Saving money is a big deal. It sets you up for success and can build confidence in all aspects of your life. But how do you know where to start? Are you supposed to be using a bank account or are there better options available?
In Canada, we have RRSP’s and TFSA’s that each have unique advantages for saving and building your wealth. RRSP’s are designed for long-term retirement savings. Contributions are subtracted from your income and can give you a tax refund. Then your money grows tax-free until you start withdrawing it in retirement. TFSA’s give you a lot more flexibility and can be used for a variety of savings goals. You don’t get the tax refund, but you do get the tax-free growth with none of the withdrawal penalties. Today we’re going to focus on TFSA’s and how to ensure you are choosing the TFSA investment options that give you the best bang for your buck.
Savings Account is a Misnomer
The most confusing thing about the Tax-Free Savings Account is that whole ‘Savings Account’ thing stuck right there in the name. I know when I think of a savings account I think of a bank account that’s going to earn me next to no interest and is basically a dumping ground for my short-term cash needs. They are a necessary evil but should not to be confused with the cool new(ish) kid on the block.
TFSA’s are SO MUCH MORE than your average bank account!
To eliminate the confusion let’s go ahead and implement a name change (I have that sort of power right?) Out with the Tax-Free Savings Account and in with the Tax-Free Investment Account.
So. Much. Better. (If only I could flick a switch and change it all over the internet)
The thing that sets your tax-free account ahead of a boring old bank account is the fact that you have a wide range of investment options available. We’re talking stocks, bonds, funds, GIC’s, ETF’s, etc. All those goodies are going to help grow your contributions and get that whole tax-free growth thing working for you.
Bank accounts = Cash
TFSA’s = Investments
The Tax Advantage
The reason TFSA’s are so beneficial is that they allow your money to grow tax-free. The key word here is ‘grow‘. To get the benefit, you need to get the growth. And that means investing. There’s a time and a place for cash, and it’s not in your TFSA. It’s not a terrible thing, but it’s just not going to do you any favours.
I’m going to back that up with some numbers and a comparison of two TFSA investment options. Even if you take it one step up from straight cash and move into a high-interest savings fund, you’re maybe looking at an interest rate of 2%. If you invest $10,000 and earn 2% over one year, you will have earned $200. If that were in a bank account, you would pay tax at your marginal tax rate. Just for the sake of numbers, we’ll assume your tax rate is 30.5%. That would be a tax bill of $61, or a tax savings of $61 if it were in your TFSA.
Instead, what if you invested that $10,000 in a stock that earned 10% in one year? The gain on that, if you were to sell it, would be $1,000. Now, because you’re selling a stock, you don’t have to pay tax on the full amount. It’s considered a capital gain, and you are only taxed on half the amount. You would be left with a tax bill of $152.50 at that same 30.5% tax rate. And that’s just over a one year period. You’re not always going to be hitting 10% returns on your investments, but you can see how the tax savings are kind of a big deal.
TFSA Investment Options
There are very few limitations on what you can hold in your TFSA, and most of those are things that the average investor wouldn’t be dealing in any way. An example of a prohibited holding would be shares of a company you have a significant (10% or more) interest in. Pretty much anything else goes though; GIC’s, mutual funds, stocks, bonds, ETF’s. If you can buy it on a Canadian market, you can almost always hold it in your TFSA.
Optimize Your Usage
Whether you are saving up for something happening in two years or something that’s still thirty years down the road, a TFSA is a good option. Unlike an RRSP that has retirement right there in the name, your TFSA is a way more flexible option for saving money.
I’ve talked before about when you should contribute to an RRSP versus a TFSA. The determining factor is your income. You’ll see the most significant benefit from an RRSP by contributing in your highest earning years. Not there yet? A TFSA should be your BFF. There’s no reason why you can’t use your TFSA to save for retirement. You can even move money from your TFSA to your RRSP at a later date when it makes more sense. It’s a one-way street though; you can’t go back without getting dinged with tax.
What about as an emergency fund?
You should keep your emergency fund in high-interest savings or a low risk, easily accessible investment. The purpose of that money is to cover you in the case of a job loss, a leaky roof, or emergency surgery after your dog swallowed a sock. The last thing you want is to have to withdraw your emergency fund when the markets are tanking. As we already discussed, the benefit of a TFSA comes when there is growth, and you’re not going to see much growth in your emergency fund.
However, I’m going to guess that many of us have more than enough room available in our TFSA’s. As of 2018, the total contribution room is $57,500 (as long as you were 18 when they were created in 2009). That’s a lot of money for most millennials. So yes, you’re not going to get the full benefit of a TFSA if it’s not earning very much. But it’s also not going to hurt to use it if the room would be sitting empty either way.
Personally, I keep my emergency fund separate for simplicity, but there’s nothing wrong with using your TFSA (or a portion of it) as long as you have the room. You will want to make sure you are being careful about contributions and withdrawals. The rule is that you can replace any withdrawals, but not until the following calendar year. Making frequent deposits and withdrawals can make it more challenging to track. If you’re still way under the contribution limit, it’s not necessarily a big deal, but the CRA has very strict penalties for over-contributing, so you don’t want to get on their naughty list. This is also a reason to limit the number of TFSA’s you have. You are allowed to have as many as you want but having more than one can cause confusion.
To sum up, TFSA’s are best for investments that you expect will increase in value. The benefit is not having to pay tax on that growth like you would in a non-registered account. Instead of wasting your TFSA contribution room by holding a cash position, it makes more sense to save it for your growth-oriented investments.
How do you use your TFSA? Are you fully invested, partially, waiting to win the lottery to get started? Let me know in the comments.
This post was proofread by Grammarly.