Canadians know that it’s beneficial to use Tax-Free Savings Accounts (TFSAs), but most aren’t taking full advantage of it. It may seem daunting to learn how to best take advantage of TFSAs, but only you truly know what suits your savings or investment style. Regardless of how you use the tool, here are 11 common TFSA mistakes to avoid.
Using TFSAs only as Savings Accounts
Because of Tax-Free Savings Account’s misleading name. Some Canadians think that it’s only used for saving. So, some people open a savings account in a TFSA to earn interest. Guess what? Interest rates are so low right now that inflation is eating away at your savings. So, you’re actually losing purchasing power.
The fact is, in a TFSA, you can hold any investments from cash, guaranteed investment certificates (GICs), bonds, stocks, ETFs, and mutual funds.
Not Maximizing Returns
The TFSA is an excellent way to avoid taxes and to save for retirement. So, it doesn’t make sense to use it entirely as a savings account. Even though interests earned are taxed at your marginal tax rate, you could gain more in investments. In fact, it’s common for people to buy mutual funds, ETFs, or stocks in their TFSAs. After all, stocks outperform bonds in the long-term.
There’s no excuse for not taking full advantage of TFSAs with stocks or low-cost ETFs since there are so many helpful resources out there from books, forums, and blogs.
Just make sure that you’re able to hold on to your investments in a market downturn. That’s why you sure make sure to hold high quality stocks or ETFs you understand and can depend on.
The big Canadian banks are great long-term investments. For example, Bank of Nova Scotia (TSX:BNS)(NYSE:BNS) has paid a dividend since 1832. More than 3 years ago when I published this article, the bank offered an attractive yield of close to 4.9% at under $58 per share. Fast forward to today, it’s trading nearly 25% higher (even after a pullback) and the yield on cost would be 6%.
Canadian utilities are also high quality long-term investments since everyone uses electricity and gas. Both Fortis (TSX:FTS) and Canadian Utilities (TSX:CU) have increased dividends for at least 40 years in a row. That’s an amazing record!
If you want to keep things simple, and don’t want to perform stock-picking, you can consider investing in low-cost index funds instead of paying higher fees in mutual funds.
Not Getting Income Tax-Free
You can build a portfolio of quality dividend growth stocks in a TFSA. I’ve already mentioned three above. However, since they pay eligible Canadian dividends, they’re favorably-taxed if held in a non-registered or taxable account.
Still, if you have TFSA contribution room, it doesn’t make sense to have Canadian dividend stocks exposed to taxation. Even if you don’t sell the shares, you’ll need to pay taxes on the dividends in a taxable account.
Other than using TFSAs, there are other ways to reduce taxes.
Canadian REITs (or Real Estate Investment Trusts) are a special niche of stocks that pay cash distributions. They receive rent from their tenants. So, they pay monthly dividends to unitholders. Their cash distributions aren’t taxed like dividends, though.
REIT cash distributions can consist of return of capital, other income, foreign income, and capital gains. Return of capital reduces your cost basis, and you only start getting taxed on return of capital once your cost basis turns zero (because it can’t go negative). Other income and foreign non-business income are taxed at your marginal tax rate. Capital gains are taxed at half your marginal tax rate.
Personally, I think it’s a hassle to keep track of all that. To keep things simple, investors can buy and hold Canadian REITs in a TFSA instead, but it’s really a personal choice.
REITs are generally good for income, but you really need to pick your areas. Do you prefer higher-growth areas such as residential or industrial REITs? If so, be cognizant to not overpay for your shares.
Under-contributing to TFSAs
Another common TFSA mistake is under-contributing. If you were a Canadian that was at least 18 years old back in 2009, you would have accumulated $41,000 of contribution room by 2015 and $63,500 by 2019.
If you’re not using your TFSA contribution room to their full potential, you’re under contributing. If you have extra cash lying around, you can contribute it to start growing your money tax-free.
Not Contributing to a TFSA
A worse TFSA mistake is to not contribute to a TFSA at all. Some people simply don’t want to learn about yet another account after the Registered Retirement Savings Plan (RRSP). However, the TFSA is much more flexible than the RRSP because you can withdraw from TFSAs anytime without a tax penalty.
Over-contributing to TFSAs
Don’t over contribute. Otherwise, you end up paying a penalty of 1% per month on the extra amount.
If you withdrew from a previous year, you can re-contribute that amount in the following calendar year, but don’t re-contribute earlier than that unless you have room left from previous years.
Not Keeping Track of How Much You Have Contributed
As stated before, you can hold different investments in TFSAs. However, your financial institution makes you create a different TFSA for each type of investment. For example, you can open a trading account in a TFSA, and you can open a savings account in a TFSA.
My bank doesn’t track well how much I have contributed at any given time, and the issue becomes more confusion if I have withdrawn some amounts before. The bottom line is, you are responsible for tracking your contributions. Not your bank. Make sure you don’t over contribute.
Keep a tidy record. Keep track of the amount that you contributed to each of your TFSA accounts and any withdrawals you made, including the dates that you performed the transactions.
Re-contribute Withdrawals in Same Calendar Year
Unless you still have contribution room from before, you cannot re-contribute any withdrawn amounts until the next calendar year.
Taking on Too Much Risk in TFSAs
Each time you’re buying a stock, you own a piece of a business. You take on the business’ risk, and share its profits. Owning high quality businesses such as banks, utilities, and real estate can be a profitable endeavour if you buy them at good valuations. But don’t take on too much risk.
For example, during the financial crisis of 2007-2008, I took on too much risk by buying inverse ETFs in a TFSA. Before I knew it, I was losing money quickly. So, don’t take on excessive risk in a TFSA because you can’t write off your losses.
If you already made mistakes in your portfolio by buying something too risky, it’s not the end of the world. We all learn from mistakes, and sometimes we just have to make the hard decision of taking losses and act wiser onward.
Using TFSAs to Experiment and Learn
TFSAs aren’t playgrounds, or sandboxes for playing. You cannot write off losses in there.
You should experiment and learn investing in a non-registered account so that you can learn most of your lessons there. At least, learn the ropes of investing and figure out a winning strategy before replicating the success in a TFSA.
Actually, better yet, experiment in a virtual account to ensure you don’t lose any money.
Withdrawing When You’re Not Supposed To
There’s no tax consequence to withdraw from a TFSA. So, it makes it very easy to withdraw from it. If you’re using TFSAs to save for a vacation or to buy a new car, that’s fine. If you are using TFSAs to save for retirement, you might have a problem.
If you’re using TFSAs for your retirement savings, don’t withdraw from them. Not even once. You know that once you withdraw, you’ll probably do it again.
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Disclosure: At the time of update, I’m long BNS.Disclaimer: I am not a certified financial advisor. This article is for educational purposes, so consult a financial advisor and or tax professional if necessary before making any investment decisions.
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