Happy New Year savers. A new year means more Tax Free Savings Account (TFSA) contribution room. Here are some fast facts about the TFSA and how you can benefit from this magical account.
The Tax-Free Savings Account (TFSA) is a flexible, registered, general-purpose savings account* that allows Canadians to earn tax-free investment income. The TFSA complements existing registered savings plans like the Registered Retirement Savings Plans (RRSP) and the Registered Education Savings Plans (RESP).
This is MUCH more than a general-purpose savings account*
The main advantage of a TFSA: tax-free growth and tax-free income earned inside the TFSA.
How the TFSA works:
- As of this year, Canadian residents, age 18 and older, could have contributed up to $46,500 into the TFSA if they haven’t opened the account yet.
- Growth and investment income earned inside the account is tax-free.
- Withdrawals from a TFSA are tax-free.
- Full amount withdrawals can be put back into the TFSA in future years. Re-contributing in the same year may result in an over-contribution amount which would be subject to a penalty tax.
- Contributions are not tax-deductible.
- Neither income earned within a TFSA nor withdrawals from it affect eligibility for federal income-tested benefits and credits, such as Old Age Security, the Guaranteed Income Supplement, and the Canada Child Tax Benefit.
- Funds can be given to a spouse or common-law partner for them to invest in their TFSA.
What should you put inside your TFSA?
I suppose the answer (as always) should depend on your financial plan and goals. Plans should probably come before products. That said, given you have your financial goals understood I personally believe equities should be inside the TFSA. Sure you could use your TFSA for your cash emergency stash or holding a bunch of bonds or fixed income investments but I think most Canadians could benefit from long-term, tax-free, growth inside this account. Heck, even for many retirees, they may want to consider equities. Not convinced? Here is what our new Finance Minister wrote in his recent book The Real Retirement:
- Studies indicate government bond yields go through cycles lasting about 60 years: 30 years for the uptrend and 30 years on the other side. If the theory holds true, yields have “virtually no room to move further downward, thus no capital gain opportunities remain”.
- “Actuaries estimate that real returns on bonds over the next 25 years will average between 1 and 1.6 per cent depending upon the term of the bond”.
So, back to the question, what should you put in your TFSA for 2016? Consider these options.
- Canadian Dividend Paying Stocks
Canadian dividend-paying stocks receive favourable tax treatment from our government; they are eligible for the Canadian dividend tax credit if left unregistered (outside TFSA and RRSP accounts). But we are talking about the TFSA right? Although Canadian dividend paying stocks will lose the dividend tax credit inside the TFSA you’re still getting tax free dividend income inside the account for as long as those companies pay dividends. Staples within my portfolio include Canadian banks, telecommunication companies and utilities inside the TFSA for the foreseeable future.
- Canadian Exchange Traded Funds (ETFs)
An Exchange Traded Fund (ETF) is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as a stock index or bond index. An index is a group of stocks or bonds used to measure the performance of a particular market – such as the S&P 500 stock index – you’ve probably heard of that one. Not all indexes are created equal though.
So, what are the benefits of ETFs, specifically those that track a broad market equity index? Here are a few:
- Index-like returns
- Income in the form of distributions
You might already know from my blog, I’m a hybrid investor. I invest in a number of dividend paying stocks for growing passive income and I also invest (more) using ETFs for better diversification. I think low-cost Canadian ETFs, like XIU, XIC, VCN, VCE, and a few others, those that track a broad index, are a great long-term fit for any TFSA.
- Canadian Real Estate Investment Trusts (REITs)
Canadian REITs are companies that invest in real estate assets and distribute their income (primarily from rent) to shareholders, usually in the form of dividends, return of capital, and income. While it depends on the REIT, if the REIT distributes a portion of their income as return of capital, interest, capital gains or dividends, each portion will be taxed accordingly. Keeping REITs inside a TFSA avoids this tax complication. Many Canadian REITs have dropped significantly in price over the last year, which makes them an interesting buying point for those that like investing when there’s “blood in the streets”.
- British American Depositary Receipts (ADRs)
You might already know this but it’s worth mentioning, there are 15% withholding taxes on U.S. stock dividends paid inside a TFSA – this is why I did not list U.S. stocks or U.S. ETFs for your TFSA in this post. If you’re going to own U.S. stocks or U.S.-listed ETFs, probably best to put them inside your RRSP. However, British ADRs traded on the New York Stock Exchange have no dividend withholding taxes.
In the end, what you invest in is your decision and your responsibility. If I had my choice, and I do, I’ll focus on Canadian content via some individual stocks and ETFs for my TFSA this year. I’ll be taking the long view with my investments inside this account and I’ll avoid making any speculative plays with penny stocks or junior mining companies. That’s my game plan, what’s yours?
What are your investments for the TFSA?