The Tax-Free Savings Account (TFSA) program was started in 2009. In the short period, it has grown to become one of the most common accounts used by Canadians to save for different goals.
While contributions to a TFSA are not tax deductible, any gains or income earned in the account is tax-free and can be withdrawn without any tax implication.
Despite its popularity and flexibility, there are some common TFSA mistakes you should be aware of and avoid.
Common Costly TFSA Mistakes
1. Not Opening a TFSA
The TFSA is a fantastic savings program available for every Canadian above 18 years.
By not opening a TFSA, you are missing out on tax-free investment growth.
The good news: you can start today and take advantage of all your unused contribution room. If you were eligible in 2009 when the TFSA started and you have never made any contribution, your contribution room will be $69,500 in 2020
2. Over contributing to the TFSA
This is a common TFSA mistake that usually happens when people withdraw from their TFSA and don’t wait till the next year to return the cash.
Having multiple TFSAs can also increase the risk of loosing track of how much contributions you have made in a year and then over-contributing.
Every year, your contribution room increases by the year’s contribution limit and any withdrawals from previous years. That is, your new contribution limit will be the sum of:
- any unused contribution room from previous years,
- withdrawals made from previous years
- contribution limit for the current year. It is $6,500 for 2023
Any excess contributions will be subject to a 1% monthly tax for as long as the TFSA over-contribution remains.
To prevent this TFSA mistake, make sure you are keeping track of all contributions and withdrawals especially if you have multiple TFSA accounts. You can check this post to download a TFSA contribution tracker.
Also, you can check your contribution limit for the year from your Notice of Assessment (NOA).
3. Not investing the cash in the TFSA
One of the commonest misconceptions about TFSA is that they are like a typical bank savings account you open, fund, and then earn a paltry annual interest.
The TFSA is like a bucket or basket that can hold different types of assets or investments, from stocks to bonds, from GICs to mutual funds.
The financial institutions contribute to this misconception and TFSA mistake by marketing it as a normal bank account, with a slightly higher interest rate (in some instances).
4. Wrong portfolio asset allocation
Depending on your investment goals, you can allocate your funds to any of the qualified investments (per CRA) in varying proportions.
For example, if you are planning to buy a house in the next 6 – 12 months, you may want to hold less risky assets like GICs, or even bonds. While stocks have higher rates of returns, in the short term, markets may be quite volatile, and you don’t want to sell when prices are low.
On the other hand, if you’re saving for longer term plans or retirements, you are in a better position to ride out any market fluctuation so you should take on more risks.
Learn more about why asset allocation is important here. And get started with investing with low-cost asset allocation ETFs by reading this guide.
5. Withdrawing cash to open another TFSA
There are several reasons why you may want to close your accounts in one financial institution and move to another. Lower fees, better relationships or simply having all your accounts in a single institution can be the reasons.
But there is a right and wrong way of doing this.
The right way is to request a direct transfer from your current financial institution to the new one. This way, your contribution room is not affected. There could be a transfer fee but the new financial institution may offer a rebate. For example, Questrade will cover your transfer-in fee up to $150.
On the other hand, if you liquidate the funds in your existing TFSA yourself and contribute it to a new or another TFSA, it will be treated as a regular contribution and there could be tax implications depending on your available contribution room. This is a common TFSA mistake.
If the contribution is higher than your available contribution room, the excess will be taxed at 1% per month as explained in 2 above
One of the advantages that TFSAs have over RRSPs is that you don’t permanently loose your contribution room when you withdraw. However, you must wait till January 1 of the next year before you can re-contribute any amount withdrawn.
Check here for a detailed guide on how to go about withdrawing funds from your TFSA.
6. Waiting to Invest
Many people wait till late in the year before making contributions to their registered accounts. For RRSPs, it could be for tax planning (reduce taxable income) but remember that the true beauty of a TFSA or RRSP is to enjoy tax-free compounded growth.
As much as possible, automate your contributions by setting up pre-authorized transfers. Move the money as soon as your paycheck comes in. This is the path of least resistance, taking away emotions in deciding whether to invest or not.
And you can always put in extra if you have any windfalls. Check this post on how to start investing with little money.
Read more: How To Build A Diversified Investment Portfolio (3 Quick & Easy Ways)
7. Investing in Foreign Dividend Stocks
Foreign income generating assets belong in an RRSP and not a TFSA. While both offer tax advantages for Canadian source income, there are differences when it come to foreign income.
RRSPs are considered retirement savings plans and any foreign income generated will not be subject to withholding tax, if Canada has a tax treaty with the country where the company paying the income is domiciled.
For example, for U.S. assets, taxes are not withheld on RRSP income but Canadians holding U.S. investments in their TFSA are subject to a 15% WHT.
So keep those foreign dividend stocks in your RRSP and use TFSA for Canadian companies.
Related Post: Can You Buy US Stocks In TFSA?
8. Investing in non-qualified investments
The TFSA allows you to hold various qualified investments like stocks, GICS, bonds, mutual funds etc, but you should know that there are penalties for holding non-qualified investments. Generally, an investment that is not traded on a designated stock exchange is non-qualified.
The penalty is 50% of the investment’s value and the income made from the investment will be taxed 100%. A big TFSA mistake!
9. Not naming your spouse as a Successor Holder
When opening your TFSA, or afterwards, you can designate someone as the beneficiary or successor holder.
You can name anyone (siblings, children, or spouse) the beneficiary of your TFSA and the account will transfer to them tax-free. The TFSA can be transferred to your spouse’s TFSA without affecting their own contribution room, however any income made between your death and when the transfer is completed will be added to their income and taxed.
To avoid this, you should designate your spouse as a successor holder. Put simply, it changes the ownership of the TFSA and the account will continue to grow tax-free in the spouse’s account (except in Quebec)
But the worst mistake is not naming a beneficiary or successor holder names. The TFSA will be added to your estate and probate fees will apply.
Learn more: Death of a TFSA Holder: TFSA Successor Holder & Beneficiary
TFSA is a smart choice for your saving goals, both short and long term. But you should avoid the common TFSA mistakes and get familiar with the contribution and withdrawal rules.
You can also read about the common TFSA misconceptions.