Is a Tax-Free Savings Account (TFSA) always tax-free? The name alone would suggest that's the case, but there are instances when income earned in a TFSA and other registered accounts – including investment income and realized capital gains – may be subject to income tax. Let's take a look.
A version of this article originally appeared in Inspired Investor, the RBC Direct Investing magazine. First, a quick review of how TFSAs work:
- You can hold stocks, options, exchange-traded funds (ETFs), mutual funds, bonds and guaranteed investment certificates (GICs) in your TFSA, as long as they are qualified investments.
- You can also hold foreign investments in a TFSA, but a foreign government may withhold tax on the foreign-sourced income received by the TFSA, which might reduce your return overall. (Tip: a W-8BEN form may help you reduce the withholding tax rate on U.S. income you may receive in your account.)
- The federal government sets TFSA contribution room each year (indexed to inflation).
- Plus, contributions to a TFSA are not tax deductible, unlike with RRSPs, but you also won't pay taxes or penalties when withdrawing funds.
- If you fall afoul of any of these rules (holding non-qualified investments or exceeding contribution room, for example) the plan is subject to tax. (For more information, read Your Guide to TFSAs.)
It's important to remember that TFSAs are registered accounts intended for investing and growing your savings over time. They are not meant for frequent trading, running an investment business or day trading. If you trade extensively in your TFSA, the Canada Revenue Agency (CRA) may consider your account to be "carrying on a business." Any income (dividend and interest) and the full amount of realized gains (net of any realized losses) would be subject to tax.
How much trading is too much?
The CRA hasn't provided precise guidelines. However, in a 2018 Income Tax Folio (a technical publication that detail the agency's interpretation of the law as it applies to income taxes), the CRA states, "The determination of whether a particular taxpayer carries on a business is a question of fact that can only be determined following a review of the taxpayer's particular circumstances."
What about frequent trading in other registered accounts?
What about frequent trading in other registered accounts? Other registered plans, such as RRSPs, RRIFs and RDSPs, are generally also taxed on income earned from carrying on business, although the exact rules and consequences may differ. As for RESPs, if the CRA considers that an RESP is carrying on a business, it can revoke the plan's registration and therefore its tax-sheltered status.
What does the CRA take into account?
Among the key factors it considers are:
- frequency of transactions (to determine if there's a history of extensive buying and selling of securities)
- period of ownership (to see if securities are usually owned only for a short period of time)
- knowledge of securities market and time spent studying the market
- financing (to determine if security purchases are financed primarily on margin or by some other form of debt)
- type of shares (to see if they are normally speculative in nature or of a non-dividend type)
Read Related Stories:
- ESG Investing: What is it and why does it matter to me?
- What is Diversification and Why Does it Matter?
RBC Direct Investing Inc. and Royal Bank of Canada are separate corporate entities which are affiliated. RBC Direct Investing Inc. is a wholly owned subsidiary of Royal Bank of Canada and is a Member of the Investment Industry Regulatory Organization of Canada and the Canadian Investor Protection Fund. Royal Bank of Canada and certain of its issuers are related to RBC Direct Investing Inc. RBC Direct Investing Inc. does not provide investment advice or recommendations regarding the purchase or sale of any securities. Investors are responsible for their own investment decisions. RBC Direct Investing is a business name used by RBC Direct Investing Inc. ® / ™ Trademark(s) of Royal Bank of Canada. RBC and Royal Bank are registered trademarks of Royal Bank of Canada. Used under licence. © Royal Bank of Canada 2021.The views and opinions expressed in this publication are for your general interest and do not necessarily reflect the views and opinions of RBC Direct Investing. Furthermore, the products, services and securities referred to in this publication are only available in Canada and other jurisdictions where they may be legally offered for sale. If you are not currently resident of Canada, you should not access the information available on the RBC Direct Investing website.