Your guide to tax-free savings accounts

Tax free savings accounts let you earn investment income tax free. Make sure you’re getting the most profit and tax benefits from your TFSA.

The federal government first made the tax free savings account (TFSA) available to investors in January 2009. These accounts let you earn investment income—including interest, dividends and capital gains—tax free.

You can now contribute a maximum of $6,000 to your TFSA each year. However, if you have not contributed in the past, or did not meet maximum contributions in any given year, you can catch up on unused contributions. (Maximums were $5,000 per year from 2009 to 2012, $5,500 per year from 2013 to 2014, $10,000 in 2015, and $5,500 in 2016, 2017 and 2018. The limit then rose to $6,000 in 2019 and 2020.)

That means that if you hadn’t contributed yet (and were 18 years or older in 2009) you could contribute up to $69,500 in 2020.

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 TFSAs are not tax deductible. However, withdrawals from a TFSA are not taxed.


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3 tips to make the most of your tax free savings account

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

  1. Avoid putting higher-risk investments in 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.
  2. Your current income can help you decide between your TFSA and your RRSP: 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. Your TFSA is a good place to hold exchange-traded funds (ETFs): The overall contribution limit is $69,500, so you could build a diversified portfolio of conservative, mostly dividend-paying stocks spread out across most if not all of the five main economic sectors (Manufacturing & Industry, Resources, Finance, Utilities and Consumer). However, you could also look to exchange-traded funds for TFSA investing.

Use your tax free savings account to complement your RRSP

Your TFSA can generally hold the same investments as an RRSP. This includes cash, mutual funds, publicly traded stocks, GICs and bonds.

Contributions are not tax deductible, as they are with an RRSP. However, withdrawals from a TFSA are not taxed. This makes the TFSA a good vehicle for more short-term savings goals.

If funds are limited, you may need to choose between RRSP and TSFA contributions. As mentioned above, 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.

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.

Hold low-risk investments in your tax free savings account

We think you are best to hold lower-risk investments in your TFSA. That’s because you don’t want to suffer big losses in these accounts. If you do, you can’t use those losses to offset 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.

If you are just starting a TFSA, and are nowhere near the $52,000 limit, you can’t yet build a diversified portfolio within your account. That’s why you are best to hold lower-risk and low-fee investments like ETFs. You could also hold interest-bearing investments, like high-yield savings accounts such as those from President’s Choice Financial or Tangerine, or index funds.

A tax free savings account-friendly index fund

One example of a suitable index fund is the iShares S&P/TSX 60 Index ETF (Toronto symbol XIU), which we follow in our Canadian Wealth Advisor newsletter. The fund’s units are made up of stocks that represent the S&P/TSX 60 Index, which consists of the 60 largest, most heavily traded stocks on the exchange. Most of the stocks in the index are high-quality companies.

The units trade on the Toronto exchange, just like stocks. Prices are quoted in newspaper stock tables and online. You’ll have to pay brokerage commissions to buy and sell them, but you will quickly make these back because of the low management fees, which are just 0.18% of the fund’s assets.

Take the long view with TFSAs

Over the years, as the value of your TFSA increases, you could switch to a well-diversified portfolio of conservative, mostly dividend-paying stocks, or ETFs that hold those stocks.

Follow our three-part Successful Investor strategy

  • Invest mainly in well-established companies;
  • Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; the Consumer sector; Finance; Utilities);
  • Downplay or avoid stocks in the broker/media limelight.

Are tax free savings accounts part of your investment strategy? Share your experience with us in comments.

Comments

  • Good advice Pat. You might also point out that with TFSAs, there are no tax treaties with foreign countries, therefore NEVER hold dividend paying issues from outside of Canada in your TFSA. Any tax withheld by a country other than Canada cannot be recovered (as they are with RRSPs RIFs LIFs etc. If one is buying a foreign stock purely for capital gains, they “might be” appropriate for a TFSA.

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