TFSA Investment Options

Although the name tax-free savings account suggests that your TFSA must be set up as a simple savings account where interest is earned on the cash you place in it, you’re actually not limited to having just cash in your TFSA. In reality, the TFSA is more of a tax-sheltered savings vehicle than it is a savings account. The money you contribute to your TFSA can be in the form of a variety of different types of investments.

How you choose to invest the money in your TFSA depends on the level of risk you’re willing to take on, as well as the time horizon of your savings goals. If you plan to use your TFSA to save up for a vacation next year, for instance, it might require a different investment strategy than using it to save up for a down payment on a house five to 10 years down the line.

With this in mind, it’s important to note that although people often try to simply find the “best TFSA investments,” it’s a flawed approach. Yes, there are financial institutions that offer better interest rates than others. But in terms of your overall investment strategy and the individual types of investments that make up your portfolio, you should instead aim to find the best TFSA investments for you.

A TFSA is different than a non-registered account. On the one hand, if your investments in a TFSA soar, you won’t need to pay capital gains taxes. However, if your investments in a TFSA drop, you won’t be able to claim a capital loss. In a non-registered account, you do have to pay capital gains taxes on and you can claim capital losses.

TFSA Investment Rules

Investments that can be held in a TFSA are called qualified investments. The Income Tax Act outlines which investments are permitted in a TFSA. In general, the types of investments that can be placed in a TFSA are the same as those that can be held in an RRSP. Common types of qualified investments include:

Each of these types of investments has advantages that will appeal to certain people, and disadvantages that will deter investors from choosing that type when considering how to build their TFSAs. Below is more information on each of the investments listed above.

TFSA Savings Account

One of the simplest ways to set up your TFSA is in the form of a savings account. This is similar to a regular savings account in that you place cash inside it, and your money earns interest at a guaranteed rate of return. Of course, this has the added benefit of allowing you to earn interest income on a completely tax-free basis, which would otherwise be fully taxed if your funds were placed in a non-registered account. This type of setup for your TFSA is useful if you’re saving for the short term or you need easy access to cash in case of an emergency.

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GICs in a TFSA

GICs offer you a higher guaranteed rate of return that’s usually higher than what a regular high-interest savings account offers. However, your cash won’t be as easily accessible because it will be locked in for a set period of time. At the end of the term, you receive the principal (the original amount that you put in), along with the interest that it earned. GIC terms range from as little as 30 days to as long as 10 years. The most common terms are between one and five years. GICs are considered a safe investment because you’re guaranteed to receive your initial investment back (plus interest) at the end of the term.

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Bonds in a TFSA

You can hold both government (municipal, provincial, and federal) and corporate bonds in your TFSA. Unlike GICs, bonds have the benefit of providing you with periodic payments throughout the term, rather than waiting until it matures to pay you in a single lump sum. Government bonds are less risky investments than corporate bonds, however, their rate of return is also less. Bonds, if held to maturity, are considered to be relatively safe investments compared to stocks. You can generally find a bond with a term to maturity that matches the time horizon of your financial goal.

Stocks in a TFSA

Stocks are one of the riskier types of investments to have in your TFSA. Because they are riskier, the potential return is much higher than that of a savings account, for instance. Investing in stocks is much like how you would do it normally, except if it’s done in your TFSA, your capital gains aren’t taxable—which means that if your investment doubles in value, you get to keep all of the profit.

In order for your shares to be considered qualified investments, the stocks you invest in must be listed on a designated stock exchange, such as the Toronto Stock Exchange, the TSX Venture Exchange, the New York Stock Exchange, and Nasdaq. The Canadian Department of Finance has a list of more than 40 stock exchanges around the world. It’s a good idea to check that the stocks you want to invest in are listed on one of these exchanges before actually purchasing them.

If you’re invested in dividend-paying foreign stocks, note that you might have to pay a withholding tax on the dividend you receive. The reason is that many countries impose a tax on the dividends they pay to foreign investors. This tax rate can vary from country to country, but for American divided-paying stocks, that rate is 15%.

Mutual Funds in a TFSA

A mutual fund pools together money from a large group of investors, and invests in stocks, bonds, and other securities on their behalf. Many people want a rate of return similar to those who actively pick and invest in individual stocks and securities. However, not everybody has the time or market knowledge to be able to do so. As a solution, they invest in a mutual fund and allow their money to be professionally managed. You’ll typically have to complete a questionnaire at the financial institution where you open your TFSA, in order to give the people who will manage your money an idea of your capacity for risk.

ETFs in a TFSA

An ETF trades like a common stock on an exchange, and it usually tracks an index or commodity. Most ETFs attempt to track the performance of an index (such as the S&P/TSX Composite Index) whereas most mutual funds attempt to beat an index. As a result, the management fees on an ETF are lower than a mutual fund.

Self-Directed TFSAs

There are usually two types of TFSAs. The investments you can hold in a regular TFSA will be restricted to your financial institution’s mutual funds, GICs, and savings accounts. With a self-directed TFSA, you can invest in other financial institutions’ mutual funds and GICs along with stocks, bonds, ETFs, and more. A self-directed TFSA provides you with the most flexibility to build your own portfolio, as it gives you complete control over the management of your investments.

Non-qualified Investments in a TFSA

Certain types of investments, such as land and units of ownership in a general partnership, aren’t considered qualified investments. Another example of a non-qualified investment is owning shares of a non-Canadian company that once traded on a designated stock exchange, but has since been de-listed.

The Income Tax Act specifies what are known as prohibited investments, which are investments expressly forbidden to be held inside a TFSA. These include shares of a company of which the TFSA holder has ownership of 10% or more.

What constitutes a non-qualified or prohibited investment can be very confusing and technical. It’s extremely important that you check with a financial advisor that your investments are qualified, especially if you hold a self-directed TFSA, because non-qualified and prohibited investments are taxed very heavily.