Do you want to enjoy the tax-free growth and withdrawals that come from having a TFSA?
If the answer to that question is yes, then you’ll need to use your TFSA the right way.
There are many ways to end up with no tax benefits inside a TFSA. Over-contributing would be the most obvious one (that actually results in a tax penalty); another way is losing money on your investment (TFSA losses aren’t tax deductible).
However, there’s one TFSA tax mistake that’s far more common than either of those. While it’s not quite the doozy that over-contributing is, it’s a good way to guarantee that your TFSA sits around doing nothing for you.
This is a mistake that should be easy to avoid, but according to Canada Revenue Agency data, 8.1 million Canadians make this mistake.
So, exactly what is this “obviously but widespread” mistake?
Not making investments in your TFSA
According to a 2018 data dump by the CRA, 8.1 million Canadians contributed to TFSAs but made no transactions in them. That’s higher than the number of Canadians who had a TFSA but did not contribute (5.65 million), which implies that many Canadians with TFSAs have investable funds but aren’t actually using them.
Why is this such a big mistake?
Apart from the fact that not investing your money means you’re missing out on returns, there’s the fact that there’s no tax benefit to holding cash in a TFSA.
While savings account interest is technically taxable, the taxes payable are usually small, so holding cash in a TFSA doesn’t give you much of a benefit.
The real tax benefit comes when you hold stocks in a TFSA and realize a return. TFSAs let you grow your investments tax-free, so if you earn a gain on stocks in your TFSA, you can avoid being taxed on 50% of the capital gain.
TFSAs sometimes have fairly high interest rates. You can therefore can save money on TFSA savings accounts compared to high interest non-TFSA accounts. However, the benefit becomes much larger when you aggressively invest, so there’s a strong incentive not to hold cash in your TFSA.
What to do instead
In order to maximize the tax benefits of your TFSA, it’s best to hold stocks inside the account. Stocks have the highest average return out of all securities, and the TFSA lets you skip the taxes on both dividends and capital gains.
One stock that could see you getting considerable TFSA savings is Toronto-Dominion Bank (TSX:TD)(NYSE:TD). A relatively high-yield stock with strong historical gains, it could be subject to two types of taxes that a TFSA will spare you from having to pay.
Thanks to its high-growth U.S. retail business, TD bank has outperformed its big six peers over the past decade. With average stock gains of about 10% a year and a generous dividend, it’s the type of stock that can reward you handsomely over time–which means that it can also leave you with a hefty tax bill.
If you see a 10% return on TD outside of a registered account and sell the stock, you’d pay a tax on half of that gain plus any dividends that accumulate. Inside a TFSA, you’d pay no taxes at all–not even upon withdrawal.
So, holding stocks in a TFSA gives you considerable tax savings–putting you ahead of a solid 8.1 million TFSA holders.
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Fool contributor Andrew Button owns shares of TORONTO-DOMINION BANK.
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