Hello my dear readers! Today I am providing another blog posts on Tax-Free Savings Account (TFSA). This time, I am going to focus on TFSA optimization strategies so you can pay as little tax as possible for your overall portfolio. I have talked at length about what TFSA is in TFSA 101, so if you are unfamiliar with this financial account, please check out the article there first. Additionally, if you are not sure about how taxation works for different kinds of savings instruments (savings accounts, bonds, mutual funds, and stocks), you may want to check out this article as well.
Now we have the introduction out of the way, let’s dive into the ways with which we can optimize our TFSA.
Use up as much TFSA contribution room as possible.
First and foremost, I’d like to emphasize on this almost all-so-obvious fact. In this world where you have to pay tax on almost every penny you earn, the tax advantages of a TFSA is a huge gift. If you have the ability to max out your TFSA, please do so, or at least try to contribute as much as you can into the account before considering other places to park your money. Unless, of course, that you prefer to use an RRSP to get the tax refund today.
Educate yourself on TFSA.
Even though it has been more than 10 years since the introduction of TFSA in 2009, some people are still nervous about using it. I think it may be because it is still relatively new if you compare it to, for example, RRSP, which was introduced back in 1957. But I want to assure you that TFSA is not that difficult to understand. If you spend an hour reading up on TFSA, or book an appointment with your local bank or financial advisor, you will feel a lot more comfortable with this account, and you can start take advantage of it.
Be careful with over-contribution.
This is definitely something worth its own section. I suspect this may have been the primary reason why people shy away from using TFSA effectively, if at all. Over-contribution will trigger a hefty penalty, at 1% a month based on the highest excess amount for the month.
However, if you educate yourself properly, and track your contributions carefully, it shouldn’t be a problem. If contributing a few times a years is too much of a hassle for you, then you may consider just contributing to your TFSA once at the beginning of the year. That way, you only need to monitor the times that you withdraw from your account throughout the year.
If you find yourself frequently withdrawing your TFSA, you may want to stick to a regular chequing account instead.
This point is related to over-contribution. Because you need to do some math when you use TFSA, the process may get complicated if you are frequently putting in and withdrawing money from it. TFSA can be used as a regular savings/chequing account, but you aren’t really maximizing its potential if you are treating it as one. If you find yourself frequently accessing your TFSA like a chequing account, then you really should just stick to a chequing account to avoid the headache of all the calculations.
Do not use your TFSA to store your cash.
The advantage that a TFSA has is that all the earnings from any financial vehicle residing in a TFSA is tax-free. If you are simply storing cash there without wrapping it in any vehicles (e.g., a savings account or bonds), you aren’t getting much of a benefit. I also don’t recommend that you use an everyday savings account offered by a big bank in your TFSA, either. These accounts only generate an interest somewhere between 0.01% and 0.05%, so you are literally wasting your contribution room for the $0.25 interest that you earn a month. Of course, there is absolutely nothing wrong with having an everyday savings account, for example, for your emergency fund. You are much better off using a high-yield savings account that offers a more reasonable interest in your TFSA.
Have a balanced portfolio, and prioritize your portfolio from highest to lowest tax obligation.
I do believe that in order to have a comfortable personal finance roadmap, having a balanced portfolio is the way to go. Of course, the definition of balance differ by individual based on our different levels of risk tolerance. Some people may be okay with 10% cash/cash-like instruments, 10% bonds and 80% stocks, whereas others may want 80% cash and 20% bonds with no stocks.
Look at yourself in the mirror and critically think about what your true risk tolerance level is. Don’t think about the highs when the market goes up by 250%, but think about the lows with the market goes down by 250%. What portion of your portfolio are you comfortable exposing such a high risk to? This is an important decision to make to protect yourself in an economic downturn. Yes you might be losing out on some gain during a bull market. However, since we are naturally risk adverse, it will be doubly painful if you lose money you aren’t prepared to.
Once you have the ideal percentages of cash/bonds/stocks in mind, it is time to optimize. As I mentioned in my article on taxation rules for savings vehicles, different savings vehicles are subject to different taxation rules. Generally speaking, you have to pay the highest percentage of tax on your interest earnings, followed by dividends, and finally capital gains.
With that in mind, the following is the order of various investments that I recommend you put in your TFSA to optimize for tax.
First: investments with only interest earnings (e.g., high-yield savings accounts, GICs and term deposits)
In order to achieve lowest percentage of overall tax paid, I recommend that you prioritize your investments that only earn interests. Examples include your high-yield savings account, GICs, term deposits, etc. For example, if you have some short-term (1-3 years) savings goals, then a high-yield savings account in your TFSA is an ideal way to park your savings. Examples may include saving for a down payment. By holding the money in a safe account, you are not at risk of losing 30-40% of your investment when you have to use the money, and you get to keep the full amount of interest earned because it is in a TFSA.
Second: investment with a mixture of interest earnings and potential capital gain (e.g., bonds)
Bonds typically fall under this category. The majority of the earnings on bonds are in the form of interest, which doesn’t have a favourable tax treatment. However, depending on the price of the bonds, you may incur capital gains. The amount of capital gains is based on the difference between the purchase price and selling price of the bonds. Capital gains enjoy a much more favourable tax treatment: you only have to pay tax on 50% of the gain. As a result, your overall tax burden is less than if 100% of your investment income comes in the form of interest, like in term deposits or GICs. Of course, because most of your earnings are still in the form of interest, generally speaking, bonds are still in a higher tax bracket than stocks.
Note that if you incur capital loss on your bonds because the purchase price is higher than your selling price, then you cannot claim capital loss to offset your capital gain in a taxable account.
Third: foreign investments with high dividend payment (high yield) and low appreciation (e.g., international stocks)
Dividends earned on foreign investments don’t get the same favourable tax treatment as those from Canadian companies. Just like interest, they are fully taxed at your marginal rate, so you do want to keep them sheltered in a registered account like TFSA as long as possible. However, through my personal experience and online research, the interest-to-capital-gain ratio is still lower for foreign investment than that for stocks, which is why I placed it in the third place on my list here.
One important aspect of foreign dividends is that they are usually subjected to a foreign withholding tax, which is generally between 15 and 25%. You don’t really see this tax, because it is most commonly paid before the dividends appear in your account. If the investment is held in a taxable account, you are eligible for a foreign tax credit depending on the treaty Canada has with the respective country. However, such a foreign tax credit is not available if you hold your investment in a TFSA.
At first glance, it may seem unfair, because you are still paying tax on an investment held in a supposedly tax-free account. But depending on your tax bracket, instead of paying 40% marginal tax on all of your dividends while claiming the foreign tax credit, you are paying only 15-25%. So you are still better off leaving the investment in our TFSA. If you want to read more about it, Advisor.ca has a great article on foreign withholding tax to illustrate this point.
Fourth: foreign investments with low dividend payment (low yield) and high appreciation (e.g., US stocks)
Compare to its European and Asian counterparts, US stocks typically has lower yield but higher appreciation rate. This means that more of your earnings is in the form of capital gains rather than dividends. Because capital gains are subject to more favourable tax treatments than foreign dividends, you tend to pay a lower tax percentage overall.
Fifth: Canadian investments with dividend payments and appreciation
When it comes to tax saving potential, Canadian investments should be the last on your list. This is because they have the most favourable tax treatments if held in a regular taxable account, so your tax saving potential is the least. In addition to the favourable capital gains tax rules, Canadian dividends are also eligible for the Canadian dividend tax credit that is not available for foreign investments. Also, since they are domestic investments, there is also no foreign withholding tax on them, either.
Tax shouldn’t be the only factor to consider when you select components of your portfolio.
Even though the above list ranks investments in the order of tax benefits, it doesn’t necessarily mean that you should prioritize them in this order in your TFSA. You want to understand their overall after-tax returns before making a decision. Sometimes an investment with a higher percentage in tax still provides an overall better after-tax return than one in a much lower tax bracket. And, although Canadian investments have favourable tax treatments in your taxable account, if you have room in your TFSA, still put it there!
TFSA optimization is a big topic on its own. We want to rely on the general principle of interest > dividends > capital gains (in terms of taxation percentages) and our understanding of historical before- and after-tax income on various choices to make a decision on what to hold in a TFSA.
If you have any other suggestions or ideas, please leave a comment down below. The above is just my understanding on this subject, and I welcome different opinions so we can all learn and grow together.