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Overcontributing

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Whether you ultimately decide to contribute to a TFSA or an RRSP, it’s critical to stay on top of your contribution limits, lest you face a penalty tax for overcontributions.

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Accidentally overcontributing to either a TFSA or an RRSP seems to be a recurring problem for some taxpayers, evidenced by the continuous flow of newly-reported cases in which taxpayers go to court trying to wiggle out of the punitive overcontribution tax they’ve been assessed.

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Excess contributions are taxed at the rate of one per cent per month, with the exception of a $2,000 overage permitted with RRSP contributions. The Canada Revenue Agency (CRA) has the discretion to waive this overcontribution tax if the excess contribution occurred because of a “reasonable error” as long as “reasonable steps” were taken to eliminate the excess. If the CRA refuses to waive the tax, then taxpayers have the right to seek a judicial review of the CRA’s decision in Federal Court.

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Day trading in your TFSA

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If you actively trade marketable securities in your TFSA, the CRA may consider this activity to constitute a business, and the TFSA, rather than being tax-free, could be subject to tax on its business income. Frequent trading in a TFSA has been a focus area for the CRA’s audit and reassessment activities.

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Generally, the CRA will look at several factors when deciding whether a taxpayer’s gains from securities constitute carrying on a business, including the frequency of the transactions, the duration of the holdings, the intention to acquire securities for resale at a profit, the nature and quantity of the securities and the time spent on the activity.

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The same rule, however, doesn’t hold true for frequent RRSP trading, provided the RRSP is invested exclusively in “qualified investments.” These include most common investments, such as guaranteed investment certificates, most securities listed on a designated stock exchange, mutual funds and segregated funds. A comprehensive list of qualified investments can be found in the CRA’s Folio S3-F10-C1, Qualified Investments — RRSPs, RESPs, RRIFs, RDSPs and TFSAs.

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Forgetting about withholding tax on foreign dividend income

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Foreign dividends are not eligible for the dividend tax credit, and are taxed at your full marginal tax rate when earned outside of an RRSP or TFSA. But the problem with foreign dividends is that in most cases, a nonresident withholding tax (typically 15 per cent) is applied by the foreign jurisdiction before the dividend is received in Canada.

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If you hold the foreign stock in a non-registered account, you can generally claim a foreign tax credit against your Canadian tax payable for the amount of tax withheld. But if the foreign dividend is paid into an RRSP or TFSA, any foreign tax withheld is non-recoverable and no credit is available, with one exception. Under the Canada-U.S. tax treaty, U.S. dividends are exempt from withholding tax when paid to an RRSP or registered retirement income fund (RRIF). But that same break does not apply to a TFSA, making U.S. dividend-paying stocks better off in RRSPs.

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Leaving contributions in cash

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Finally, while it may seem obvious to most of us, don’t forget to actually invest your RRSP or TFSA contributions, rather than leave them sitting in cash. Remember that, in most cases, the main benefit of contributing to an RRSP or TFSA is not the tax deduction (with an RRSP) or the tax-free withdrawal (with the TFSA), but rather the tax-free rate of return you are earning in either plan.