Following up on our recent article on the basics of Tax Free Savings Accounts, there are certain ways to maximize the growth and efficiency of investments held in a TFSA. Here are a few ways to ensure you’re getting the most out of your TFSA:
1. Put your money into investment funds
If you are just starting to invest, you likely don’t have a huge pool of financial assets at your disposal. On top of this, given the cap placed on TFSA contributions, you would have to invest small sums of money into numerous individual positions in order to earn the benefit of diversification within a TFSA account. All of these small positions will add to transaction and monitoring costs.
The simplest solution to this problem is holding TFSA assets in investment funds (either mutual funds or exchange-traded funds). These funds can specialize in various market segments (tech, pharma), geographies (domestic, North American, global), or may simply attempt to track index performance (such as an S&P 500 index fund). The proliferation of such funds has extended into other asset classes beyond equities; the bond component of a portfolio can also be held via a bond fund. Construction of an investment portfolio via investment funds can be tailored based on an individual investor’s risk profile and time horizon. There are even target date funds available, which gradually reduce equities and increase fixed income as an investor approaches retirement age.
One caveat: fund cost is critically important. Famed investor Jack Bogle speaks of “the magic of compounding returns and the tyranny of compounding costs”. Investment funds charge fees based on your total investment, not just the return that you earn. Higher-fee investment funds will erode your long-term savings. If you are just starting out as an investor, consider a couple of low cost ETFs to construct your TFSA portfolio (for example, a relatively conservative portfolio of 60% stocks and 40% bonds could be created using an S&P 500 index fund and a diversified bond fund). You are investing to save for your future, not to make fund managers rich.
2. Consider how returns on different financial assets are taxed
Income earned off of investments in non-registered accounts (interest on bonds, stock dividends, etc.) are taxed as ordinary income at your highest marginal tax rate. Capital gains*, however, are taxed more favourably for investors: 50% of your capital gains are not taxed at all; the remaining 50% is taxed at your highest marginal rate. Further, investors may engage in “Tax Loss Selling” – which means that they can sell positions that have declined in value so that their realized losses offset their realized gains and further reduce their tax burden. Because all returns, be they capital gains or income earned off of investments, aren’t taxed in a TFSA, the benefits of favourable tax treatment of capital gains will not be borne out.
The impact of tax legislation on your TFSA investments is dependent on both your risk profile and your amount of investable assets. If you have not maxed out your TFSA contributions, impacts of taxation are moot; simply manage all of your investments in your TFSA until you have hit your contribution ceiling. If, however, your investable assets exceed your TFSA (and RRSP) contribution room, and your asset mix includes income-producing assets, consider holding these assets in a TFSA to benefit from the different tax rates on income and capital gains.
If you wish to have holdings in actively managed investment funds, put these holdings in your TFSA. As the fund manager trades individual stocks within these active funds, capital gains will be realized. Investors holding shares in the funds will have to pay taxes on these realized gains if they are holding the investment in a taxable account.
3. Establish rules for rebalancing your TFSA
It’s tempting to jump in and out of positions when you won’t be taxed for doing so. This temptation has been exacerbated by recent moves by numerous online brokerages to commission-free trading. Even though you will not have tax consequences for frequently buying and selling positions, you should apply a rules-based method for rebalancing in a TFSA. Otherwise, you will likely fall into one of the investing traps that have nothing to do with taxation and fees:
Letting your losers run too long in hopes that they will come back; selling your winners too early to lock in gains; and buying a stock that you wish you had purchased sooner (regret aversion bias).
Establish common-sense rules for rebalancing and portfolio construction. You may not get taxed in a TFSA, but poor returns from a lack of discipline will be punishment enough.
4. Do not underestimate the benefits of tax-free growth inside your TFSA
The S&P 500 has a historic annualized average return of around 10%. With this rate of return, it takes just over 7 years for money to double.”
Held in a taxable account, 50% of this growth would be subject to capital gains tax at your top marginal rate. In a hypothetical world with no transaction costs or tracking error, $50k invested in the S&P would grow to over $2.2 million over a 40 year period (a rough estimate for average total length of employment). If this investment were held in a taxable account, 50% of this growth would be subject to income tax. Assuming a top marginal tax rate of 50%, over $500k of these proceeds would go to the CRA. If you work for a company with an Employee Share Option Plan, look to see if you have the option to hold these shares in a TFSA (if you haven’t otherwise maxed out your contributions).
Lastly, remember that the benefits of tax-free growth become more pronounced the longer your holding period is. Start early, invest as much as you can, and your future self will thank you for your discipline.
*A capital gain (or loss) is the difference between the purchase price of an asset and its current price. A capital gain/loss is realized when the asset is sold, at which point the investor will have tax implications associated with the investment.
Opinions are those of the author and may not reflect those of BMO Private Investment Counsel Inc., and are not intended to provide investment, tax, accounting or legal advice. The information and opinions contained herein have been compiled from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness and neither the author nor BMO Private Investment Counsel Inc. shall be liable for any errors, omissions or delays in content, or for any actions taken in reliance. BMO Private Investment Counsel Inc. is a wholly-owned subsidiary of Bank of Montreal.