The Tax-Free Savings Account (TFSA) was introduced in 2009 to encourage Canadians to improve their savings habits by providing tax incentives. The tax-sheltered account, when used right, lets you get returns on your holdings in the account without incurring taxes. However, the power that it can provide to you for your long-term financial goals comes with responsibilities you cannot forget.
The benefits of a TFSA are excellent. You get tax-free growth on holdings that you have in the account. You have complete flexibility on when you want to contribute to the account and the amount you want to withdraw at any time. The Canada Revenue Agency (CRA) will not come for taxes on interest income, capital gains, or dividend income from assets held in the account, as long as you follow the rules.
Suppose you like the tax-free nature of the account and decide it’s a good idea to run a business through it. In that case, the CRA can reclassify your TFSA gains as business income that it can tax. You can lose the tax-sheltered status for your account. Here are the biggest ways misusing the TFSA can land you in trouble.
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Day trading using the account
The tax-free status of the account makes many people consider it more than merely a savings account. I think calling it a TFSA is a mistake because the account can work well as an investment vehicle. Instead of generating interest income on cash held in the TFSA, you can build a portfolio of stocks that can appreciate in value over time without incurring taxes.
Unfortunately, using the account for frequent trading can land you in trouble. If the CRA finds you day trading with your TFSA, it can consider the earnings as taxable business income. There is no clear number of trades per day that can trigger a CRA investigation, but it is better to play it safe and focus on long-term investments in the account.
Investing in penny stocks
Using the TFSA for day trading is a clear violation that can compromise the tax-free status of a TFSA. It is also important to remember another major thing about a TFSA: Just like how the CRA will not tax you on capital gains for assets in the account, you cannot deduct capital losses from assets held in the account in your returns. This means using the account to hold speculative penny stocks can be detrimental as well.
Using the TFSA to hold penny stocks doesn’t go against the rules, but it can attract unnecessary attention from the CRA. Penny stocks can result in significant losses, but also deliver 10-fold returns. The more aggressively you bet on penny stocks in a TFSA, the greater the chances of the CRA taking a closer look to see whether you are treating it as a business account.
Foolish takeaway
Day trading and speculative trades can be risky. However, you can benefit from using the TFSA with a long-term investment strategy. You can identify and hold high-quality investments that can deliver substantial long-term returns. Fortis (TSX: FTS) might be one of the best holdings to this end.
The $35.46 billion market-cap utility holdings company has several natural gas and electricity utility businesses in Canada, the U.S., and the Caribbean. It generates predictable cash flows through its long-term contracted assets in rate-regulated markets. The essential nature of its services gives it a defensive quality. No matter how bad the economy gets, people need natural gas and electricity. Providers like FTS are some of the last companies that worry about consumers cutting costs.
Fortis has a lengthy track record of paying dividends to investors and increasing payouts. As of this writing, it trades for $70.16 per share and pays investors $0.64 per share each quarter, translating to a 3.65% dividend yield. It can be an excellent long-term holding to consider for your TFSA.
