The Tax-Free-Savings Account (TFSA) is one of our favourite accounts to build long-term wealth with. It’s also an account that can trigger huge opportunity costs if not used wisely. For today’s post, we’ll share how you can avoid these 5 big TFSA mistakes – in your asset accumulation and asset decumulation years.
Mistake #1 – Not using the TFSA for investing
We love the account.
We hate the name!
The Tax-Free Savings Account (TFSA) is far more than a savings account, and unfortunately, many Canadians still cannot get over this fact. Check out these facts according to a recent BMO study:
- Cash might be king…the majority (56 percent) of Canadians have cash in their TFSA and 29 percent say cash makes up at least three-quarters of their holdings.
- Mind the knowledge gap because…although 73 percent of Canadians consider themselves knowledgeable about TFSAs, only half (49 percent) of Canadians are aware that a TFSA account can hold both cash and at least one of the other investments.
- If you don’t have goals…Canadians primarily use their TFSA accounts for various financial goals, with 44 percent using a TFSA for retirement savings, 43 percent using it as a savings account, but just 15 percent using the account as a means to achieve financial independence as early as possible.
While the TFSA can absolutely be used for short-term savings, earning tax-free interest while you’re at it, we believe you should use your TFSA for investing.
Using your TFSA for investing, will mean your money has the potential to make more money over time (lots of it) via dividends, capital gains or a combination of both depending on what you own.
To see the real power behind the TFSA as an investment account, check out one of our more popular posts below. You can actually retire just using your TFSA!!
Mistake #2 – Making TFSA over-contribution
In our Everything You Need to Know about the TFSA post, we highlighted the dangers of TFSA over-contribution. While there is no significant tax burden in making mistakes with your TFSA, you can break the rules and pay penalties for it.
A common mistake we’ve heard about in the media (we haven’t made it ourselves!) is the over-contribution penalty. Every fall, our Canadian Revenue Agency (CRA) announces the annual contribution limit for the following year. As users of the TFSA, we need to comply with that rule.
Over-contributions to TFSAs are subject to a 1% penalty tax per month (only on the over-contribution amount).
The folks at Wealthsimple had a good example on their site:
“…If by October you’d reached your contribution room and then over-contributed $2,000 the rest of the year and did nothing to correct the over-contribution, then you’d have to pay 1% of $2,000 for October, November, and December. That’s $2,000 x 0.01 x 3, which means $60 in penalties. “
Learn more at CRA here.
In fact, over-contributions can occur in another way given many investors, unfortunately, jump in and out of investments inside the TFSA, withdrawing money and thinking they can put that money back in almost immediately like a trading account. Not so fast.
If you have maxed out your TFSA, including this year’s annual contribution limit, and then you withdraw say $10,000, you can’t redeposit money back in the same year without a penalty. That example too creates an over-contribution. The 1% penalty tax on the excess contribution will also apply.
Here are some tips to avoid over-contributions.
- Keep track of yourself. Yes, maybe a bit tedious but then again, it is your money!
- Check your TFSA contribution room on the My Account – CRA website. Just be mindful that the information in the My Account tab won’t include contributions from the current year.
- Contact your TFSA provider/brokerage. Get them to help you walk through any recent TFSA contributions and/or withdrawals. See #1.
Once you know for sure, you’ve over-contributed, act swiftly with CRA since your penalties will apply – fast. Again, you’ll be charged for each calendar month that the excess is in your TFSA.
Mistake #3 – Focusing on fixed income or bonds inside the TFSA
Cash, bonds, GICs, ETFs, mutual funds, and stocks are all eligible investments to own inside the TFSA – but we believe some assets are far better to own than others.
Remember, you can create hundreds of thousands of dollars in tax-free wealth by using the TFSA wisely.
While high-frequency trading activities will definitely raise alarm bells with CRA, and we don’t advise you to trade inside the TFSA anyhow for many reasons, a far more predictable long-term path to generating wealth can be accomplished via owning mostly equities, in the form of low-cost Exchange Traded Funds (ETFs) or blue-chip dividend-paying stocks.
In our work with clients helping them with some complex portfolio drawdown solutions and options, we know that typically cash is a long-term loser to inflation, bonds and fixed-income are not much better, however stocks can be inflation survivors and in many cases, inflation beaters long-term.
Here is a quick snapshot from the FP Canada Standards Council – Projection Assumption Guidelines for advisors to use for their 2021 work:
You can see from this table, that short-term fixed-income is expected to deliver far less than common stocks. While this is just a simple guideline, we know history also tells the same tale and that the future might be in line with that history.
So, with any asset allocation in your TFSA, choose wisely. We choose long-term growth via equities.
Further Reading: Build Wealth with these Diversified ETF Model Portfolios.
Furthermore, while on the subject of stocks, while some TFSA investors prefer international diversification beyond Canada by owning U.S. stocks, we think you should re-think that approach when it comes to the TFSA. If you own such U.S. assets, you will incur a 15% withholding tax on U.S. dividends or income generated from foreign assets when held inside the TFSA.
A much better solution is to use Canadian equities (ETFs or stocks) inside the TFSA and instead use the Registered Retirement Savings Plan (RRSP) (if you have one) to hold U.S. stocks or U.S.-listed ETFs to completely avoid the 15% withholding tax. Our U.S.-Canada tax treaty is in place for pension accounts and while the RRSP and RRIF accounts qualify for that, the TFSA is not recognized as such.
Mistake #4 – Not using the TFSA for estate planning
My Own Advisor encouraged everyone to avoid missing the “fine print” when it comes to naming beneficiaries for your RRSPs, RRIFs, TFSAs and other key accounts.
Given TFSA assets can be passed along tax-free, this makes the TFSA one of the accounts to consider keeping “until the end” when it comes to portfolio draw-down considerations. In our work with clients, this is a common subject that comes up given the high level of flexibility this account offers in asset decumulation. This makes the TFSA one of the last accounts to own, and prior to the TFSA, the consideration to draw down RRSP/RRIF assets and/or non-registered assets before any TFSA assets are tapped.
For estate planning purposes, we’ve worked with clients to highlight a couple of key options for folks to consider when it comes to getting the most out of the TFSA in this phase:
- Consider naming a TFSA beneficiary – whereby the surviving spouse as an example could pay taxes on any interest or growth earned in the TFSA after their spouse’s death OR better still….
- Strongly consider naming a TFSA successor holder.
A beneficiary would get all of the money in your TFSA, and get it tax-free, and after that, the account would be closed. A successor gets the account and the money.
Here is a great example from a recent Morningstar post – with a hypothetical couple Jim and Sally:
“If Jim passes away what happens? “She [Sally] will get the money as a beneficiary, but she could only put that money into her TFSA if she had the contribution room,” adds Bornn, “If Sally was listed as a successor holder on Jim’s TFSA, then she’d actually be able to lump it into her TFSA even if she didn’t have the contribution room.”
Estate planning rules can be tricky, and we know it’s different in Quebec, so make sure you talk to a lawyer and also your financial institution about this naming process when in doubt.
Mistake #5 – Not using the TFSA at all
You can definitely use the TFSA as a short-term or even medium-term savings account, and we won’t scold you – we promise!
We would however be disappointed if you never opened an account at all for all these good reasons:
- TFSAs are highly effective for every Canadian regardless of their tax bracket. Read on to put an end to the RRSP vs. TFSA debate subject here.
- After you select investments for the account, the income you earn on those investments inside the TFSA can grow tax-free.
- If/when you decide to take money out of the account, money can be withdrawn tax-free.
- Contribution limits have nothing to do with your annual income.
- Unused TFSA contribution room can be carried forward in future calendar years.
- The amount you withdraw from your TFSA this year can be re-contributed next year along with any new contribution room. Amazing.
I mean, really, every adult Canadian should take advantage of the TFSA.
These are just some of the TFSA facts.
Avoid these 5 big TFSA mistakes summary
The Tax-Free Savings Account (TFSA) is one of our favourite accounts to build long-term wealth with, and we see some clients already owning hundreds of thousands of dollars in their TFSAs as they stride towards semi-retirement or retirement with well-funded portfolios.
That can be you too if you avoid these 5 big TFSA mistakes.
Improve your retirement readiness at a low cost!
Everyone has a different path on their asset accumulation journey. We know. At Cashflows & Portfolios, even though we both own 7-figure investment portfolios now, we’ve built our respective portfolios similarly but differently.
The common denominator on our retirement readiness path is we avoided these big 5 TFSA mistakes and mistakes with other investing accounts. Thanks to that navigation, we’re now working through our own semi-retirement income solutions right now!
We can help you with your personal plan too.
Whether that’s understanding how best to keep the TFSA “until the end” in asset decumulation, or knowing when to drawdown other assets (such as RRSP/RRIF assets, a workplace pension, government benefits, LIRA/LIFs, corporations, and more), we can help.
We answer client questions such as:
- What registered accounts do I draw down first?
- How much income will my investments generate?
- Do I have any idea how long this income might last?
- What amount of taxes will my portfolio incur?
- When should I take my workplace pension?
- Is it more beneficial to draw down non-registered money before RRSPs?
- Can I avoid OAS clawbacks?
- And much, much more…
If you are interested in obtaining private retirement projections for your financial scenario, please contact us here to get started.
Stay tuned for more, great, FREE content on our site. We’re happy to help.
Mark and Joe.
Further Reading and Posts:
- How to get started with investing – as a beginner?
- Here are some of the top tax tips for any retiree to consider.
- Is it even possible to retire at 32 with a $1 million portfolio – on FIRE?
- As a prospective retiree, why you should take CPP at age 70 and not sooner.
- How soon can you retire using just your RRSP (and not any TFSA contributions)?