Are you a Canadian investor holding significant sums of money in a tax-free savings account (TFSA)?
If so, you may be surprised to learn that there are ways you can be taxed inside of your “tax free” account… or even worse, face fines and other legal consequences!
Though the Canada Revenue Agency probably isn’t actively watching your TFSA account, there are things that can tip them off. Your account’s manager (i.e. your bank or broker) reports your contributions and other key pieces of information to the government. This information, along with other things (e.g., unusual audit findings) can trigger an investigation into your TFSA. If you are found to have violated TFSA account rules, you may be taxed inside of your TFSA… or worse. In this article, I explore three red flags that the CRA is watching for, so you can keep your TFSA tax-free.
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Day trading in your TFSA
One of the big CRA red flags that can cause you to lose all of your account benefits is day trading. Specifically, day trading full time while relying on specific professional expertise, such as financial software or subscription services. In the eyes of the CRA, this looks suspiciously like running a securities business. If the agency deems you to be running a securities business, it will tax you accordingly. It doesn’t matter that the securities are held in a TFSA, you will still be taxed.
To avoid the day-trading TFSA tax, adopt a long-term investment strategy, perhaps with quality Canadian index funds such as the iShares S&P/TSX 60 Index Fund (TSX:XIU). Not only is it more tax-friendly to hold such funds long term than to engage in complex day trading strategies, but it’s also likely more profitable. Most people who attempt day trading never make any money at it. The handful that do, if they realize outsized profits in their TFSA, are vulnerable to taxation. Meanwhile, if you hold XIU long term, you will enjoy the full benefit of diversification, pay ultra-low management fees (0.05%), and likely not get taxed in your TFSA. It’s a long-term investor’s dream come true.
Over-contribution
Another red flag the CRA is watching out for is excessive contributions. If the CRA finds you making absolutely massive contributions to your TFSA (let’s say, $100,000 per year for several years), it will almost certainly investigate. If it does, and finds you’ve been over-contributing, you’ll pay a 1% tax on the excess amount, and lose the tax-free benefits on said amount. This is quite a double whammy of punishment. So, be sure to contribute within your limits. Pro-tip: if you were younger than 18 in 2009, and have not made past TFSA contributions and withdrawals, your personal amount is much less than the $109,000 sometimes advertised!
Contributing while not a Canadian resident
Last but not least, a big TFSA red flag that the CRA looks for is contributing to a TFSA while not a resident of Canada. The CRA has an extremely easy time catching you doing this one, because you’ll likely be reporting any time spent as a non-resident to the CRA, and the CRA gets all your TFSA contributions from your bank/broker. The rule says you need to be a resident of Canada to contribute to a TFSA or accumulate TFSA room. The penalty for breaking this rule is a 1% tax each month, similar to over-contribution.
The bottom line
The TFSA is a tax-free account, as long as you play by the rules. Contribute within the limit, hold long term, and remain a Canadian resident, and the TFSA works in your favour. Run afoul of the account rules, and don’t be surprised if the CRA comes a-knockin’.
