Stocks Held Inside TFSA’s
If you are an ambitious investor you probably want to invest some shares from your stock portfolio to your TFSA, where the gains can grow tax-free. This works best for self-directed investors as brokerage firms specialize in stocks whereas your typical bank or credit union does not.
What kind of stock do you own?
A stock is basically the remaining assets of a company after any outstanding debts have been paid off. Stocks are divided up into shares (fractions of ownership), and it’s these shares that investor’s actually hold. These shares have a certain value associated with them, and this value can go up or down according to market forces.
- Common Stock: If you own common stock then you have voting rights into company decisions. Of all investors with interests in the company, common stockholders get paid last. This means if the company goes into bankruptcy you are likely out of luck.
- Preferred Stock: If you own preferred stock then you have dibs on company assets and dividends, but you don’t have any voting rights. Preferred stockholders can also exercise their option to convert their preferred shares into common stock and gain voting rights.
- Hybrid Stock: If you own hybrid stock then you have the benefits of both preferred and common stock. You have dibs on company assets and you have voting rights.
Do your stocks qualify for a TFSA?
The Canadian Income Tax Act allows for stocks to be considered qualified investments so long as they are listed (or cross-listed) on a designated stock exchange.
If you put non-qualified stocks into your TFSA you will get dinged big-time by the CRA. You’ll be penalized 50% of the stock’s value in the year it was moved into the TFSA. If you did this accidentally and can prove it, you can get this 50% back when you move the offending stock back out of the TFSA. In addition to the 50% stock value penalty, you’ll also be taxed (at the highest rate) on any gains made while the offending stock was inside the TFSA.
How to put stocks into your TFSA
Generally you can transfer your stock shares directly into your TFSA account without first having to sell it. The caveat is that you need to have your TFSA held within a brokerage firm and not your regular bank. If your TFSA is held within a brokerage firm and you are a self-directing investor, you’re OK. But if you try to do this at your bank you may run into trouble since banks don’t generally deal in stocks.
When putting the stocks into your TFSA look to see if you have made any to-date profits outside the TFSA. If you have, you’ll be taxed on that gain since that money was made outside the TFSA (unfortunately you can’t claim the reverse). Once inside the TFSA, the stock shares are protected and any gain (profits) you make after this date will be tax-free.
After the stocks are safely inside your TFSA they can start making gains (or losses) tax-free. Because you aren’t guaranteed to make a profit on these shares, you really should make sure your TFSA portfolio is diversified enough to handle any downturns. Put some mutual funds, bonds, ETFs, or even GICs in there to make sure you have a healthy mix of funds.
Foreign stocks are eligible for TFSAs so long as they are traded on a designated stock exchange and your bank allows them (assuming they allow stocks in the first place). If your stocks pay foreign dividends then you will have to pay foreign non-resident withholding tax on that money, which could be costly!
Note that while there is an exemption for US dividends being paid into a RRSP or RRIF through the Canada-US Tax Treaty, there is currently no such exemption for TFSAs. So in this case it may actually be better to hold foreign stocks inside an RRSP vs a TFSA.
Using your TFSA as margin power
Sometimes you may want to borrow extra money in order to invest more. Some brokerage firms will allow this by using your TFSA as collateral and charging you interest on the borrowed money.
Note that your margin and TFSA are now linked (leveraged) so changes in your overall value are amplified. If your stocks are rising in value, your margin is doing good as well. But if your stocks tank, you may get a margin call and be required to sell some of that stock! Because of this extra risk, do your homework if you are thinking of leveraging the money inside your TFSA to invest in stocks.
Note that your margin account is not inside your TFSA and is thus subject to tax regulations. Any interest you pay on the margin debt will be tax deductible.
Also note there may be commissions or other fees attached to margin trading. Check ahead of time to make sure as some of these fees are on a per-trade basis so could add up if you are a frequent margin trader.
Note that if your stocks are already held by a brokerage firm and you are moving them elsewhere, you may incur a transfer fee. However it’s possible for you to get this transfer fee back at your new firm. Just ask and they may oblige, as a thank-you for moving your business to them!
Gains, losses, and your contribution room
Make sure you stay within your contribution limit when buying stocks for your TFSA:
- Make sure when you buy the stocks that their value is less than your contribution limit. If you have foreign stocks, remember to convert the value to Canadian dollars.
- Any gains within the TFSA won’t count towards your contribution limits. For example, if you invest $5500 in stocks in your TFSA and that’s your limit for the year, and you end up making $1000 in gains inside the TFSA, you are still OK and haven’t over-contributed.
- In the same $5500 investment scenario, any losses within the TFSA won’t count either, so you can’t use a $1000 loss to justify investing $1000 more of stock without going over your contribution limit.
TFSAs and DRIPs
If you regularly get dividends from the stock you hold in a company, you have to decide what to do with it. Withdrawing it is an option, but if you are looking for long-term investment try a Dividend Reinvestment Plan (DRIP). This is where you take your dividends, and instead of withdrawing them, you simply reinvest them in the same stocks, acquire more shares, and enjoy the compounded interest.
This only really works if you invest in a company that has steady positive growth and reliable dividend payments. Do your homework to make sure the company you are looking to reinvest shares in has a reputation for growth and regular dividend-sharing.
How to use a DRIP to bolster your TFSA
After a period of time of reinvesting in the company of your choice you most likely have a fairly substantial block of shares. Transfer this block of shares to your TFSA; you will have to do some paperwork with your online broker to complete the in-kind transfer.
Note that there is a tax implication by moving investment funds to a tax-free situation (your TFSA). The CRA will tax you on any capital gains before the shares were put inside the TFSA. On the other hand, if you incurred any losses while the shares were still outside the TFSA, you are not allowed to claim a capital loss. So be aware and strategic about when you move your investments from a taxable situation to a tax-sheltered situation!
Once inside your TFSA you can request your (now tax-free) shares by enrolled in the broker’s own DRIP program. Your shares can then continue to enjoy compound interest, tax-free!
When using the company’s DRIP, you get to bypass the brokerage company’s purchase fees and deal with the company directly. When moving your shares into the TFSA and enrolling them in the broker’s DRIP program, make sure to ask if there are any DRIP, transfer, or commission fees with the brokerage company.
Since you are moving investments into your TFSA in intervals (and paying tax on each chunk before it makes it inside the TFSA), you have to be very careful not to inadvertently over-contribute. Keep careful records of how much you are moving in and out of your TFSA or else you may discover a notice of over-contribution letter in your mailbox one day!