The benefits are generous: tax-free growth, tax-free withdrawals, complete flexibility in timing contributions, and no tax on investment income whatsoever. Honestly, the only mistake was calling it a “savings account” when most people should use it as their primary investment account.
But this isn’t an account you want to mess with. In addition to the fact that you cannot claim capital losses within a TFSA, the Canada Revenue Agency (CRA) keeps an eye on how people use it.
If they determine that you are running a business within your TFSA, the tax bill could be significant. In that case, the CRA may classify your profits as taxable business income, meaning the account loses its tax-free status. These are the biggest warning signs that could get you into trouble.
Day trading
Day trading is the practice of buying and selling securities quickly to profit from short-term price movements. That includes stocks, options, leveraged products, and anything else you flip regularly. Some investors execute high-volume options strategies within a TFSA, under the assumption that gains are tax-free forever.
The CRA has challenged this many times. There is no one rule that defines what “overtrading” looks like, but past court cases show clear patterns. If they can determine that you are
- Regularly trading at a business activity level;
- Using specialized knowledge or experience in the field of investing;
- Spending a lot of time managing positions; And
- Aggressively using leverage or derivatives…
…they can treat the TFSA as a business. If you are profitable and make a big hit, you may owe taxes on any profits you made in the account.
Penny stocks
Speculative micro-cap stocks create another problem. If you lose money, you cannot deduct those losses. But if you buy a small penny stock that goes from $0.05 to $2.00 and your account increases tenfold overnight, that kind of outsized gain is exactly the kind of situation that invites CRA investigation.
The logic is the same as in day trading. Extremely speculative behavior that resembles business investing may lead to a review. The more concentrated and aggressive the bets, the more likely the CRA will question whether the activity is “investment” or “business.”
What your TFSA should be used for
The TFSA is best used for patient composition. That means sticking to diversified long-term investments, such as exchange-traded funds (ETFs). Because all profits and income are tax-free, it is also one of the best accounts to hold dividend-paying investments.
One ETF I like for this is Vanguard FTSE Canadian High Dividend Yield Index ETF (TSX:VDY), which pays 3.53% interest over 12 months with monthly payments. It keeps costs low with an expense ratio of 0.22%, and unlike many dividend ETFs, it historically outperforms the S&P/TSX 60 when dividends are reinvested.
If you want to use your TFSA to build wealth quietly and efficiently, this type of dividend ETF is a great place to start, or you can build your own collection of Canadian dividend stocks.
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