Maximizing the tax free in your TFSA

To get the most out of your TFSA, it should likely not be used as a short-term savings account. It should be an integral part of your long-term financial plan

Most people have heard of tax free savings accounts (TFSA) but many don’t use them to full advantage.

A big reason is that many people incorrectly assume that a TFSA has to be invested as a saving account, similar to a bank account.

In fact, a TFSA can hold almost any type of investment.

Yet many people simply invest their TFSA money into an account that pays low-interest returns.

While this strategy is great for savings you plan to spend in the near future, it’s not such a good idea for a longer term investment. A better name might have been the tax free investment account (TFIA) since investing in a low-return account is hardly taking advantage of the tax free part of the TFSA.

If you’re making regular withdrawals from your TFSA, you don’t want to buy anything other than a safe investment. However, if that’s how you’re using your TFSA, you’re not likely benefiting much from the tax savings as you’re not earning very much.

If you had maximized your TFSA from day one into a typical TFSA account earning two per cent, by the end of this year, you should have an account balance of around $57,178. The annual contribution limit was $5,000 from 2009 to 2012, $5,500 in 2013 and 2014, $10,000 for 2015 and $5,500 in 2016. The income for 2017 would be around $1,121. If this money was held in a regular investment account, and you were in a 40 per cent marginal tax rate, this year you would save about $448 in taxes. That’s not bad.

But if this is longer term money, surely you can do better.

Let’s take a look at what could have happened if you had taken that same investment each year and purchased a dividend-paying stock. Assume a three per cent dividend and two per cent capital gain each year. Using this example, at the end of this year your TFSA would be worth around $66,000 and the gain for this year would have been $3,142. If you were in a 40 per cent marginal tax rate, the amount you could have saved would be around $1,256 (if you ignore the fact that the income is made up of capital gains and dividends and would have been taxed at a lower rate than interest income if held outside of a TFSA or RRSP).

You can clearly see that the more you earn, the greater your tax savings.

To get the most out of your TFSA, it should likely not be used as a short-term savings account. Rather, it should be an integral part of your long-term financial plan.

If you have non-registered long-term investments and a short-term TFSA, then you can save more taxes by switching them around. Holding your short-term savings in a fully taxable account and your longer term investments inside the TFSA is likely going to save you more tax in the long run.

Since there’s no tax recovery for any losses you incur inside a TFSA, it’s likely a good idea to not use them for high-risk investments. However, if you do this and manage to pick a winner, holding that inside your TFSA is likely a good idea.

Be aware that the Canada Revenue Agency frowns on high-frequency trading inside TFSAs. And if you have significant gains, they could deem that you are running a business and tax the gains fully as if the money was not invested inside a TFSA.

Bill Green is an hourly financial and estate planner, public speaker and author of The Success Tax Shuffle. Bill has over 26 years of experience in the financial services industry.

The views, opinions and positions expressed by columnists and contributors are the author’s alone. They do not inherently or expressly reflect the views, opinions and/or positions of our publication.

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