Common TFSA mistakes to avoid

A new year means new TFSA contribution room for Canadians and permanent residents 18 years and older. In case you’re not familiar with the TFSA, please check out the ultimate TFSA guide to understand the basics. 

We really like the TFSA because of its totally tax-free nature. Unlike RRSP withdrawals in which you have to pay taxes at your marginal rate, TFSA withdrawals are completely tax free. Thus, the RRSP is tax-deferred. This makes the TFSA an extremely powerful and beneficial account to use for retirement.

Despite the benefits and versatility of TFSAs, mistakes can happen which can cost you a lot of money. Here are some common TFSA mistakes to avoid. 

1. Not opening a TFSA

The most common mistake is not opening a TFSA at all. Some people think that TFSA is nonsense or they don’t have enough money to contribute to the TFSA. Less than 60% of adult Canadians have a TFSA and arguably even more shocking is the fact that less than 5% of Canadians have maxed out their TFSA.

This is a very costly mistake! 

Even if you only contribute $500 when you first open your TFSA and do not contribute any more money, at an 8% yearly return over 45 years, you would end up with $15,460.22. All completely tax-free!

Best of all, you can take out that money without paying any income tax. 

2. Over-contribution 

Over-contribution is another common and costly mistake you want to avoid. When you over-contribute to your TFSA, you are subject to a 1% penalty tax per month for the over-contribution amount. So if you over-contribute by $1,000 and didn’t find out for a year, you’d need to pay a penalty of $120.

Years ago, we mistakenly over-contributed $10,000 to Mrs. T’s TFSA. We didn’t realize the mistake until the CRA contacted us three years later. Because of this mistake, we had to pay $3,600 in penalty to the CRA.

Ouch!

To avoid additional penalties, we withdrew the $10,000, paid the penalty, and wrote a letter to the CRA asking for forgiveness. In the letter, we explained that the over-contribution was an honest mistake on our part. Fortunately, the CRA agreed with us and waived the penalty. 

In case you’re wondering, here’s what to do when you over contribute to the TFSA. 

3. Making a withdrawal then contribute in the same year

If you withdraw money from your TFSA, you can re-contribute that same amount. What many people don’t realize is that you can only contribute that amount in the next year, not the same year that you withdrew the money.

So if you withdraw $7,000 from your TFSA this year, you don’t magically gain $7,000 in contribution room. You can only gain the additional $7,000 contribution room on January 1st of the following year. 

If you contribute $7,000 back to your TFSA in the same year as your withdrawal, you may end up over-contributing your TFSA, and be subject to the CRA penalty.

Note: you can only re-contribute the $7,000 if you haven’t maxed out your TFSA and still have $7,000 or more in your contribution room.

4. Not knowing your contribution limit

Although you can find your TFSA contribution limit on the CRA website, it is typically not up to date. For example, when I checked my CRA account, it showed that I have $7,000 in the TFSA contribution room even though I already contributed the money this year. (The reason for that is CRA’s figures are typically as of January 1st of the year.)

Why does this happen? Well, it’s because my TFSA discount broker hasn’t provided my TFSA contribution info to the CRA. 

In other words, it’s very important to keep track of how much money you have contributed to your TFSA. This can be pretty straightforward if you only have one TFSA but can get more complicated if you have multiple TFSA accounts.

My best recommendation? Have a spreadsheet and keep track of when and how much you contribute to your TFSA. 

5. Believe you can only have one TFSA

Some folks believe you can only have one TFSA.

Wrong! 

Just like you can have multiple RRSP accounts, you can have as many TFSA accounts as you wish. For example, you may have a TFSA account for investing only in stocks and another TFSA account for investing in GICs. 

Of course, the more TFSA accounts you have, it may be harder to track them and your total contribution. This is why you want to have your own spreadsheet to keep track of how much you have contributed. More importantly, while you have multiple TFSAs, their combined contributions cannot exceed the allowable annual maximum.

6. Holding cash 

Since money compounds inside your TFSA tax free and any withdrawals are also tax-free, you want to “invest” your money in assets that have a decent return to allow your money to grow and compound.

Therefore, it is a huge mistake if you contribute money to your TFSA and just let it sit in your TFSA as cash (Many people have argued that the mistake was made in originally naming the account. It should more rightly be called a Tax Free Investment Account!).

If you need to make withdrawals in the short term, at least invest your TFSA money in either money market funds or GICs so you can get a slightly higher return as opposed to simply holding cash inside the account.. 

7. Only using TFSA as a savings account 

Yes, I get it, it’s called a Tax Free Savings Account, so it makes sense to use the TFSA as a savings account. But you should consider the TFSA as a retirement account and utilize it for maximum potential. 

If you have short-term spending needs, it’s fine to put money in your TFSA, let it grow tax-free and make a withdrawal later. 

However, over the long term, it is better to treat the TFSA as another retirement account and invest in higher return assets than GICs or money market funds. For example, both dividends and capital gains earned on investments held within your TFSA are completely tax-free.

8 Believing gains affect your TFSA contribution limits 

Oddly enough, some people believe gains in your TFSA will affect your overall contribution limits. 

Let me be clear – gains inside your TFSA don’t affect your contribution limits! 

Say you have a TFSA contribution limit of $80,000 and contributed $50,000 into your TFSA to invest in a stock. You can still contribute a further $30,000 to your TFSA.

Let’s pretend you got lucky and your money doubles in six months, from $50,000 to $100,000.  

How much contribution room do you have left? 

Yup, it’s still $30,000.

Similarly, when you receive dividends in your TFSA, it doesn’t affect your contribution limits.

9. Successor vs. beneficiary

If you have a spouse or a common-law partner, do you make your spouse the beneficiary or the successor of your TFSA?

A common mistake is that people designate their spouse or common-law partner as a beneficiary for their TFSA. 

If you intend to leave your TFSA to your spouse after you pass away, you should name your spouse or common-law partner as the successor, not the beneficiary. When your spouse or common-law partner is the successor, it means they will become the new owner of your TFSA with the same tax free status. All the investments held by the spouse who passed away are passed in kind to his/her spouse when the ‘successor’ designation is used.

Please note that you can only designate a spouse or common-law partner as the successor. 

What happens if you name your spouse or common-law partner as the beneficiary instead?

Well, they will still receive your TFSA’s assets tax-free but it would require a bit more administrative work. Furthermore, they may be liable for tax on any income or gains earned for the period between your death and when your TFSA is assigned to them. 

To avoid any headaches, it’s best to name your spouse or common-law partner as the successor of your TFSA. 

Note: I made this mistake in the past, naming Mrs. T as the beneficiary instead of the successor (and vice versa for her TFSA). This mistake has been corrected since. 

10. Not using in-kind or in-cash transfers between TFSAs

If you make this mistake, it may potentially cost you a lot of money.

As mentioned, you can have multiple TFSAs. If you’re transferring money between the different TFSA accounts, do not make a withdrawal and then contribute. If you do that, the contribution will count against your current year’s contribution room.

If you are transferring money between the different TFSA accounts, you need to do either in-kind or in-cash transfers. 

In-kind transfers mean you’re transferring the investments from one TFSA account to another TFSA account. For example, transferring your Waste Connections shares from your TD TFSA to your Wealthsimple TFSA. This is exactly what we did when I moved my self-directed TFSA from TD Direct Investing to Wealthsimple Trade.

In-cash transfers mean you’re selling assets in one TFSA and then transferring the cash to the other TFSA. This is common if you’re holding mutual funds and transferring the money to a discount broker. For example, imagine you’re transferring your TFSA from TD to Wealthsimple Trade and you hold TD e-series mutual funds in your TD TFSA. Because Wealthsimple Trade can’t hold TD e-series mutual funds, you must sell them and transfer everything in cash.  

11. Legal age to open & contribution room

Per the CRA rules, you can open a TFSA when you are 18 years of age or older. But there’s an exemption to this rule because the age of majority is different across Canada. 

Since the age of majority is 19 for BC, New Brunswick, Newfoundland and Labrador, Nova Scotia, Northwest Territories, Yukon, and Nunavut, if you’re a resident of these provinces or territories, you can’t open a TFSA until you turn 19. 

However, you can accumulate TFSA contribution room when you turn 18.

In other words, we won’t be able to open a TFSA for Kid 1.0 until when he turns 19. But when he has a TFSA, he can contribute two years’ worth of contribution room. 

12. Not aware of the 15% withholding dividend tax 

If you invest in a US dividend stock or US ETF in your TFSA, you will be subjected to the 15% withholding tax on any dividends and ETF distributions. This money is not recoverable. Please note that this is different from a non-registered account where the 15% withholding tax will give you the same equivalent foreign tax credit. 

Unfortunately, many people don’t realize this and are surprised when they receive only 85% of the expected dividend income. 

• Does it make sense to invest US dividend stocks in TFSA?

13. Avoid foreign income investments 

Because of the withholding dividend tax, many investors believe it is best to avoid foreign income investments in the TFSA completely. 

But as I pointed out in this post, it may make sense to invest foreign income investments in your TFSA, because gains and withdrawals are completely tax-free. 

14. Day Trading or high trading frequency

When the TFSA was created, the intention was that it should be used for investing and growing your savings. Although there’s no specific rule about how often you can trade, there have been cases where the CRA ordered the investor to pay taxes on TFSA investments after frequent trading. 

Generally speaking, if you trade excessively in your TFSA, the CRA may flag you and you may be required to pay taxes. 

So don’t day trade or trade frequently in your TFSA. Another key thing to remember is that day trading is a terrible idea for DIY investors. 

15. Not giving money to your spouse/common-law partner for TFSA contribution

If you’re a higher income earner than your spouse, you should consider giving your spouse or common-law partner money, and have them contribute to their own TFSA. 

Please note that you can’t contribute to your spouse or common-law partner’s TFSA. This is a violation of TFSA rules. But gifting money and having them contribute is allowed. 

The beauty of this practice is that the contribution, any earned income, and any gains will not be allocated back to you. 

Summary – Common TFSA mistakes to avoid

There you have it, 15 common TFSA mistakes to avoid. 

We treat TFSA as a retirement account rather than simply a savings account. Furthermore, we believe the TFSA is a far superior retirement account than an RRSP due to its tax-free nature (not to mention the RRSP/RRIF withdrawal restrictions). 

If you currently don’t have a TFSA and are eligible for one, please do yourself a favour, open one, and start investing! Your future self will appreciate this.

Did I miss any common TFSA mistakes? Have you made any TFSA mistakes before?