Did you know that your TFSA can be penalized and taxed by the CRA? Let me show you the 3 red flags you need to avoid to stay on the CRA’s good side and keep your TFSA truly tax-free.
Red Flag 1: Turning Your TFSA into a Business
Imagine this: You started your TFSA with $15,000, watching it grow and grow, until one day, three years later, you’re sitting on $617,000. Sounds like the TFSA dream, right? Well, for Fareed Ahamed, that dream turned into a nightmare when the CRA came knocking.
Fareed was an investment advisor who opened his TFSA in 2009. He wasn’t just dabbling in stocks; he was diving headfirst into high-volume trading, mostly with penny stocks. Fareed’s strategy involved flipping stocks at lightning speed—sometimes holding them for just hours or days.
Over time, he turned his modest initial contribution into a massive sum. But here’s where things went sideways: the CRA took one look at the nature and frequency of his trades and decided he wasn’t investing anymore. They said he was running a business inside his TFSA.
And when the CRA decides you’re running a business, your TFSA stops being tax-free. Instead, Fareed’s $617,000 profits were reclassified as taxable business income. This meant hefty tax bills, potential penalties, and a massive headache. Fareed appealed the ruling, but his case has become a cautionary tale for anyone tempted to turn their TFSA into a day trading playground.
Why Does the CRA Care About Day Trading?
Day trading is all about quick buys and sells to profit from small price changes. It’s fast and risky. But here’s the thing: the CRA doesn’t see that as the kind of activity a TFSA is meant for. They look at your trading patterns, and if you’re flipping stocks like a pro trader—especially with short holding periods, expert strategies, or borrowed funds—they might say you’re running a business.
And once your TFSA is considered a business, every dollar you make is taxable. Goodbye, tax-free dream.
How to Stay on the CRA’s Good Side
The CRA doesn’t lay out a crystal-clear rulebook for what counts as “too much trading” in your TFSA. There’s no magic number of trades per month or specific dollar amount that sets off alarms. Instead, it’s all about using common sense.
The key is to keep your TFSA looking like a long-term investing and savings vehicle, not a Wall Street trading desk. Stick to investments you plan to hold for a while—like ETFs, blue-chip stocks, or bonds. Avoid flipping stocks frequently or using leverage.
Fareed’s story is a wild ride, but it’s a reminder: the CRA is watching. Use your TFSA wisely, and you’ll avoid the kind of drama that turns a $617,000 win into a financial cautionary tale.
Red Flag 2: Overcontribution to Your TFSA
General Overcontribution
This is maybe the the funniest TFSA penalty story that I’ve ever heard. In 2020, a taxpayer decided to supercharge their TFSA growth by overcontributing $639,308—yes, you heard that right—using borrowed funds from a line of credit. Their plan? Invest the excess funds into stocks and watch the profits roll in. But this plan backfired spectacularly when the CRA got involved.
Under the Income Tax Act, any overcontribution to a TFSA is hit with a 1% penalty per month on the excess amount. For this taxpayer, that meant a whopping $6,393.08 in penalties for just one month of overcontribution in December 2020. And that’s not counting additional penalties and interest that quickly piled up.
The taxpayer claimed they didn’t understand the rules and even blamed their financial institution for not explaining them properly. They pleaded for leniency, citing financial hardship and investment losses of up to 50%. But here’s the kicker: they didn’t withdraw the excess funds when the CRA told them to. Instead, they held on, hoping the market would recover.
When the case went to Federal Court, the judge ruled against the taxpayer. The overcontribution wasn’t considered a “reasonable error,” and their delay in removing the funds violated the rule to fix such issues “without delay.” This case is a hard lesson in knowing the rules before contributing to your TFSA and acting quickly if something goes wrong.
Non-Resident Contributions
Now, here’s another way overcontributions can sneak up on you: contributing to your TFSA when you’re no longer a Canadian resident. Imagine this: you move abroad for work or a new adventure, but you keep contributing to your TFSA, thinking everything’s fine. Then, out of nowhere, the CRA hits you with a 1% monthly penalty on every dollar you contributed while living outside Canada.
For example, meet Jessica. She moved to the U.S. for a new job but kept contributing $6,000 to her TFSA, unaware non-residents aren’t allowed to contribute. The CRA charged her a 1% monthly penalty, costing her $360 in six months before she withdrew the excess.
Common Overcontribution Mistakes to Avoid:
- Trusting the CRA’s Contribution Limits
The CRA’s online records aren’t always up-to-date. If you rely on their figures, you could accidentally overcontribute. Keep your own records—whether it’s a spreadsheet or a quick note on your phone—to avoid this pitfall. - Re-Contributing in the Same Year
Withdrawing from your TFSA doesn’t mean you can re-contribute the same amount right away. Contribution room from withdrawals doesn’t reset until the following calendar year. If you jump the gun, you’ll face penalties, so always wait until January 1 of the next year. - Not Transferring Investments In-Kind
When moving investments between accounts, selling them first and redepositing the funds into your TFSA can cause overcontribution problems. Instead, transfer the investments “in-kind” (without selling). Even then, be careful with timing to avoid unintentionally reducing your contribution room.
Think of your TFSA as a tightly packed suitcase. Adding more than it can hold doesn’t just make it burst—it incurs a hefty luggage fee.
I go over way more TFSA mistakes to avoid in another video, so be sure to check that out!
Red Flag 3: Prohibited Investments in a TFSA
What Are Prohibited Investments?
Your TFSA isn’t a free-for-all—it comes with clear restrictions on what you can invest in. Prohibited investments include:
- Significant Interest Holdings: Owning 10% or more of a private company’s shares.
- Non-Arm’s Length Relationships: Investments in businesses where you or your family have significant control or influence.
The CRA’s objective is to prevent individuals from using TFSAs as a tax loophole for personal ventures. By enforcing these rules, the CRA ensures TFSAs remain tools for legitimate, arm’s-length investments.
Penalties for Prohibited Investments
The penalties for prohibited investments is huge:
- 50% Special Tax: If your TFSA acquires a prohibited investment, you’ll face a tax equal to 50% of the fair market value (FMV) of the investment at the time it’s acquired.
- 100% Tax on Income and Gains: Any income or capital gains earned from prohibited investments are taxed at 100%, effectively erasing any benefit from holding these investments in your TFSA.
A Common Example
Let’s say you invest $10,000 in a private tech startup owned by a relative. If the business grows and your shares are worth $50,000, the CRA could deem the investment prohibited because of your close connection. The result? A 50% tax on the $50,000 value ($25,000), and the shares must be removed from your TFSA, meaning future gains are no longer tax-free.
How to Stay Safe
Consult the CRA’s Guidelines: Review the list of qualified investments provided by the CRA.
Canada.ca, here’s the list here on the screen for you to review.
Your TFSA is a powerful wealth-building tool—but only if you use it wisely. Download our “TFSA to $1 Million” guide and check out our investment management services while you’re there.