Topic: How To Invest

3 proven ways to make the most of your tax free savings account

Every year, you gain an additional $5,000 of contribution room in your tax free savings account (TFSA). That means you have $10,000 of contribution room in 2010, rising to $15,000 in 2011, $20,000 in 2012 and so on. You also get to carry forward unused contribution room from previous years.

Tax-free savings accounts let you earn investment income — including interest, dividends and capital gains — tax free. But unlike registered retirement savings plans (RRSPs), contributions to tax free savings accounts are not tax deductible. However, withdrawals from a TFSA are not taxed.

Here are three tips you can use to make sure you’re getting the most profit — and tax benefits —from your tax free savings account:

1. Keep higher-risk investments out of your TFSA: Holding higher-risk stocks in your TFSA is a poor investment strategy. That’s because high-risk stocks come with a greater risk of loss. If you lose money in a TFSA, you lose both the money and the tax-deduction value of the loss. (Outside your TFSA, you can use capital losses to offset taxable capital gains.)

You’ll also lose the main advantage of a TFSA: sheltering gains from tax. You won’t have gains to shelter if the value of your investments falls.

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2. Let your current income help you decide between your tax free savings account and RRSPs: If funds are limited, you may need to choose between TFSA and RRSP contributions.

RRSPs may be the better choice in years of high income, since RRSP contributions are deductible from your taxable income. In years of low or no income — such as when you’re in school, beginning your career or between jobs — TFSAs may be the better choice.

Moreover, investing in a TFSA in low-income years will provide a real benefit in retirement. When you’re retired, you can draw down your TFSA first, then begin making taxable RRSP withdrawals.

3. Consider holding exchange-traded funds in your TFSA: Even though the limit is now $10,000, it’s still difficult to build a diversified portfolio within your TFSA. Instead, look to exchange-traded funds for TFSA investing.

We recommend a number of carefully selected exchange-traded funds in our Canadian Wealth Advisor newsletter. You get a subscription to Canadian Wealth Advisor, along with our other three investment publications, when you become a member of Pat McKeough’s Inner Circle.

Stick with our picks for long-term TFSA investing

Over the years, as the value of your TFSA increases, you could switch to a portfolio of conservative, mostly dividend-paying stocks spread out across the five main economic sectors (Manufacturing & Industry, Resources, Finance, Utilities and Consumer).

You could pick from the stocks we recommend in our newsletters, including the 19 companies in Canadian Wealth Advisor’s Safety-Conscious Stock Portfolio. It’s one of three portfolios the newsletter offers to conservative and income-seeking investors (the other two are the Index Fund and ETF Portfolio and our Safety-Conscious Income Trust Portfolio). We continually monitor and update all three portfolios.

Members of Pat McKeough’s Inner Circle get Canadian Wealth Advisor and our other three publications: The Successful Investor, Wall Street Stock Forecaster and Stock Pickers Digest, every month. Plus, you get to ask us about stocks or other types of investments you’re considering buying (or selling). Click here to learn more.