Mutual Fund Tax-Free Savings Accounts
When tax-free savings accounts (TFSAs) were first introduced in January 2009, a common misconception about them was that they were just simple savings accounts. This is untrue.
By design, TFSAs allow investors to hold a wide range of investment products. From the cash you would deposit into a high-interest savings account within a TFSA, to the stocks and bonds you can buy in self-directed TFSAs, and GICs within a TFSA offered by many banks and trust companies, your options are seemingly endless. If you have a long-term investment strategy, you may also want to consider buying mutual funds in your TFSA.
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What are mutual funds?
In its simplest definition, a mutual fund is a collection of investments (bonds, stocks, etc.) owned by a group of investors (you’d be one of them) and managed by a financial institution and/or portfolio manager. When you buy a mutual fund, you’re basically just pooling your money in with all the other investors, so you can own units of the fund.
Traditionally, many people are used to the idea of buying mutual funds in their RRSP. The length of time you have to invest as well as your risk tolerance are used to determine which type of mutual fund you should purchase (explained in more detail below). The only difference between buying mutual funds in an RRSP or a TFSA is that the money in your TFSA can be withdrawn tax-free. This is because TFSA contributions are made using after-tax dollars, whereas RRSP contributions are tax-sheltered by the government (up to a certain point, of course!).
What are the advantages of buying mutual funds in your TFSA?
Some of the reasons you may want to buy mutual funds in your TFSA include:
- They are diversified, meaning your money is in multiple investments versus just a few individual stocks or bonds. This is not only easier to manage, it also comes with slightly less risk (depending on the fund you choose).
- They are managed by a professional portfolio manager. The manager’s job is to decide where to invest all the money in the fund, as well as to actually buy and sell the investments.
- You have a large number of funds to choose from, depending on the length of time you have to invest, your risk tolerance, portfolio performance and fees.
- They’re easy to buy and sell.
- Your withdrawals are tax-free.
What are the disadvantages of investing in mutual funds?
While there are advantages, there are also disadvantages:
- They’re not as transparent as you might think. Your portfolio will come with a fund fact sheet that usually lists the top 10 to 20 investments in the fund, but not all of them.
- You don’t have any influence or control over which investments are included in the portfolio.
- You have to pay fees, known as the management expense ratio (MER), for the portfolio manager’s services. A typical MER may be between 1.00% and 3.00%. Depending on the value of your portfolio, these fees can be much more expensive than what you’d pay in fees for ETFs, even if you pay someone to manage your ETFs for you.
- There is no guarantee you’ll make money. Depending on when you withdraw your money from the fund, you may get back less than what you invested.
- Mutual funds are not CDIC-insured.
How are mutual fund management fees calculated and paid?
As we mentioned above, one of the disadvantages of investing in mutual funds is that you have to pay the fund’s MER. The MER is expressed as an annual percentage of the total value of the fund. For example, you may choose a portfolio that has a MER of 1.50%. In that 1.50%, you’re paying for the portfolio manager’s time in overseeing the fund, making investment decisions and covering their operating expenses. Theoretically, higher fund performance is supposed to more than cover the MER, but that’s not always the case. Fortunately, you don’t actually pay this fee directly, but it does reduce your fund’s return. Let’s look at an example.
Case study: High-interest savings account vs. mutual funds in a TFSA
Alex has $5,000 sitting in a regular savings account and decides he wants to make a contribution to his TFSA. He’s never invested in mutual funds before, but is trying to decide between putting his money in a high-interest savings account with an annual interest rate of 2.00%, and a mutual fund that has historically seen a gross return of 5.00% each year but with a 2.20% MER. If he only made a one-time investment, and didn’t contribute anything more to the account in the first year, which option would give him the best return on his investment?
|Return After First Year (2.00%)
||Return After First Year (5.00%*)
||MER Fees (2.20% of Investment + Return)
|Final Value of Investment
||Final Value of Investment
*Fund companies report returns after fees, but we provided this as an example to show how MERs can impact investment performance.
In this example, despite having to pay the MER fees, Alex would get a better return by investing in a mutual fund TFSA.
What types of mutual funds exist?
While there are literally hundreds of funds to choose from, you’ll likely find them under one of the following categories:
Equity funds: Equity funds own stocks in companies. The goal of these funds is to generate returns in excess of their comparative index. However, in their quest to do so, there’s always the potential for the investment to not yield the anticipated return. Mutual funds are best viewed as a long-term investment product. There will be ups and downs, but a well-diversified portfolio is designed to meet an objective. It’s common for young investors to take on more risk. However, as the investor gets closer to retirement, he/she will look to reduce risk and will shift assets to more fixed income funds.
Fixed income funds (bond funds): Fixed income funds consist of investments that pay a fixed rate of return, such as government bonds and corporate bonds. Someone approaching retirement may want to move their investments into fixed income funds because they provide a steady source of income.
Balanced funds: Balanced funds are a mix of equities and fixed income funds, which try to provide a mixture of income and growth. Typically, if the fund holds a large percentage of equities and fewer fixed income securities, they are considered aggressive. On the flipside, if they hold more fixed income securities than equities, they are more conservative and will likely see smaller rates of return when stocks rise.
Money market funds. Money market funds purchase safer types of investments like government treasury bills or short-term bonds. These funds are low in risk and provide a small level of income.
Index funds: Index funds are classified as the type of fund they intend to match. They’re built to mirror the performance of an index, such as the S&P/TSX Composite Index for an equity fund or the DEX Universe Bond Index for a fixed income fund. They usually have lower costs than other mutual funds, because the portfolio manager doesn’t have to do as much research or make as many investment decisions. As such, it’s not surprising that the data shows indexing usually leads to higher returns than typical mutual funds.
How to choose a mutual fund
If you want to invest in a mutual fund, start by:
Deciding how long you want to invest for. Before you can choose the type of mutual fund you want to invest in, you need to decide what your financial goals are and how many years it’ll take to accomplish them. For example, are you saving for a home and want to buy in 2 to 3 years? Or are you saving for retirement and, if so, are you 10 years away or 30 years away?
Choosing the type of mutual fund you want to invest in. As outlined above, if you’re a young investor who has many years to deal with fluctuations in the market, you may want to choose a riskier fund, such as an equity fund. However, if you’re mid-career or close to retirement, you should look at something with less risk/more guaranteed returns.
Comparing fees and past performance. Not all funds are built the same, so not all come with the same fees. When you’re comparing different funds, look at their MERs as well as how they’ve performed in the past. However, past performance is not an indicator of future returns. Read the fact sheet for each fund. It’ll pay to compare!
Once you’ve completed these steps and decided on a specific fund, you make a purchase in one of three ways:
- Online through an online discount brokerage, such as a bank (e.g. TD Waterhouse) or an independent brokerage (e.g. Questrade).
- Make an appointment with a financial advisor at your bank.
- Make an appointment with a financial advisor who works at an independent brokerage (i.e. not for a bank).
During the application process, you’ll need to provide some personal information, as well as tell them how much risk you’re comfortable with, and how much you know about mutual funds. You must answer these questions in order to buy a fund.