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. Read More