The Tax-Free Savings Account or the TFSA is an amazing investment tool developed by the government of Canada to encourage its residents to save money. The primary benefit of a TFSA is that it helps you grow your money tax-free. i.e. any income or gains within your TFSA investments will be exempt from taxes, even at withdrawal. In countries that are heavily tax-regulated, such as Canada, a TFSA can be the only safe haven from taxes.

The Tax-Free Savings Accounts are not actually savings accounts, or should not be considered savings accounts. It should be treated as an investment account because there is no better place to grow your money without getting taxed in Canada.

While the Canada Revenue Agency (CRA) does present you with this amazing investment tool, they also don’t want any of us to cheat the system or abuse the system. So, there are some strict rules in place when it comes to maintaining your TFSA account.

This article is not about the TFSA rules in Canada. But this is about some TFSA mistakes you might be doing without knowledge of it. ‘Not being aware’ is not an excuse in the eyes of law, so, it is much better to know what you can and cannot do with your TFSA.

6 Common TFSA Mistakes that You Might be Doing Right Now

(1) Over contributing – knowing your TFSA contribution limit

CRA is very strict about the contribution limit of an individual’s TFSA. You should be able to find this in your CRA account when you create an account with them for tax matters. If you have never contributed to a TFSA until 2021, your contribution room is $75,500. This is a little different if you became a resident of the country after 2009, the year which TFSA was started.

If you do happen to overcontribute knowingly or otherwise, CRA will tax you on the overcontributed amount at 1% per month. That’s a massive 12% per annum and can erode all your gains within the TFSA. If they catch you trying to sneak through these rules, they can even tax up to 100% of the incomes in your TFSA.

So, don’t ever exceed the contribution room for your TFSA.

(1.1) Undercontributing

Okay, this is not a rule imposed by anyone. You can never open a TFSA in your life and be fine. But, we strongly encourage you to open one as soon as you are eligible and max out your TFSA contribution limit if possible. TFSA is just too good of an opportunity to pass on.

(2) Frequent trading or day-trading in your TFSA

CRA wants to give you an opportunity to ‘save’ or ‘invest’ money and grow it through the years. They don’t want you to turn your TFSA into your livelihood. Very frequent buying and selling or day-trading (buying and selling stocks within the same day) in your TFSA might raise a red flag with CRA. If so, they might decide to audit you and could decide that you are earning a ‘business income’ in your TFSA. CRA also has very vague rules about this, most likely to keep some wiggle room for themselves to go after day traders in TFSAs. If they do end up deciding that you are making a business income in your TFSA, they will tax your income as a business as well.

So, just invest and hold. Hunt for growth stocks, ETFs, or just dividend investments.

(3) Prioritizing investments over debt settlement

So far, we were encouraging you to start your TFSA. But here we say do not invest in your TFSA or any other investment, for that matter, if you have outstanding debt. There are very little to no investments you can hold in your TFSA that can beat your credit card debt rate of 19% or higher. So, it does not make sense to pay massive interest on outstanding debt and invest in a TFSA that can yield way lower. Clear your debt first, and then think about investing.

If you want to open a self-directed TFSA, you can do so in Canada’s first commission-free trading platform, Wealthsimple Trade.

(4) Using the TFSA as a savings account

Yes, it does say tax-free SAVINGS ACCOUNT. But as we mentioned earlier in the article, a TFSA should not be treated as a savings account. It is an investment account and CRA does not argue with you on this. So, do not invest in GICs or very low-yielding investments, or worst yet, just deposit money in TFSA without investing!

GICs can earn you somewhere around a 1.5% return. With annual inflation of around 2%, you are essentially losing the value of your money within the TFSA. This is one of the worst mistakes you can do.

So, pick some sound investments with yields over 5% per annum. Your TFSA will grow exponentially with re-invested returns.

(5) Withdrawing and contributing in the same year

Withdrawing and re-contributing money to your TFSA within the same year can complicate things. If you have already maxed out your TFSA contribution room, you definitely cannot contribute more without getting penalized heavily. But, even if you withdraw money from your TFSA, and re-contribute the same amount, you can still be penalized.

Let’s take an example. Let’s assume you have maxed out your TFSA contribution room for 2021 with investments of $75,500 by January 2021. You need some cash in hand for some reason and you decide to withdraw from your TFSA. So, you withdraw the entire $75,500 and end up not using the money in the end (it happens!). So, you want to put the money back into your TFSA because it has 0 dollars now, right? Well, according to CRA you already have maxed out your TFSA for the year 2021. Your TFSA will ‘reset’ to zero only in January 2022. If you unknowingly deposit the $75,500 back into the TFSA, this will be considered as overcontribution by CRA and will be penalized at 1% per month. That’s a casual $740 per month!

Second scenario. Let’s assume you have not maxed out your contribution room in your TFSA. Say, you have only invested $60,000 out of your allowed $75,500 limit. Again, you think you need some money and withdraw $60,000 from your TFSA and end up not needing it. So, you want to put the money back. In this case, you actually have a contribution room of $15,000 ($75,000 – $60,000) left for 2021. But still, a massive chunk of your re-contribution i.e. $45,000 ($60,000 – $15,000) will be considered overcontribution and will be taxed as such.

Third scenario. Let’s assume you have the full contribution room of $75,500 as of 2021 and have never contributed money to a TFSA before. You begin your TFSA journey in January 2021 and deposit $10,000, to begin with. Again, you think you want this money for a downpayment of a brand new car, so you withdraw the full amount. Again, you change your mind about the car and want to put the money back to the TFSA. This time, you are in the clear. You still have a TFSA limit of $65,000 left and you are only putting back $10,000. There is plenty of room in your TFSA limit to accommodate this “second” contribution. You will regain the TFSA room from your 2021 withdrawal only in January 2022.

Just be careful of withdrawals and re-contributions in the same year if your TFSA is close to maxing out.

(6) Receiving foreign currency dividends in your TFSA

You can invest and hold shares of the US or other accepted stock exchanges in your TFSA. However, you might run into the possibility of getting taxed by those respective countries on the incomes earned on these holdings. For example, dividends received from US stocks can be liable for withholding taxes in the United States. This is not a mistake per se, but it still erodes the full potential of your TFSA. Canada has equally amazing dividend or growth stocks, so why bother the extra cost?

There is much more nitty-gritty when it comes to TFSA investing in Canada. But those are for another day. These are some of the most common mistakes that many Canadians do. To exploit the full potential of your TFSA growth, you must avoid these pitfalls.

Let us know what you think about TFSA investing in Canada and what mistakes have you done in the past.