What’s the best use for a TFSA?
The Tax Free Savings Account (TFSA) is a government program that allows Canadians to invest their after tax dollars and not pay any tax on the interest earned or growth. When this program was introduced in 2008, I saw it as a great “gift” to tax payers and was excited to see it put to work.
Recent polls suggest that over the past four years approximately 45% of Canadians have opened one of these accounts. The problem is, many seem to be using them the wrong way. There is a large majority who use their TFSAs as a chequing or savings account at the bank and earn almost no interest. When you put $5,000 into your TFSA and it earns 0.5% per year, the savings you realize are the taxes due on $250 of growth. Meanwhile, these same people are holding other investments that are earning anywhere from 1-10% per year and are fully taxable.
So what are the different options that a TFSA can be used for?
Short Term Savings – Completely contradictory to what I said above, this is one of the uses for a TFSA. It’s just not one we recommend unless the TFSA room isn’t needed elsewhere. You may choose to use this account for an “emergency fund” or a place to save up for annual expenses such as property tax or insurance. In this case, a high interest savings account probably does make sense.
Parallel Account to Your Non-Registered Investments – This is often the preferred use for a TFSA. Many investors have substantial savings in non-registered mutual funds or stocks. By setting up a parallel TFSA with the same company, you can transfer the maximum allowable amount over each year. You will have to pay tax on the capital gains of any amounts transferred but this allows you to spread out the tax bill over time. Once funds are moved over, there will be no further taxes due. The end goal is to eventually transfer the entire non-registered holdings over to the TFSA as room allows.
Aggressive Growth Account – Some investors like to take 5-15% of their portfolio and put it into more aggressive investments. They hope to take on a bit more risk and maximize gains but still want to be more conservative with the bulk of their portfolios. Putting this smaller amount into a TFSA will give you huge tax savings if you end up picking the right investments and seeing those big returns. You can set up a TFSA in this manner online and manage it yourself by picking your own selected stocks. Or you can set it up with your advisor and work with them to select some more aggressive investments that align with the rest of your investment plan.
The same poll quoted above also found that 40% of Canadians didn’t know the difference between their RRSPs and a TFSA. Both of these investment options have some great features and benefits but each are quite different. Often a blended strategy that has contributions going to both works well. The key is to understand the differences between these options and make sure you’re maximizing the potential of what your investments can do for you.