One of the most flexible wealth-building tools available to Canadian investors is the Tax-Free Savings Account. That comes thanks to its tax-free treatment of dividends and capital gains. Despite those advantages, there are some TFSA red flags that investors should be aware of.
Notably,, those TFSA red flags can attract the CRA’s attention, leading to penalties or even taxes on that investment income.
Fortunately, earning a large return isn’t automatically one of those TFSA red flags. The CRA is more concerned with how investors use the account, how much they contribute and what they hold inside it.
Here’s a look at each of those TFSA red flags to be aware of.
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Trading that starts to resemble a business
Canadian investors can buy and sell stocks within their TFSAs. However, the account isn’t intended to operate as a tax-free day-trading business.
The CRA doesn’t provide an exact number of trades that investors can make before crossing that line. Instead, it considers the overall pattern of activity. That includes how frequently someone trades and how long investments are held.
GameStop (NYSE:GME) provides a perfect example of this. Buying GameStop shares inside a TFSA isn’t against the rules. Neither is selling the investment after it rises.
The concern arises when an investor repeatedly moves in and out of a volatile stock such as GME, holds positions for extremely short periods, and follows a pattern that resembles professional trading.
In short, if the CRA determines that the TFSA is carrying on a business, it can tax the income from that activity.
An investor could buy a growth stock like Shopify (TSX:SHOP), hold it for several years in a TFSA, and earn a substantial return. The size of that gain alone wouldn’t necessarily make it business income. From the CRA’s perspective, what matters more is how the investor used the account.
Contribution mistakes can trigger penalties
Overcontributing is another of the major TFSA red flags that investors should avoid.
TFSA contribution room applies across every TFSA an investor owns. Opening accounts at multiple financial institutions doesn’t provide additional room. Account providers may not know how much an investor has contributed through accounts held elsewhere.
It falls on the investor to track their total contributions and stay within that limit.
Withdrawals from a TFSA are another confusing area. The CRA adds withdrawn amounts back to an investor’s contribution room in the following calendar year.
This means that investors who withdraw funds from a TFSA and then deposit more funds a few months later may have inadvertently overcontributed to their TFSA during that year.
Investors who overcontribute are subject to a 1% per month tax from the CRA for as long as those overcontributed amounts remain in the TFSA.
Not every investment qualifies for a TFSA
Investors can hold most common stocks and exchange-traded funds inside a TFSA. However, the CRA may impose additional taxes when the account includes a non-qualified investment.
The CRA can impose a tax equal to 50% of a non-qualified investment’s fair market value when the account acquires it or when it becomes non-qualified. Income or capital gains connected to that investment may also lose their usual TFSA protection.
That doesn’t mean investors should avoid U.S. stocks or ETFs. For example, the Schwab U.S. Dividend Equity ETF (NYSEMKT: SCHD) is a publicly traded U.S. ETF that can be held in a TFSA.
Its U.S. dividends may still face foreign withholding tax, but that’s different from a sudden CRA penalty. The withholding tax reduces the income received from the investment. It doesn’t mean holding SCHD violates TFSA rules.
Know the TFSA red flags
The CRA doesn’t penalize TFSA holders simply for investing successfully. The bigger risks come from treating the account like a trading business, contributing more than permitted or holding investments that don’t qualify.
Avoiding those three TFSA red flags can help investors keep more of their long-term investment growth tax-free.
