Last Updated: 9 November 2018 | Written By: Andrew Goldman
The government only introduced Tax-Free Savings Accounts, or TFSAs for short, in 2009, and since then, there’s been only one thing not to love about them: The name. It totally stinks. It sounds like the kind of savings account that you opened as a kid to hold birthday money and quarters you collected from the couch—an account that would yield about $.03 a year in interest. So, disabuse yourself of the notion that this is one of those; TFSAs certainly could be used as a savings account or to buy a GIC, but they’re in fact incredibly versatile vessels to hold just about any kind of investment.
They’re a lot like brokerage accounts, but with one notable difference; whatever you put in a TFSA grows tax-free. Say you invest a $1,000 in one, and by the time you retire, it’s grown to $3,000. When you withdraw the money, you pay absolutely no taxes on that $2,000 you made.
So unless you’ve got some odd moral quirk that doesn’t allow you to take free government money, you should absolutely open a TFSA. What you put in yours is entirely up to you.
Here’s a concise little guide to help you narrow down your TFSA investment options. We firmly believe that putting together a diversified, low-cost portfolio with an asset mix specifically suited to your goals and risk tolerance is the absolute best way to use your TFSA.
TFSA Investment Options
There are a few ways you can go about investing in a TFSA. The two main ways include the self-directed DIY method, where you decide what to invest yourself. The other approach is to have your TFSA investments managed for you by a financial institution. Here’s an overview of all your investment options for a TFSA:
- Self-directed TFSA
- Mutual funds
- Stocks & ETFs
- US Stocks
Are you the sort of person who would never in a million years allow anyone to put their hands on your Liatorp? If you’re the DIY type who does your all your own Ikea assembly, you’re probably also the kind of person who would open a self-directed TFSA, a term that simply means that rather than having any kind of professional management of your TFSA, you prefer to decide exactly what goes in and comes out of it at all times. While your local bank branch may specialize in selling TFSAs containing low-interest GICs or high-fee mutual funds, you’ll have absolutely no trouble locating a discount brokerage that will allow you to start trading whichever stocks, bonds, ETFs, and mutual funds you choose all by yourself.
In finding the ideal self-directed TFSA for your needs, pay attention to how much you’ll need to come up with to open the account and how much it will cost you to maintain it. Some online brokers will not allow you to open an account without a minimum deposit (commonly $1,000). Others may charge an annual fee of $100 or so unless you keep a minimum balance of $10-$25,000.
Since many online brokers make their money on trading fees, be wary of how much a broker charges per trade. Like checking accounts, some will provide a few free transactions then start charging for subsequent ones. Some discount brokerages provide free ETF trades, others do not. And also be aware of niggling little costs that add up quickly, such as ECN fees and “inactivity” fees. Fees are the enemy of investment growth and wise investors do whatever they can to eliminate as many as possible. Competition is so fierce these days that with a little shopping, you’ll be able to find an almost 100% fee-free self-directed TFSA with little or no account minimum.
Investing TFSA in Mutual Funds
You should always listen to your parents — except when they tell you to invest in mutual funds. There’s really nothing wrong with mutual funds. They employ lots of smart people. They might have done a good job of securing a tidy retirement for your parents or grandparents. But with the average management expense ratio of over 2% for Canadian mutual funds, you can now do much better investing in the same sectors, with likely better results over time, for a quarter of the fee by passive investing in stock ETFs.
As the number crunchers have shown over and over again, fees are predictive of returns; the higher the fees, the lower the returns. One Toronto-based investment advisor showed that a fee of just 2% could decrease investment gains by half over the course of 25 years. If you do turn to mutual funds, watch out for the fees.
How to Invest a TFSA In stocks
If you’re hoping to turn your small TFSA deposit into something that really grows over time, you’ll probably want some portion of your money invested in the stock market. Between the years 1950 and 2009, the stock market grew by 7% per year. That being said, for guaranteed returns in the future, you’ll have to go to Costco. All investments are speculative in nature, and past gains don’t guarantee future performance. Consider yourself warned!
Assuming you want to buy stocks, which ones? Just about everybody has a friend who has an uncle who knows a guy who invested $700 dollars in Amazon in 1997 and now owns his own continent. Less heralded but more prevalent are the tales of other guys who went all in on Snapchat and now can only afford to eat off fast food dollar menus.
The point is, stock picking is extraordinarily hard to do well, and tons of studies show that even professionals paid to pick stocks fail to outperform the market as a whole over the long term. For this reason, many of the greatest investing minds in history, like Warren Buffet and the father of Modern Portfolio Theory Harry Markowitz have long advised that a highly diversified portfolio maximizes investment upside and minimizes potential downside over the long term.
One of the cheapest, simplest way to diversify a stock portfolio is by buying ETFs. These may contain large numbers of stocks, bonds and real estate investments. Many track an entire economic sector or index, like the S&P 500, a task that can easily be performed by a computer algorithm. So one price could buy you a tiny sliver of the 500 most valuable companies on the stock market. Online investment providers allow you to invest in ETFs and typically charge lower fees than big banks or traditional investment providers.
Investing US Stocks in TFSA
US stocks are an incredibly popular way to harness the growth of our neighbour’s diverse economy. But do they have any business being in your TFSA?
Sophisticated investors will know that even though RRSPs and TFSAs are similar in the way they save you taxes, the tax authorities do not look on them as equals. America doesn’t tax dividends on US stocks in RRSPs, but they do assess taxes on dividends within TFSAs. (Our neighbours grant tax leniency to accounts intended specifically for retirement.)
Americans levy a 30% withholding tax on any US stock dividend, only half of which can be claimed as a deduction on your tax returns. So effectively, you’ll be paying a 15% tax on dividends. (Dividends should not be confused with the increase of stock prices, which would represent much, much more in taxes over the long term.)
So does this mean that your RRSP should only contain Canadian stocks? Not necessarily, no. As Toronto-based financial planner Jason Heath points out, because Canada’s economy is concentrated so heavily in natural resources and financial services, solely investing in Canadian stocks won’t provide you with the adequate diversification you’ll get from adding in a nice mix of US Stocks. Plus, according to Heath, the US stock market has returned 11.4% historically per year versus 9.6% for Canada’s since 1935, returns that would certainly justify the relatively low cost of those dividend taxes. If paying any tax is especially galling to you, consider investing in “growth” ETFs, since they’ll be dominated by stocks from companies that don’t pay dividends.
TFSA Stock Trading Rules
TFSAs being so new, there are still some aspects of the accounts that haven’t been entirely worked out. Like, how much stock trading does the CRA allow you to do within your TFSA? At present, there’s no clear answer to how much is too much trading, but if you’re on your iPhone trading tech and marijuana stocks in and out of your TFSA like it’s Candy Crush Saga, you’re probably headed for trouble. If you do enough trading within your TFSA the CRA might decide that you’re not just an amateur citizen investor but rather someone “carrying on a business,” that is, trying to earn a living through investing.
The CRA’s been reluctant to quantify what threshold would tip you from one category to another, but according to recent reports, the CRA says they know a tax dodger when they see one and will audit accordingly. In an audit, they’ll take into account trading volume, length of time equities are held, and how much time a person spends researching and trading. If they deem you to be trading professionally, you’re in for a cold dose of reality since 100% of all business profits are taxable. Lest you think this is some sort of fake-a-roo warning from the taxmen, The CRA has been publicly crowing that audits have brought in more than $75 million in unpaid business taxes.
TFSA Day Trading
Maybe you were too busy dumping your APPN positions to make way for a chunk of AMD to read the above, about how the CRA looks upon TFSA day traders. Come in real close so we can repeat the message for you a bit louder, whatever you do — don’t day trade in your TFSA!
If you do, a CRA auditor may show up at your doorstep looking very much like this. Some movement of equities in and out of an account is perfectly acceptable but use your head. If something’s wrong with your head, borrow the noggin of a trained investment or tax professional.
TFSA Investment Strategy
If you’re scratching your head wondering what’s the best TFSA investment strategy, follow these four simple steps:
- Create clear investment goals, for example, save $20,000 for a new car in three years or save $1,000,000 for retirement in 25 years.
- Have an investment plan that will help you achieve that goal. Start by figuring the return that you need, then design an investment portfolio that contains a mix of assets and savings that will likely yield the desired result. If you need help with this, use a robo-advisor or a financial planner.
- Watch your fees. They drag down your returns and over the course of a lifetime, high fees can add up to a significant amount of money.
- Stay disciplined. Don’t stop investing or saving because of bad performance. Increase your savings rate if you have to — the best way to do this is to grow your income.
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