000 in accumulated room. If you are a younger reader who will not turn 18 by the end of this year, you have no accumulated room and are ineligible to open a TFSA.
If you contribute more to your TFSA than you are allowed to, then you pay a 1% monthly tax on the amount in excess of your limit. Additionally, you waive the TFSA’s tax shelter on the excess contributions when they are invested.
Why it’s a bigger risk than day trading
The reason why over-contributing is so much more dangerous than day trading is that it doesn’t require any special luck to get in trouble for it. With day trading taxes, a person needs to achieve significant day trading profits in the first place before they risk being taxed. With studies estimating that 90% to 99% of day traders lose money long term, few will ever find the CRA coming after them for taxes on day trading profits — they won’t have any profits in the first place!
What to do instead
Instead of obsessively trying to boost your TFSA balance to the point where you’re cutting corners, you should simply be modest in your TFSA goals. That will spare you the fate of over-contributing.
Besides, you can do well by investing in a TFSA, even if your contribution limit is pretty small. This can be achieved with quality dividend stocks. Take Fortis (TSX:FTS) for example. It has a 4% dividend yield, which can produce a lot of income on a $102,000 position. It has a good track record, delivering about 12% annualized returns over the last few decades. It has raised its dividend every year for 52 years running. Finally, the company has a strong financial position today, with a sensible debt-to-equity ratio and a dividend payout ratio well under 100%. Overall, you can do well even with small sums invested in stocks like Fortis.
