Ottawa takes an ‘all-you-can-eat buffet’ approach to eligible investments for your tax-free savings account (TFSA). Almost anything you can stuff in—within your annual contribution limit—is okay in the view of the Canadian Revenue Agency (CRA).
Cash, bonds, GICs, stocks, or whatever an investor thinks is a reasonable place for their money—with a few exceptions—is eligible for their TFSA. That means a person has a wide degree of latitude regarding what they want to put in their tax-free account.
A person can slam a stock or other tradable investment vehicle into the TFSA as long as the financial instrument is listed on one of six Canadian or 41 foreign stock exchanges acceptable to the federal Department of Finance. Here, we are talking exchanges from Austria to London and most developed markets in-between.
You can even put a delisted stock into your account. In this case, however, government rules permit only Canadian—not foreign—unlisted equities to go into the TFSA.
Private shares are also okay. But experts note there are special rules that make these investments potentially less attractive as a TFSA holding.
For example, if the person receives the shares as a result of an exercisable stock option, they’re taxed on the difference between the exercise price and the fair market value of the shares as they go into the TFSA.
As well, you have to keep an eye on these holdings. If the percentage held by the individual and related parties exceeds 10% of the private company’s equity, the shares become poison for the TFSA and are subject to CRA penalties.
While you can also put cash into a TFSA, it raises a crucial issue concerning eligible investments—not what you can but what you should put into a tax-sheltered account.
A 2013 BMO Bank of Montreal survey found that Canadians held 57% of their TFSA-eligible assets in cash, 25% in mutual funds, and only 14% in stocks.
Financial experts say such an allocation is the exact reverse of what you should have in your TFSA, especially if you’re, say, less than 40 years old.
That’s because the TFSA allows a person to accumulate investment returns, whether through dividends or capital gains, without drawing the attention of the taxman.
So, this line of thinking goes, it’s nonsensical to hold cash, which currently returns less than 0.5% in a savings account, and uses up valuable contribution room on an investment that—after subtracting out inflation—essentially loses money.
Savers are better served by putting their stocks with a potential for higher rates of returns or ones that spin off quarterly dividends and long-term capital gains in the TFSA. That’s because these gains accumulate tax-free.
And, for younger people, the returns can compound for decades, not just for a few years in the case of Canadians closer to retirement. Take $5,000 in cash in a high-interest savings account earning a 5% rate of return—admittedly unimaginable in today’s environment but one can dream. After 10 years, that nugget is worth $8,235. Holding the cash for another 30 years means the cash grows exponentially.
But, if you have a series of bad investments—stocks likely to yield capital losses—you might be better off holding these outside of a TFSA. Since you didn’t pay tax on the returns within the tax-free account, you can’t use any capital losses to offset other gains.
The TFSA rules allow for wide flexibility in devising a portfolio within the account. But the existing restrictions and investment strategies do mean one thing: Only by paying careful attention can someone make sure that their TFSA buffet doesn’t wind up eventually causing them financial indigestion.