The Tax Free Savings Account (TFSA) is a tremendous way to invest. As good as it is there are things to consider so “buyer beware”.
This word of caution comes from our observation that many people completely misuse this investment option costing investors significant tax savings.
The TFSA was introduced by the federal government in 2009 as an incentive for Canadians to save more. This is allowing money inside a TFSA to grow tax- free.
The annual contribution rate was initially set at $5,000 per year. In 2013 the limit was increased to $5,500. As of this year the total cumulative contribution allowed is $31,000. If you have not contributed to a TFSA or maximized those contributions you can make up for any missed contributions this year or in any year in the future.
The mistake many make is missing the true advantage of a TFSA which is maximizing the benefit of investments growing tax-free. For long-term investing, the mistake occurs when low-paying investments are held inside a TFSA.
Current interest rates on bank savings accounts or GICs are virtually zero. Therefore, why would you use the tax-free benefit of a TFSA to protect yourself from tax by investing in something that earns so little where paying the tax is not an issue?
The valuable tax-free opportunity you have with a TFSA should be used for something that has the expectations of a higher return. That would be stocks or mutual funds that own stocks.
My comment about preferring to hold stocks inside a TFSA is by no means a recommendation on how you diversify your portfolio between stocks and bonds. That decision is made based on your financial situation and objectives. A TFSA can hold a wide range of investment options.
The logic of building a portfolio is to first determine what investments should be owned. Then as a part of the normal tax planning process, allocate those investments to the several plan types including an RRSP, RRIF, TFSA or a non-registered investment account.
Most investors owning stocks are better from a tax planning perspective holding these inside the TFSA. Low- paying bank savings accounts or GICs can be held inside your RRSP, RRIF or Investment account.
Inside which of these should you hold your stocks that have appreciated in value by $10,000? Hold them outside any registered plans and one-half of that gain is added to your income and taxed accordingly when they are sold.
If these investments are held inside an RRSP or RRIF then the total amount of funds, including the gain is added to your income when it is withdrawn and taxed. The TFSA is clearly the best from a tax perspective because investments are not taxed while they remain inside the TFSA nor when withdrawn.
There are two potential reasons for so many misusing the TFSA to hold low-paying investment options. The first has to do with the name. The word “account” in Tax Free Savings Account should have been “plan” as in Registered Savings Plan. The word “account” is identifiable with a bank account. Canadians expect those to be low paying interest vehicles.
The second issue is the way banks advertise TFSAs. They promote the ownership of low-paying interest options. Banks would be helping educate Canadians if they alerted customers they would be better served holding investments inside a TFSA with the highest chance of paying a higher return.
Deciding when and if a TFSA is suitable takes a little planning. Here are some rough guidelines.
For most it is better to maximize RRSP contributions first because of the immediate income tax deductions of a contribution. Then contribute to a TFSA and finally invest in an Investment Account.
TFSAs are still relatively new. The government gets full credit for creating such a beneficial savings vehicle.
Investors are encouraged to consider how and when to use a TFSA. The benefits can be significant and should be carefully considered as part of your investing strategy.