How to Maximize the Potential in Your TFSA. What You Should (and Shouldn't) Invest in Your TFSA
Wednesday, November 29, 2023
How to Maximize the Potential in Your TFSA. What You Should (and Shouldn't) Invest in Your TFSA
Wednesday, November 29, 2023
Mitch Zaba
The Canadian tax code does not treat investments within an RRSP and TFSA equally. Therefore, If you are an investor with RRSP and TFSA accounts, it's important to carefully plan your investment strategy within your TFSA.
The Tax-Free Savings Account is a powerful account to grow your wealth. Just like your home, you never have to pay taxes on any growth accumulated within your TFSA.
If you were age 18 in 2009, your contribution room today is $88,000. With reasonable investment growth, many TFSAs are easily over $110,000.
TFSAs balances of this size didn't get there by investing in GICs, Term Deposits, or High-Interest Savings Accounts. These investors correctly held their long-term strategies in their TFSAs such as stocks, ETFs, and mutual funds.
The Right Mindset for Your Tax-Free Savings Account
TFSAs are meant for long-term wealth creation. Whether it's for your retirement, lowering taxes on your estate, or gifting money to your children's TFSAs, your TFSA mindset should be decades, not years or months.
When you take a decades-long mindset, you can afford to take on a multi-decade investment strategy as well.
This will maximize the power of compounding tax-free growth. Just like your principal residence.
Let's explore.
Don't Underestimate a 2% Difference
Let's imagine the difference between investing safely and being long-term focused is a 2% average. Right now (2023), is a 4% GIC and a 6% average medium-risk ETF portfolio.
Reasonable.
Now take the maximum annual contribution of $6,500 and look 30 years into the future. A 4% average will grow to $379,134.
An investor with a long-term investment strategy averaging 6% will have $544,711.
$165,577 more in tax-free money.
What Should I Invest in My TFSA?
With the right mindset, you should hold your long-term investment strategies in your TFSA. That means you should avoid strategies like holding cash, GICs or bonds and pursue holdings like stocks, and equity-focused ETFs or mutual funds.
Where should I hold my cash, GICs or Bonds?
Many investors will just put all the same holdings in their TFSA and RRSP, this is a mistake. For example, you could be a balanced investor which means holding 60% equities(stocks) and 40% bonds. Then you or your advisor will choose a matching fund and put that fund in all of your accounts equally.
Simple right?
The problem with this approach is it isn't tax-efficient.
The most tax-efficient way to invest a portfolio is to hold your equity-focused holdings in your TFSA and your short-term, lower-risk holdings, like bonds and GICs in your RRSP.
In the example of a balanced investor, you would take the 60% stock allocation and invest it into your TFSA, then put the 40% bond allocation into your RRSP.
Note: This assumes you need both an RRSP and TFSA. If you do not need an RRSP, then you will put your whole portfolio in your TFSA and vice-versa. However, many married or common-law partners have TFSAs and RRSPs invested at the same time.
I've allocated my equities to my TFSA and my bonds to my RRSP. I'm done, right?
Unfortunately, you're not. Not all countries are treated equally in Canada.
Since Canada makes up less than 4% of the world's economy, investors often hold stocks from international companies. However, a U.S. company is not taxed the same as a Japanese company.
This requires some additional tax planning.
For a full overview of investment allocation from a tax lens, check out this article from Passiv, https://passiv.com/blog/tax-efficiency/.
Here is a summary:
- The U.S. and Canada have a tax treaty for RRSP accounts only. This means you can recover any foreign income taxes withheld by the U.S. by placing your U.S. holdings in your RRSP.
- International investments outside of the U.S. don't qualify for the dividend tax credit and are taxed at your marginal tax rate. Hold your international holdings in your TFSA, then RRSP.
- Canadian companies, especially ones that pay dividends, are taxed more favourably to Canadians. That's because dividends are usually paid as eligible dividends. Hold your Canadian investments in your TFSA, then non-registered, then RRSP accounts.
Again, for more clarification, read Passiv's article here, https://passiv.com/blog/tax-efficiency/.
Conclusion
Your TFSA can be an excellent strategy to exponentially grow your wealth. With some advanced planning and the right mindset, you can minimize your taxes and maximize your growth for you and your children.
Hi, I Am Mitch Zaba
Over the past 10+ years, we've worked closely with clients showing them how to grow their wealth, pay less taxes and how to create predictable passive income in the stock market.
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