The Tax-Free Savings Account (TFSA) is one of the most powerful tools available to Canadian investors. With great power comes great responsibility, and the TFSA is the perfect example of that.
The benefits are generous: tax-free growth, tax-free withdrawals, full flexibility for contribution timing, and no tax on investment income of any kind. Honestly, the only mistake was calling it a “savings account” when most people should be using it as their primary investment account.
But this is not an account you want to mess around with. Beyond the fact that you can’t claim capital losses inside a TFSA, the Canada Revenue Agency (CRA) keeps an eye on how people use it.
If they determine you’re running a business inside your TFSA, the tax bill can be substantial. In that case, the CRA can classify your gains as taxable business income, meaning the account loses its tax-free status. Here are the biggest red flags that can get you in trouble.
Daytrading
Daytrading is the practice of buying and selling securities rapidly to profit from short-term price movements. That includes stocks, options, leveraged products, and anything else you flip frequently. Some investors run high-volume options strategies inside a TFSA, thinking that gains are forever tax-free.
The CRA has challenged this many times. There’s no single rule that defines what “too much trading” looks like, but past legal cases give clear patterns. If they can establish that you are
- Trading frequently with a business-like level of activity;
- Using specialized investing knowledge or experience;
- Spending considerable time managing positions; and
- Using leverage or derivatives aggressively…
…they can treat the TFSA as a business. If you’re profitable and hit it big, you may owe taxes on all gains earned inside the account.
Penny stocks
Speculative micro-cap stocks create another problem. If you lose money, you can’t deduct those losses. But if you buy a tiny penny stock that goes from $0.05 to $2.00 and your account jumps 10-fold overnight, that kind of outsized gain is exactly the type of situation that invites CRA scrutiny.
The logic is the same as with daytrading. Extremely speculative behaviour that resembles business-like investing can trigger a review. The more concentrated and aggressive the bets, the more likely the CRA is to question whether the activity is “investment” or “business.”
What your TFSA should be used for
The TFSA is best used for patient compounding. That means sticking to diversified, long-term holdings such as exchange-traded funds (ETFs). Since all gains and income are tax-free, it’s also one of the best accounts to hold dividend-paying investments.
One ETF I like for this purpose is Vanguard FTSE Canadian High Dividend Yield Index ETF (TSX:VDY), which pays a 3.53% trailing 12-month yield with monthly distributions. It keeps fees low with a 0.22% expense ratio, and unlike many dividend ETFs, it has historically outperformed the S&P/TSX 60 when dividends are reinvested.
If you want to use your TFSA to build wealth quietly and efficiently, this type of dividend ETF is a great place to start, or you can build your own collection of Canadian dividend stocks.
