Did you know that you can get taxed in your Tax-Free Savings Account (TFSA)?
It’s a little-known fact, but it’s true. By breaking your TFSA’s rules, you can find yourself on the hook for thousands worth of taxes. In some rare cases, these “surprise” taxes even reach the hundreds of thousands.
Being taxed for large sums of money in a TFSA isn’t exactly a “common” occurrence, but it happens. In this article, I will explore three ways to avoid being taxed unexpectedly in your TFSA.
Tip #1: Don’t over-contribute
One way to avoid being taxed in your TFSA is to only contribute what you’re allowed to. Your contribution limit is the amount of contribution room that accumulated on and since your eighteenth birthday, less past contributions. The annual addition is the same for everyone, but your total contribution room may be different from someone else’s, depending on your age.
If you’re a 34-year-old native-born Canadian, you have contributed $95,000 worth of contribution room in your lifetime. If you’re 18 or acquired permanent residency this year, then you have accumulated only $7,000.
Tip #2: Don’t put shares of a business you control in a TFSA
Another way to avoid being taxed in your TFSA is to not put shares of your private business into the account. If you’re not a business owner, this TFSA mistake isn’t really applicable. However, every now and then, someone will get the bright idea of incorporating their business and putting the shares in their TFSA. They figure that by doing this, they will be able to pay themselves tax-free dividends and make off like a bandit.
The problem here is that the Canada Revenue Agency (CRA) sees this as a business activity, not an investment. If you’re caught doing it, you will have to pay taxes on the business assets held in your TFSA.
Tip #3: don’t day trade
A final way to avoid TFSA taxation is to hold quality stocks long term rather than day trade. If you day trade in a TFSA, you risk being forced to pay business taxes. This might sound far-fetched, but it has happened many times. A recent example, reported in the Toronto Star, involved a trader who reached a $600,000 TFSA balance and was assessed as owing hundreds of thousands in taxes.
Here’s a hypothetical example of how somebody could wind up getting taxed for day trading in a TFSA:
Johnny is a financial advisor who recently went into early retirement. Although he is not conventionally employed, he day trades as a kind of “side hustle.” The stock he trades most of the time is Shopify (TSX:SHOP), a growth stock that is highly volatile, giving it the kind of big price swings on which large profits can be realized.
Shopify stock has a 2.36 beta coefficient, meaning that it’s more than twice as volatile as the index. Stocks with such dramatic swings sometimes produce outsized profits for day traders. The question is whether they can hold on to their gains.
Let’s say that John bought a Bloomberg terminal for $20,000 per year, invested in a number of research services, and quit his job to day trade SHOP stock full-time. If he had been lucky, he might have made big profits by doing this. The problem is that the CRA would take his unemployment, his Bloomberg Terminal and his rare news subscriptions as signs that he was running a day trading business. John would probably end up being taxed if the CRA got wind of what he was doing.
The lesson is simple: buy and hold stocks for the long term. Not only does it tend to work better than day trading long term, but it also allows you to keep your TFSA benefits.
