Problems to avoid with your TFSA

A Tax-Free Savings Account (TFSA) is a great way to build wealth whilst reducing the amount of tax you might pay. But mistakes are possible when investing in a TFSA, which can prove costly. Here are some common mistakes people make and how to avoid them:

Replacing a withdrawal in the same year

You can withdraw from your TFSA at any time. But that withdrawal does not increase your contribution room for the current year. Instead, the amount withdrawn will be added back to your contribution room for the following year. The only way you can make contributions in the current year is if you still have contribution room available. Contributing more than your contribution room for the year will result in a monthly tax penalty.

Not keeping track of your contributions

It is quite common to have many TFSA accounts. But that can make it hard to track contributions and the risk of making over contributions increases. When this happens, the CRA will impose a tax penalty: 1% per month on any contributions over your limit. That penalty will apply for every month the overcontribution remains in the account. You will also need to file Form RC243 with the CRA, paying taxes owed by June 30 in the following year.

You can track your contributions by using the My Account feature through the CRA’s website. But this information isn’t always up-to-date. It would be better to track your contributions yourself and avoid the tax penalty.

Using a TFSA for day trading

You can choose to manage your investments in a TFSA. But if you make frequent buying and selling transactions or outright day trading, this will flag the attention of the CRA. And if the CRA determines you have been using a TFSA as an active trading business, all dividends, interest, and gains may be taxed as business income.

Naming your spouse a beneficiary instead of a successor holder

If your intention is to leave your TFSA to your spouse when you die, it’s better to name them as a successor holder. This means that they will become the new owner of your TFSA with the same tax-free status.

Naming your spouse as beneficiary would make them liable for tax on any income or gains earned for the time between your death and the data your TFSA is distributed. It also involves extra administration work to receive the assets of the TFSA tax-free. A beneficiary works best when distributing a TFSA to your children, grandchildren or to charity.

Holding investments that produce foreign income

Whilst foreign investments can be held in a TFSA, there are potential tax implications to be aware of. Withholding tax may be applied when the foreign investment distributes income. This is known as non-resident withholding tax.  As the investment is held in a TFSA, claiming a foreign tax credit to recover the foreign tax is not possible.

It may be worth considering holding foreign investments in a non-registered account, where a foreign tax credit can be claimed.

Investing in a TFSA if you are a U.S taxpayer

If you are a U.S taxpayer, it’s best to avoid holding a TFSA. The IRS in the United States does not recognize a TFSA as a tax-free account for U.S tax purposes. Those that do hold a TFSA will be subject to tax on any income earned in the TFSA and will have special reporting requirements to submit on a yearly basis. Note that the United States taxes both its citizens and residents. Even if they haven’t lived in the United States. So it’s important that U.S taxpayers understand their U.S income tax obligations.