Here in Canada, we pay lots of tax on our income. So whenever there’s a chance to save tax, if you’re anything like me, you jump at it. One of the best way to save tax is using the Tax Free Savings Account (TFSA). The TFSA allows you to grow and invest your money without any taxation. Now because this is a registered account, there are rules and restrictions with the usage. The penalties for breaking these restrictions can be severe, so it’s important to know what to look for. In this article, I am going to walk through some potential traps, important things to know, and tips for making the best use of this great tool for tax free savings.
Contribution Limit
The most important thing to be aware of with TFSAs is the contribution limit. Starting the year you turn 18, you accumulate contribution room every year on January 1st (see the annual amounts here). This contribution room is cumulative. If you don’t use your contribution room all in one year it will carry into the next. So if you have $10,000 in unused room at the end of 2022, and the 2023 dollar limit is $6,500, you will then have $16,500 in room come January 1st.
If you overcontribute, depositing more money into your TFSAs than you have contribution room, the overcontributed amount is taxed at 1% per month. This will add up very quickly so it’s important to keep track of your individual contributions and limit.
CRA Contribution Limit Reporting
The Canada Revenue Agency (CRA) provides your contribution limit for your TFSA, however it’s important to note two things:
- This contribution limit is as of January 1st of the given year. So if at the beginning of 2023 you had $16,500 in contribution room, and in March 2023 you deposited $5,000 into your TFSA, your CRA account would not update until the following year. So it’s important that you keep track of your intra-year contributions.
- The contribution limit does not update fully on January 1st. The CRA has until the end of February to receive documentation from banks and update the figure you see on your accounts. So your contribution limit may be listed as $10,000 in January, but in March it’s updated to be $5,000. Meaning that if you go by the number you saw in January, you could over-contribute. Make sure you’re keeping track of your previous years contributions, because if the figure shown by the CRA is off, you’re the one on the hook to pay the penalty.
How Withdrawals Affect Tax Free Savings Account Limits
When you make a withdrawal from your TFSAs, the contribution room is not immediately available again. The contribution room resets in the next calendar year. So if you had used up all your contribution room (i.e. you can’t deposit any more without over-contributing) in a given year, then withdrew $5,000, you still wouldn’t be able to contribute any more that year (even though the account balance went down by $5,000). The contribution room would be returned the next calendar year, alongside your annual dollar limit. So the following year, your new contribution room would be $5,000 (withdrawal) plus $6,500 (annual dollar limit) for a total of $11,500.
Investing in U.S. Securities in a Tax Free Savings Account
Though you can hold any currency (CAD, USD, etc.) in a TFSA, and you can invest in stocks listed on an international stock exchanges (e.g. NYSE, Nasdaq), there are tax implications to be aware of. Most notably, is the withholding tax on dividends issued by an American stock. If you were to invest in a stock listed on the NYSE, and that stock issued a dividend, the U.S. government withholds 15% for Canadian investors. So if the total dividend you were to receive was $100, you would only receive $85. For taxable accounts, this tax can be credited back to reduce the tax you pay. However with tax free savings accounts, because you don’t pay any tax, you can’t get this back.
If you’re investing in U.S. stocks, this is hard to avoid. However if you’re investing in index funds, try to look for ones listed on the TSX. That way you get the entirety of the dividend.
Borrowing to Invest in Tax Free Savings Accounts
Typically in Canada, when you borrow money to pursue a money-making opportunity, you can write off the interest on the loan to reduce your taxable income. This encourages Canadians to pursue opportunities, and invest in business that can boost our economy. However, if you borrow money to invest in a TFSA, this write-off is not allowed. Tax free savings accounts are not producing any taxable income, you can’t deduct the interest, as there is no taxable income to reduce. This is important to think about before borrowing to invest in the stock market. Using leverage (borrowing to invest) can be risky at the best of times, and it’s most likely better suited for a taxable account.
Day Trading in a TFSA
Day trading is an investing style where you make a high number of short term trades, typically never holding any stock positions overnight. Engaging in day trading in a TFSA however, can result in a significant tax bill. TFSAs are meant to be long-term savings and investing tools, and TFSAs cannot be used for business activities. Engaging in a lot of short term trades in a TFSA may catch the eye of the CRA, and result in a large tax bill. Now the definition of trading too much or too often is not clear, so I would err on the side of caution. You are okay to periodically adjust your holdings, but if you’re looking to day trade, I would recommend doing it in a non-registered account.
Conclusion
TFSA are maybe the best tool in Canada for Tax Free Savings. That said there are key things to watch out for. In this article you learned potential traps and considerations of TFSAs, including:
- Contribution limits and the importance of keeping track of your deposits
- U.S. withholding tax and how it can affect your returns
- Borrowing to invest in the stock market – You can’t write off the interest on the loan for TFSAs
- Day Trading in a TFSA – Why you’re better to use a taxable account
Looking to learn more about TFSA or Registered Accounts in General? See my articles on the topics here: