Tax-Free Savings Accounts (TFSAs) are catching on in Canada, with more than four in 10 Canadian households already contributing to one, according to the latest Census. Unfortunately, some investors are missing out on the full benefits of this registered vehicle because they think TFSAs are just for bank savings accounts, as the name seems to imply.
The truth is, TFSAs can hold a wide variety of investments, allowing you to earn much more than typical bank interest rates — completely tax-free.
To help you get the most out of your savings, here are some guidelines and tips on investing in a TFSA.
What is a TFSA?
A Tax-Free Savings Account is a registered tax shelter for your savings and investments. You can put cash, GICs, stocks, bonds, mutual funds and exchange-traded funds (ETFs) into a TFSA, just as you would with a Registered Retirement Savings Plan (RRSP).
You never pay tax on the income earned in your TFSA — whether it be bank interest, dividend payments or capital gains. You also pay no income tax on the money you withdraw from a TFSA, and you can re-contribute that sum in the following calendar year without penalty.
The annual TFSA contribution room for 2019 is $6,000, up from $5,500 last year. Any unused contribution room is carried forward indefinitely. That means Canadians who were at least 18 years of age in 2009 (when the TFSA first came into effect) now have a cumulative maximum of $63,500 in TFSA contribution room.
Why You Should Invest Your TFSA
If you have non-registered investments, such as GICs, stocks or bonds, you can avoid paying tax on earnings from those investments simply by transferring them into a TFSA.
For example, if you bought $10,000 in stock in a non-registered account and sold it at $15,000, you’d have to pay tax on the investment’s growth (called a capital gain) by declaring 50% of the earnings (or $2,500) as income on your tax return. If you instead made that stock purchase within a TFSA, you would pay no tax on the capital gain. The same is true of income on any investment sheltered within a TFSA.
For those who aren’t yet investing, a TFSA can be the perfect place to start because of this tax-sheltered growth. While a high-interest savings account might be a smart option if you expect to make frequent withdrawals from your TFSA, it is not a good strategy for long-term savings. Bank interest does not typically keep up with the rate of inflation, meaning that the purchasing power of your long-term savings will erode over time. A diversified portfolio of low-fee investments, on the other hand, tends to beat inflation over the long term — making it the wisest choice for long-term savings growth.
Where to Invest Your TFSA
You can invest in a TFSA at any financial institution that sells GICs, mutual funds, and other securities. If, however, you want to maximize your returns by paying the lowest investment fees possible — and you are comfortable with DIY investing — a self-directed TFSA is a better option.
Start by choosing an online brokerage which allows you the flexibility to build your own portfolio of low-cost exchange-traded funds (ETFs).
ETFs are like mutual funds in that they are a collection of stocks, bonds or other investments, but with a key difference: they track the performance of a particular market index. Because there is no management professional selecting investments in the fund with the hopes of beating the market, ETFs have much lower management fees, usually around 0.15%, as compared with 2% to 3% for Canadian mutual funds.
Other costs of using an online brokerage include a flat annual maintenance fee and a small charge for each ETF trade or sale. When you use an online brokerage, you perform all the transactions yourself, and you alone decide which investments to buy and how conservative or risky you want to be with your portfolio.
If you’d prefer the convenience of a ready-made portfolio of ETFs that matches your risk tolerance, and you’d like to automate your transactions instead of doing them all manually, a robo-advisor might be a better alternative for you. Robo advisors are slightly costlier than online brokerages, with management fees up to 1%, but still cheaper than mutual funds.
Benefits of Investing Early
The earlier you start investing, the greater the effect of compound returns.
Here’s an example to illustrate the magic of compounding. Say you invest $10,000 in a TFSA today, with a 5% average annual rate of return. In 25 years, you’d have nearly $34,000.
But if you wait 10 years to invest that $10,000 in a TFSA, thereby short-changing yourself of a decade of tax-free compounding, you’d end up with less than $21,000 in 25 years’ time. If you wait 15 years to invest, your total drops to just over $16,000.
In other words, if you start investing immediately, you’d have 62% more money at the end of 25 years in our example than if you waited a decade to invest, and 112% more than if you waited 15 years to invest.
By investing in a TFSA as early as you can, your earnings have the maximum amount of time to compound, tax-free, giving you the best results.
Tamar Satov is an award-winning journalist specializing in the areas of personal finance and parenting. Her work has appeared in Canadian Living, The Globe and Mail, Today’s Parent, Parents Canada, Walmart Live Better and many other consumer magazines and websites. She is the former Managing Editor of CPA Magazine, for Canada’s Chartered Professional Accountants, and contributes to other publications for finance professionals including FORUM, for Canada’s financial advisors.