Avoid These 6 TFSA Mistakes

This episode comes from The Canadian Money Roadmap YouTube channel from a video I posted on March 8 2024. If you want more content like what you find here on the podcast, the YouTube channel is the place for you!  Thanks for listening and watching as always.

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Chapters

• 0:09 Avoiding Mistakes When Investing in TFSA
• 10:42 Passing on TFSA Wealth Tax-Free

Transcript

Speaker 1: 0:09

Hello and welcome back to the Canadian Money Roadmap Podcast. I'm your host, evan Newfeld. Today's episode is actually coming from my YouTube channel. If you haven't been to the YouTube channel, you can find it at the Canadian Money Roadmap, and you'll find all sorts of new content that I haven't recorded here on the podcast. So, just to pique your interest a little bit, here is an episode that I recorded on the YouTube channel about mistakes you want to avoid when investing in your TFSA. The tax-free savings account, or TFSA, is a great tool for a young person, a middle-aged person or a retired person, because you get to keep all of the investment growth that happens inside the account, and you get to keep it forever, and so in this video, I'm going to explain a few things that you want to avoid to make sure that you get all of the benefits of the TFSA. The first thing you definitely don't want to do with the TFSA is day trade inside of it. Day trading is the idea of trading, that's, buying and selling stocks on a high-frequency basis. Typically speaking, you open the day, you buy your stocks, you throw out the day, you end up buying and selling, buying and selling. At the end of the day, you sell everything and you sit on a pile of cash. That's typical day trading as far as a definition goes, and so for people that end up being successful with that there are very few of them, by the way, but the few people that are able to be successful with that there have been cases already where the Canada Revenue Agency, or CRA, has come back and said actually, it looks like you're running a business inside of your TFSA, because in some cases, they actually made a ton of money in there. So there are some weird rules with the TFSA where the CRA can come back to you and say if you're running a business, that's actually business income and that is not tax exempt in this case. So they can look at a variety of things like your frequency of trading, your knowledge and experience, your use of leverage, all sorts of different things, and they can decide without any sort of specifics. They are not going to put it online and say like this is how many trades you can do. This is the knowledge you can have, nothing like that. So day trading, especially profitable day trading, is something that is kind of a no-fly zone for TFSA investors. The problem in this specific case is that if you're found to have invested in a way that resembles actually running a business inside of your TFSA, they will tax you on the income, but in my opinion here I don't know if there's actually a case on this, but I do not believe that there would be a case to be made to be able to deduct any expenses that you incur along the way as a result of it. So this is just an absolute dumb move. Please do not do this. Use your TFSA for prudent, long-term investing. A similar but different version of this that would be mistake. Number two, in my mind, would be trading individual stocks. The reason I don't like to trade individual stocks inside of a TFSA is that you do not get the benefit of being able to write off any losses that happen in there. So anyone that's invested for any period of time knows that not every stock you pick or every fund you pick is going to be an absolute winner, and so when you have losers in a non-registered account, you can use losses to offset future gains and there can be a tax benefit there. In a TFSA, if you have losers that go to zero, you can never get that contribution room back. You get no tax benefit from claiming that loss. There's nothing there, you just lose it. So, in my mind, investing with a broadly diversified strategy using mutual funds or ETFs is a great way to go to make sure that you don't have too many instances where you have the opportunity to have a permanent loss of capital inside of your TFSA. I recently met with somebody who had $70,000 in a TFSA and they invested in penny stocks, thinking that it was just going to take off, and it's like, oh great, the TFSA will protect me from all of these gains I'm going to have. Turns out that's incredibly difficult to do, and picking individual stocks, especially penny stocks and garbage like that, it's very, very hard to do. So in this person's case, they lost everything that went into their TFSA, so that contribution room is gone forever and they're starting from scratch. You only get the new room. That happens every single year because you put the contributions in, you invested it, it went to zero and so you don't get that room back. The only way you get room back from a TFSA is if you withdraw something, and withdrawing does not count as the same as losing money in the account. So you want to minimize the opportunity to have permanent losses of capital inside your TFSA because that contribution room is so valuable to you over the course of your entire life. Mistake number three would be over contributing to your TFSA. If you don't know how much you can contribute to your TFSA, check out this video over here where I go in detail as to how much contribution you will have, so that you don't make this mistake. Over contributing to your TFSA can come with a 1% per month penalty on any amount over your allowed contribution room. Mistake number four is recontributing in the same year that you made a withdrawal. So again in that previous video that I linked before, I talk about how those rules work. So when you make a contribution to your TFSA and you withdraw it, you don't get to contribute that same amount back into your TFSA until the calendar year rolls over and so many people will take money out and put money in. Take money out, put money in and they don't really realize that they're over contributing in the process. So these two mistakes go hand in hand and it comes with that same penalty. Now it is worth mentioning that in some instances there are simple mistakes that people make, and Canada Revenue Agency has been known in the past to issue warnings by letter and explain exactly what you did, and in many cases, people didn't realize that that was their mistake, and so if you are able to show proof that you then withdrew your over contributions and it was a mistake and you weren't trying to profit necessarily from your over contributions, there have been instances where Sierra says, okay, that's great. This is your one warning. Thank you very much, please don't do it again. So you want to be careful, but you also don't want to bank on the fact that Sierra might be generous with you this time. The next mistake you don't want to make with your TFSA is using leverage. Leverage is the idea of borrowing money to invest, and you can do that through a whole bunch of different ways, but easiest one that people often do will be borrowing from the line of credit, contributing to a TFSA and then investing inside the TFSA. In my mind, the two reasons yet you don't want to do that are the first one, why you might not want to use leverage in the first place, is that leverage magnifies your results, and so it's great if it works. It's terrible if it doesn't. So adding leverage increases the odds that you could not only lose everything, but you could lose more than everything. So again, let's use an example here. Say you borrow $10,000 from your line of credit and currently lines of credit tied to your house. They usually cost somewhere in the realm of Prime plus one Think of that around 8% per year right now, here in early 2024. And so you take that $10,000, you put it inside your TFSA and you invest it in some garbage stock that you only realize is garbage in hindsight because everybody invests thinking that they've got the best, next great thing, whatever. And so you realize after the fact oh no, this is a pile of garbage and this investment goes to zero. And when it declines and it goes to zero, you've lost everything. You've lost your money and you've lost your contribution room. But hold up, you still have this debt over here on your line of credit that you have to pay back, and so you've lost everything here plus interest. So, on 10,000 bucks at 8%, that's not very fun. You have to come up with that money on your own. So using leverage inside of a TFSA, you have the potential to lose everything and then some. And the worst part is, if you're borrowing to invest inside a TFSA, that interest is not tax deductible against other sources of income. So if you are borrowing to invest in a non-registered account, you can deduct your interest in that case, but not when you are borrowing to invest in either a TFSA or an RRSP. Leverage is something that is really niche and is for people that are in a really unique circumstance that maybe can use it. But here on YouTube, if I'm giving blanket advice to anybody that might be watching this video, please do not borrow to invest. The potential outcomes here are not worth the potential risks, and so borrowing to invest inside of a TFSA is a mistake that you definitely want to avoid. The last mistake that I'm going to mention here on this video is naming an incorrect beneficiary. So when you have a TFSA, that's a plan type. So a TFSA is what we call a plan type and RRSP is a plan type. And when you have a registered plan like this, you can name a beneficiary, and a beneficiary is someone who just gets your money after you die. And in the case of a TFSA, there's a unique beneficiary rule for spouses and it's called a successor holder. So those are the two types of beneficiaries you want to keep in mind. The first one, just beneficiary. The second one is a successor holder and that's for a spouse or common law partner. So the reason you want to make sure that your beneficiaries are correct is that when you pass away, you want your money to go to someone you love and someone that you know would benefit from that money. In many cases, if you are married or you have a common law partner naming your spouse, there would be the absolute no-brainer option to do so. What happens with a successor holder designation is that if you were to pass away and your spouse is named as your successor holder, your money then rolls over to them and they can actually absorb that into their TFSA and keep that money invested tax-free forever. It's a really great rule that allows the tax-free benefits of a TFSA to continue on even beyond your own lifetime. So for folks that are close to retirement, in retirement and in elderly ages, I still recommend using TFSAs because of these amazing benefits that continue on beyond them. If you do not have a spouse that you can roll your TFSA over to through a successor holder designation, you can use a beneficiary to pass it on to someone who isn't a spouse. The difference there is that they cannot roll it into their own TFSA afterwards, but they receive the money tax-free. In Canada, we don't have estate or gift taxes, and so in that case, if you name a friend, if you name a child even an adult child, whatever you can name them as a beneficiary on your TFSA and they'll receive that money tax-free. It flows through your estate without hitting probate or anything like that. It's a really clean and simple way to do it. So if you have a TFSA, please make sure you name a beneficiary. If this list of TFSA mistakes was helpful for you in building your long-term TFSA investment portfolio, give me a subscribe or a like and share it with a friend, and hopefully this will be helpful for them too. Thanks so much for watching and we'll see you in the next video.