Where does the TFSA fit into my overall financial plan?
It has been 14 years since the tax-free saving accounts (TFSA) first came into effect. The results of this RBC survey indicate that Canadians may not fully understand where, in relation to their overall plan, the TFSA fits. From our conversations, we believe the confusion, at least in part, is due to the name itself: TaxFree Savings Account. Specifically, the combination of the words “savings” and “account”. A “savings account” has traditionally been used with a short-term purpose in mind and may have earned a modest amount of interest.
But the TFSA is not a simple savings account. Canadians would be better served by thinking of the TFSA as an investment account. We believe a more appropriate name would in fact be, Tax-Free Investment Account. Let’s start with the basics…
The Basics
Since 2009, TFSA contribution room has accumulated for each year in which you were at least 18 years old and a resident of Canada. Your TFSA contribution room is cumulative and unused room is carried forward indefinitely to future years. As of January 2022, if you have been a resident in Canada and at least 18 years old since 2009 (and have not yet contributed to a TFSA), you would be able to contribute $81,500.
Stocks, bonds, mutual funds, GICs, Exchange Traded Funds (ETFs), and cash can be held within a TFSA. The growth earned on investments within the TFSA – capital gains, interest, or dividends – is not taxed in the year in which they were earned or when you make withdrawals. The withdrawal amount is also not included in your income for tax purposes. Unlike a Registered Retirement Savings Plan (RRSP), you cannot deduct your TFSA contributions from your taxable income. Where the RRSP is a tax-deferral plan, the TFSA is a tax-free plan.
Another misconception is that you can only open a TFSA with your bank branch. You can open a TFSA with most financial advisory firms and it usually makes sense to do all your planning with one firm.
Within my TFSA, what should I invest in?
We have already pointed out that with a TFSA you can invest in stocks, bonds, mutual funds, GICs, and Exchange Traded Funds (ETFs). So which investment or combination of investments are best suited for my TFSA? The answer to this question depends on factors such as age, risk tolerance, objective, and retirement income sources to name a few. Depending on the circumstances, the strategies in each example below may be used as part of a comprehensive financial plan. It’s been our experience that most people fall in to one of the first two examples. Let’s look at three simple examples comparing a TFSA with a RRSP:
Example 1: Investing your TFSA the same as your RRSP
Risk tolerance is a gauge of your comfort level with variability in your investment returns. In most cases, investing has a long-time horizon. You need this money to last for a long time. There is a lot of data that demonstrates that successful long-term investing doesn’t happen by buying and selling (also known as market timing), but by formulating a plan and sticking with it through the good times and the bad. If you see the return in one of your accounts go below a level that you feel comfortable with, which may cause you to react by selling, this sabotages the long-term plan. Therefore, it makes good sense to have each of your investment accounts invested in line with your risk tolerance. This may help you stick to the plan when the stock market inevitably goes through periods of turbulence.
Example 2: Investing your TFSA more aggressively than your RRSP
Growth within a TFSA is tax-free whereas growth within an RRSP is tax deferred. This distinction is an important one. Combining this understanding with the fact that, historically, stocks have outperformed bonds, and it may also make some sense to expose your TFSA to more equities. You can participate in the longer-term growth and then withdraw the growth tax-free. If you keep your overall investment portfolio in line with your risk tolerance, this strategy may be for you.
Example 3: Investing your TFSA less aggressively than your RRSP
You may not have the need or the ability to use your TFSA for a long-term purpose. Therefore, you may want to use your TFSA for a short-term goal. The shorter the end point of your goal, the less volatility you will want to expose your money to.
Additional considerations
Any amount you withdraw from your TFSA will be automatically added to your TFSA contribution room for the following year (but not the same year it is withdrawn). This is an important distinction for those at or near their contribution limits. Neither income earned in your TFSA, nor withdrawals, will affect your eligibility for federal incometested benefits, such as the Canada Child Tax Benefit and the Guaranteed Income Supplement. TFSA contribution room starts to accumulate when you turn 18 regardless of the age of majority in your province but you can’t open a TFSA until you are the age of majority.
In Canada, the age of majority is different depending on where you reside:
- 18 years of age – AB, MB, ON, PEI, QC, SK
- 19 years of age– NS, NB, NL, BC, or any of the three territories
For example, in Nova Scotia, you can’t open a TFSA until you are 19, but you will have two years’ worth of room when you open a TFSA at 19.
Summary
The TFSA is a great tool for building wealth and with a total contribution room in 2022 of $81,500, it is becoming a larger part of people’s portfolios. Investors are becoming less likely to use their TFSA for play money and rightfully so. The TFSA is an important piece of your overall financial plan.
