We have mentioned the TFSA in a lot of our articles. In fact, some of our articles specifically talking about TFSA’s are our most viewed pieces. For example, check out You Should be Maxing Out Your TFSA.
The name Tax-Free Savings Account is a little misleading and oversimplified. We would argue that a more suitable name would be Tax-Free Investment Account. You might be asking, why? Well below we hope to answer that question as well as effective ways you should be using your TFSA.
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TFSA or TFIA?
Calling it a Tax-Free “Savings Account” is a little too simplistic in our opinion. When people think of savings accounts, we often think of our High-Interest Savings Account (HISA) at the bank. However, the capabilities of a TFSA are far more complex.
For instance, in a HISA or daily interest savings account you are at the whim of the financial institution. They might advertise that their savings accounts have a rate of 1.75%. Well, not surprisingly, if you put money into that account, it will generate 1.75% of interest. If that is all you are looking for, than it might be a suitable fit for you.
On the other hand, with a TFSA, the type of investments you can hold is extremely diverse. According to Canada.ca, the list of eligible investments includes:
- Guaranteed Investment Certificates (GICs)
- Mutual Funds
- Securities listed on a designated stock exchanges
- Certain shares of small business corporations
With such a diverse investment selection, the returns that are generated can be completely different from person to person.
Even if you were happy with the 1.75% guaranteed return of the HISA, you would be better off using a TFSA. Within the it you can hold High Interest Savings vehicles from many different institutions. At the bank or credit union, only in-house savings vehicles are available.
Secondly, by holding it in the TFSA the interest generated is tax free. Using just a regular HISA, any interest generated must be reported on your tax return.
If even in the most basic scenario, TFSAs are more effective, what are other ways you can use your TFSA?
As we mentioned above, you could use a TFSA as an alternative to your HISA. However, this may not be the most effective use of it. Other potential uses include:
- Retirement savings
- Emergency fund
- Saving for a specific goal
- Saving for final expenses
There are many ways that a TFSA can be used. However, some are more efficient than others.
If you are young, in a low tax bracket, and expect to make more money in the future, a TFSA should most likely be your primary savings vehicle. This will allow you to save for retirement or other goals while leaving your RRSP contribution room for a time when you’re in a higher tax bracket.
Maybe you’re older and have maxed out other retirement savings accounts. A TFSA is a great way to save more for retirement completely tax-free. Additionally, money withdrawn from the Tax-Free Savings Account is not included in your income. So means tests for retirement or other government programs are not affected by TFSA withdrawals.
Using the TFSA as your emergency fund is a great option too. If your emergency fund is inside a non-registered account that withdrawal will be taxed. A withdrawal from a Tax-Free Savings Account, as the name suggests, is completely tax free.
So what should you hold in your TFSA?
Well, we won’t tell you exactly what to buy on our blog, for that you should visit your investment advisor. However, some investments generate more tax-efficient returns; dividends, or capital gains.
Assuming you have maxed out your RRSP, TFSA and have non-registered investments there are ways to optimize your holdings. Investments that are already tax efficient, i.e., dividend or capital gains are better suited for non-registered investment accounts than interest barring investments. But as mentioned earlier, you should sit down with your financial planning professional to determine what asset mix is best for you and where you should hold what.
A Word of Caution
Before you go open a TFSA, here is a word to the wise. Do not use it as a trading account. A fair number of people have “fun-money”; Money that they invest on their own or use to day trade. There is nothing wrong with this. However, it should not be done inside a TFSA.
If a TFSA is used as an active trading account it will lose its tax-free nature. CRA will deem that to be business income rather than investment income. This means that income tax will have to be paid just like it would on a non-registered investment account.
For more information on the basics of a TFSA like contributions and withdrawals, check out A Beginners Guide to The TFSA.
In the end no matter what life stage your in, utilizing your TFSA is a must. Whether it is used for short term savings, emergency fund or retirement savings, the benefits are worth it.
If you want to partner with someone to develop a financial plan and figure out how you can maximize your TFSA room, contact us. The earlier you start with your financial plan and building good habits the further ahead you will be in the future.
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Disclaimer: This Forbes Wealth Blog is for informational purposes only and does not constitute financial, legal, or tax advice of any kind. Please consult your legal, accounting, tax, investment, banking, and life insurance professionals to get precise advice relating to your particular situation before acting upon any strategy