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A tax-free savings account (TFSA) is a fantastic way to earn money on your savings, without having to pay tax on those earnings. Registered by the federal government, TFSAs are available to Canadians aged 18 and older. Unlike a Registered Retirement Savings Plan (RRSP), you cannot deduct contributions to your TFSA from your income tax, so you will have to pay income tax on that initial money. But as long as you adhere to TFSA guidelines, you won’t pay taxes on any earnings made within the TFSA, not even when you withdraw it. Plus, you can withdraw as much as you want at any time.
There’s a specified limit to how much money you can put inside a TFSA. For 2020, the annual TFSA contribution limit is $6,000, and there is a lifetime maximum of $69,500 for those who were 18 or older as of 2009. The good part is that any unused contribution space and any amount that you withdraw from your TFSA becomes available to you as contribution room in the next calendar year.
Even though the word ‘‘savings” is in the name, it’s actually better to think of TFSAs as investment accounts, rather than simply a savings account. You can certainly have a savings account within a TFSA, but the real potential for tax-free earnings is maximized by keeping other kinds of investments inside a TFSA. We’ll go through the different options that are available to you.
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Types of tax-free savings accounts
Let’s break down each of the kinds of investments that can be used within a TFSA, see how they differ, and consider what to keep in mind when choosing which one is the best for you and your financial goals.
TFSA Savings accounts
These are the most basic types of TFSAs. In order to set up a savings account within a TFSA, you simply have to contact your financial institution and provide your social insurance number along with other identification s to ensure you are an adult Canadian resident for tax purposes. It is also worth shopping around to see which bank or credit union offers the best interest rate on savings accounts. Many will advertise higher rates for the first few months to attract new business.
One big advantage of this kind of TFSA is that it is incredibly easy to set up. If wrapping your head around how to go about investing your money is preventing you from opening a TFSA, then you might as well set up a basic savings account for now. Remember, even if you can only afford to deposit the minimum amount (can be as low as $25), any unused allowable contributions will carry forward to the next year, so the sooner you open your account, the more money you will be able to invest down the road. Even better: arrange for automatic deposits to your TFSA savings account, say, monthly or each time you get paid.
It is also a very safe, almost no-risk, way of squirrelling away money. If you are uncomfortable with the idea of taking any risk whatsoever with your investment principal, this could be a good choice for you. Even high-interest savings accounts, however, have a very low rate of return when compared to other kinds of investments. You would be looking at an interest rate topping out in the 2% range. And beware that some savings accounts offer interest rates even lower than the rate of inflation, so any money you deposit will have less purchasing power in the future when you withdraw it.
TFSA Guaranteed Investment Certificates (GICs)
In a nutshell, Guaranteed Investment Certificates (GICs) guarantee a certain interest rate on a given investment for a specified period of time. A one-year GIC might pay 1%, for example, while a 5-year might pay 2.5%. Traditionally, when you cash out your GIC earnings at the end of the term, you have to pay tax on the interest you’ve earned. But with TSFA GICs, the interest you earn is tax-free. You can open a GIC within a TSFA with most major lenders within Canada, including banks and credit unions.
There are two types of TFSA GICs offered by most banks: cashable/redeemable and non-redeemable. Just the way it sounds, cashable/redeemable GICs offer the flexibility to cash in your investment at any time, while non-redeemable GICs are locked in for the entire fixed term.
Cashable/redeemable GICs trade flexibility for lower interest rates while non-redeemable GICs reward your commitment with higher rates. If you think you might need access to your investment, for example, then the cashable/redeemable option might be right for you.
But if you have a clear idea of your investing timeline, you can choose a fixed term that aligns with when you’ll need the money. (Getting married in 14 months? Choose a 1-year GIC, which will mature just before you need the cash.)
If you are in a place in your life where you are comfortable with your investments being off-limits for some time, then the non-redeemable choice makes the most sense.
Consider laddering a series of GICs to reduce the chance of locking in your money at a less-than-optimal interest rate, and also ensure that you have locked-in money becoming accessible to you at regular intervals.
An example of GIC laddering is buying a GIC that matures in one year, another that matures in two years, and yet another that matures in three years, all on the same day.
GICs offer a very safe, low-risk form of investing with two major drawbacks. One, their rate of return is still lower than other forms of investing. Two, the earnings from a GIC are fully taxable at your top marginal income tax rate. By keeping GICs within a TFSA, low-risk investors are able to avoid paying that high tax and have the peace of mind of a secure nest egg.
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Exchange-traded funds ETFs
ETFs are investments that consist of a collection of securities, such as stocks or bonds, that can be traded like individual stocks, through a brokerage. They offer the flexibility of stocks in that they can be quickly and easily sold, along with the diversification of mutual funds.
ETFs are typically pegged to follow a particular market index and can be fairly hands-off compared to mutual funds, resulting in management fees—and more of the funds’ upside returns in your pocket. They are, however, more hands-on than savings accounts or GICs, and may require occasional recalibration, which may be more than some people want to manage.
Investing in ETFs within a TSFA is a good choice for a moderate return on investment with moderate risk. There are also so-called robo-advisors such as Wealthsimple Invest*, Questrade* and Modern Advisor, which will consider your goals and appetite for risk and align that to a computer algorithm that will manage your ETFs for very low fees.
ETFs do tend to track the stock market as a whole which means your investment could be subject to more volatile ups and downs than the more conservative investment options, like GICs. They do tend to pay a significantly higher return over the long term than savings accounts or GICs.
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Stocks/equities and bonds
Investing in stocks and bonds within a TFSA is definitely a more advanced financial strategy that should be considered by those with some understanding of the stock market and a stomach for moderate-to-high risk. As a whole, the stock market grew by 7% between 1950 and 2009. There were people who made much more than that, and those who lost everything.
Still, for those who want the chance at a sizeable return on small investments, the stock market is their best shot. Since TFSAs contributions are capped at $6,000 a year (and if you are someone who thinks that is not a lot of money to invest), you may want to consider carefully investing in stocks and bonds that are traded on the open stock market. You can also hold foreign investments, but beware that these investments have different tax rules that may require you to pay some tax, even though you’re holding them inside your tax-sheltered TFSA. For example, if you purchase dividend-paying U.S. stocks inside your TFSA, the dividend income subject to 15% withholding tax.
Note that TFSAs are for personal long-term savings and are not intended to be used by businesses. If you are found to be actively trading stocks in and out of a TFSA, the Canada Revenue Agency (CRA) will be within their right to impose a stiff penalty. Instead, find a financial planner or use an online brokerage such as Wealthsimple or Questrade to invest.
From a tax-savings perspective, you should consider that there is less of an advantage to investing in stocks (equities) inside a TFSA. That’s because only 50% of the capital gains—the growth in value of your stocks—are taxed, and you only pay tax when the shares leave your hands, either by selling or deemed disposition (such as transferring them into a different account).
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TFSA Mutual funds
Mutual funds are among the most popular investments in Canada. They are basically a diverse collection of stocks, bonds or commodities (or a combination thereof) that are managed by a portfolio manager or financial institution. When you invest in mutual fund shares, you become a part owner of the larger fund. And, as with all TFSA investments, the money earned on mutual fund investments within a TFSA will not be taxed.
You can open up a TFSA mutual fund through your own bank or financial institution, with independent portfolio managers or through a robo-advisor. Since they are managed, mutual funds have higher fees than ETFs or self-managed stocks.
There are a number of funds to choose from, with higher or lower levels of risk to align with your own risk tolerance. They offer a solid hands-off option with professional guidance for long-term investments and are easy to buy and sell if you need access to your investment at any point. But do make sure to consider how the management fees will impact your rate of return.
Contributing to your partner’s TFSA
There’s no such thing as a joint TFSA. Each TFSA must be opened in one person’s name. For couples who pool their finances, however, it is possible to use TFSAs as a means of maximizing retirement savings and lessening your tax burden in retirement. You cannot directly deposit money into your partner’s TFSA, but you can give them money which they can then contribute on their own.
They do not need to have earned any income that year in order to make a contribution. So if you’ve maxed out your TFSA contribution for the year, but your partner hasn’t, this is a good way to maximizing the tax-free investment potential for both of you.
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