Mystery of the TFSA, Solved
The TFSA is one of the most misunderstood accounts amongst Canadians. That's a shame because it has so much potential to add a financial cushion to retirement. This article aims to solve the mystery of what a TFSA is so that Canadians can start using them to their benefit.
What is the TFSA?
Think of a TFSA or tax-free savings account as a basket that holds different investments. It could include any combination of cash, HISA, stocks, bonds, ETFs, mutual funds, GICs and more. Anything within that TFSA basket gets treated in a special way. Specifically, they enjoy tax-free growth and tax-free withdrawals.
There is more to a TFSA of course, including estate planning and contribution and withdrawal rules. For all intents and purposes of this article though, the most important thing to know is that tax-free growth is its most powerful feature.
HISA In Disguise
Things get confusing for consumers with banks offering a TFSA basket with only one item - a savings account with a fixed rate of interest. In fact, this type of product helps reinforce the mistaken belief that a TFSA is just like a regular savings account, but with slightly higher interest and a tax-free feature.
What banks are really offering is a High Interest Savings Account (HISA) in disguise. Sure, they throw the HISA into a TFSA "basket" to provide the tax-free growth, but it loses the benefit of its main feature: tax-free growth. Since HISAs only offer a fixed rate of interest, the potential for higher returns and more compounding gets lost.
There is a place for a HISA within a TFSA (more on this below), however, it shouldn't make up the majority of what's held inside a TFSA basket.
The TFSA Is for Long-Term Saving
The TFSA was specifically created by the federal government to help Canadians save and grow money for the future. Primarily, for retirement.
Consider these 2 key features of the TFSA:
- Just like the RRSP, the TFSA can hold any combination of stocks, bonds, GICs, ETFs, mutual funds and more. This provides an opportunity for growth far beyond what a fixed rate could offer over time.
- Growth is allowed to compound within the account tax-free, forever. This powerful feature alone indicates that money is meant to stay invested in the account for a long time.
Also, consider some of the rules around using a TFSA:
- Annual contribution limit
- Limit on total contribution room
- Amount withdrawn cannot be replaced in the same year
- Over contributions come with a financial penalty
Does this sound like a regular savings account? Unlike a HISA, the TFSA is not meant to be used for depositing and withdrawing money regularly. It was specifically built for long-term saving, hence, all the rules.
It’s worth repeating: the TFSA should be used for long-term saving, which means it needs to hold investments (ETFs, stocks, bonds), not cash.
Exceptions To the Rule
Admittedly, using the TFSA to hold cash with a fixed rate of interest (like a HISA) or holding a GIC within a TFSA for short term saving might be advisable in certain circumstances.
One common scenario is when a person is saving for a down payment on real estate that they plan to buy in the next 1 to 5 years. In this case, if they have the TFSA contribution room, they might as well protect their cash from tax by holding it in a HISA within a TFSA. This protects their capital and provides tax-free growth, however small.
Once the home is purchased though, the focus should be on long-term saving. Their next move should be to open a TFSA that can hold investments. (You can have more than one TFSA, as long as the total contributions between all accounts do not exceed your limit).
Another common scenario is retirees who use the TFSA for travel, major purchases or to supplement retirement income. In this case, it might make sense for them to hold a portion (not all!) of their money in a HISA within a TFSA to ensure the capital is there when they need it. In other words, if markets are down when they want to travel, they will have the funds they need.
How Do You Invest in a TFSA?
Believe it or not, this is the easy part. If you already use a financial advisor to invest, then get in touch with them about opening a TFSA. You can also open a TFSA through a discount brokerage, bank or credit union.
Once the account is open, a financial advisor will ask you some questions about your financial goals (retirement I hope!) and timelines to determine what your TFSA basket should hold. Someone who is 20 to 30 should invest more aggressively than someone who is 50 to 60, for example.
After that, the best way to start building wealth inside your TFSA (or any account for that matter) is with regular and automatic contributions.
RRSP or TFSA?
It’s worth noting that the RRSP is still one of the best ways to save for retirement. Plus, the RRSP can be used to purchase a home with the Home Buyer's Plan (HBP). And yes, the HBP and FHSA can be used together, giving a prospective buyer access to up to $75,000 (per buyer) for a downpayment between the two programs.
Deciding whether to save in the RRSP or TFSA (or both) depends on things like income, age, employer retirement plans and personal goals. It’s best to speak with a financial advisor first, before deciding which accounts to use for retirement saving and how to allocate available funds.
The Most Important Thing About the TFSA
The important thing to understand about TFSAs is that in most cases, they should not hold too much cash. Use the powerful tax-free growth feature to it's fullest potential by holding growth-oriented investments.
Once you open a TFSA, you’ll need to deposit cash and then buy investments with the cash. If you use a financial advisor, they will buy the investments for you. If you use a discount brokerage, you’ll need to buy the investments yourself. By the way, the most common mistake with self-directed investors: depositing cash into their TFSA and thinking they are done, when in fact they are making zero dollars. Don’t make this mistake!
Here’s a recap of the main take aways in this article:
- Use the TFSA to hold investments (not cash!) for the long-term to take advantage of compound tax-free growth.
- Use a GIC or HISA to hold cash for short term savings.
- Consult with a financial advisor about whether the RRSP, TFSA or both is your best option for retirement savings.
- Automatic and regular contributions to all types of accounts will help you achieve your goals.
If you have a TFSA but aren’t sure whether it’s invested correctly or want to know if you should be using the RRSP or TFSA, you can book a free Second Opinion call with Frank Gasper, owner and financial advisor at CSR Wealth Management.