Self-Directed Tax-Free Savings Accounts

When you decide to open a tax-free savings account (TFSA), you have a wide range of account types to choose from, all of which are based on the type of investment product you’d like to purchase (i.e. GICs, mutual funds). Remember that a TFSA is in itself not a product, rather an account that you purchase investment products in.

The products that you purchase should reflect your risk profile and your savings timelines. If you’re saving for a short-term goal, you may just choose a high-interest savings TFSA or GIC TFSA, both of which have low interest rates but guarantee both your principal and a return on your investment through interest. If you’re saving for the long-term, you may also have a mutual fund TFSA with the intention of providing diversification. However, if you’re more of a do-it-yourself type of investor, you may want to consider a self-directed TFSA.

Here’s a description of what self-directed TFSAs are, how they work and how to decide if they’re the right option for you.

What is a self-directed tax-free savings account?

A self-directed TFSA is an account arrangement with a financial institution, (usually an investment dealer or broker), in which all the decisions about what to buy are made by the account holder (you), not the bank. This contrasts with a mutual fund TFSA, where you might have a certain degree of choice, but only among specific mutual funds offered by your financial institution. Mutual funds are professionally managed on behalf of unit holders, so the individual does not do most of the work in deciding where to allocate their money. With a self-directed TFSA, you are in complete control of where your money goes. People with self-directed TFSAs commonly purchase shares of companies and ETFs within their discount brokerage account such as BMO InvestorLine, RBC Direct Investing or CIBC Investor’s Edge.

What investments can be held in a self-directed tax-free savings account?

With a self-directed TFSA, Canadians are able to construct a portfolio consisting of a wide variety of investments1, including:

  • Cash
  • GICs
  • Bonds
  • Publicly traded stocks on a recognized exchange
  • Mutual funds
  • Exchange-Traded Funds (ETFs)

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What are the advantages of a self-directed tax-free savings account?

Some of the reasons you may want to get a self-directed TFSA include:

  • Lower fees. For mutual funds in Canada, it is standard to pay an annual fee equal to 2.00-2.50% of the value of your portfolio; this is known as the management expense ratio (MER). With a self-directed TFSA, however, you can buy exchange-traded funds (ETFs) that track the equity/bond markets just as a mutual fund tends to. The difference is that your annual fee will usually be more in the range of 0.25-0.50% of the value of your portfolio. The ETF companies can undercut the mutual funds on the fee front because with an ETF the investment decisions are more or less automated and do not require a large amount of research and analysis.
  • Higher returns. Historically, investment returns over the long-term tend to be around 7.00% per year. Paying 2.00% of this as a mutual fund fee versus 0.25%-0.50% as an ETF fee is a very significant difference, and this becomes even more dramatic over time due to compound interest. A person who is able to keep the 1.50% difference in fees (2.00% - 0.50%) will be dramatically better off as the years go by. And research has consistently shown that most mutual funds don’t beat the market’s performance, so ETFs are a great way to get exposure to the bond and equity markets.
  • You’re in control. If you are an active investor, a self-directed TFSA allows you to be more aggressive with your investments than a bank-run TFSA. The self-directed TFSA is the only kind of TFSA that permits you, for example, to buy individual stocks and bonds. A savvy investor can therefore potentially do better by building a self-directed TFSA than they could by choosing a mutual fund TFSA. You still can lean on professionals to take care of some of your money, because a self-directed TFSA may still invest in mutual funds. However, you have more latitude about which mutual funds to choose, as you’re not restricted to your bank’s offerings.

What are the risks associated with self-directed tax-free savings accounts?

Of course, there are also noteable risks associated with having and maintaining this type of TFSA:

  • Extra risk. When you buy individual stocks, and especially if you fail to properly diversify your portfolio, you may subject yourself to a higher level of risk than if you invested in a mutual fund TFSA. However, you can mitigate the risk by purchasing ETFs, which hold a diversified basket of stocks (and in many cases, are similar to the portfolios of actively managed mutual funds).
  • The onus is on you. With a self-directed TFSA, it’s your responsibility to make regular contributions, monitor and rebalance your portfolio; this means you need to commit the time to regularly monitor what the markets are doing and how what you own is performing. If you want a little bit of help with this, you could open a self-directed TFSA with one of Tangerine Bank’s Streetwise portfolios, or invest through WealthSimple; but allow for consistent contributions in balanced portfolios, and have fees that are low compared to actively managed mutual funds.

Neither of these is meant to suggest that you should avoid going the self-directed route; you just need to understand what you’re getting yourself into. If you are going to manage your own portfolio, you should probably spend a reasonable amount of time following your investments, to see how they’re doing and whether you might want to change course. Remember, consistently beating the market is hard if not impossible to do!

What if you already have stocks and bonds, but they aren’t in a tax-free savings account?

You may already have a non-registered brokerage account that holds securities such as stocks or bonds. If so, you can transfer these investments into your new self-directed TFSA so they can begin enjoying tax-free gains. Just be aware that the moment the transfer takes place, the Canada Revenue Agency deems the investment to be sold for tax purposes. As a result, one of two things will happen:

  • If the investment had a capital gain at the time of its transfer, you will have to pay capital gains tax
  • If the investment is transferred at a price below its purchase price, however, no capital loss may be claimed.

Fees associated with self-directed tax-free savings accounts

Self-directed TFSAs are not free. It’s not uncommon to be charged an annual “maintenance” fee of $100 by a bank simply to keep an account open, whether or not you made transactions in a given year. On an investment of $5,000, for example, this represents a 2.00% charge, which is quite significant.

There are some other fees associated with self-directed TFSAs. Transferring money from your account to another financial institution can cost $50-$150, depending on whether it’s a full or partial transfer. Closing an account can also cost upwards of $100. Finally, commissions on things like stock trades are extra. Most Canadian discount brokerages2 charge a flat fee of around $9.95 per trade.

Should you go the self-directed route? If so, how?

If you have sufficient investment knowledge, a self-directed TFSA could be a great investment option for you. Just remember that it’s completely ok (and maybe even advisable) to have a self-directed account but still be very conservative in your investments. For example, just because you’re managing your own portfolio does not mean you have to become a stock picker. You can buy all sorts of safer things like GICs, government bonds and mutual funds, too.

Once you’ve decided to go the self-directed route, you can open an account one of two ways:

  • Through an online discount brokerage, such as a bank (e.g. TD Waterhouse), or
  • Through an independent brokerage (e.g. Questrade).

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 what level of investment knowledge you have. You will also have to acknowledge that you understand the risks involved, particularly if you plan on using the account for active stock trading or using complex financial instruments like options.

References and Notes

  1. This list isn’t exhaustive, but it does cover the investments that the vast majority of Canadians will put in a self-directed TFSA.
  2. A discount brokerage simply buys and sells securities based on a customer’s orders. They do not provide investment advice, like a “full-service broker” would.