The tax free savings account (TFSA) is an ace in the hole for those with a long way to go before retirement. No other account can match its potential for tax-exempt growth and flexible, tax-free withdrawals over the long term.
Yet fitting a TFSA into an overall portfolio strategy can be a challenge for investors younger than 50. Part of the confusion lies with what kind of investments to hold inside these accounts.
The answer is that it varies depending on your appetite for risk, time horizon and tax considerations, says Rob Tetrault, a portfolio manager with National Bank Financial in Winnipeg.
“If a client has a high risk tolerance, for example, and is invested wholly in equities, that individual should place the highest growth equity sector in his or her TFSA, whether that’s small-cap stocks or emerging-market equities,” he says.
“If a client has a low risk tolerance and owns nothing but fixed income products, he or she should own the highest paying bonds, for example, in the TFSA because that would save the most money come tax time.”
In other cases, investors may choose to use a TFSA for their emergency cash stockpile. That’s because it’s flexible – money can be withdrawn without tax penalty at any time, and the contribution room can be replaced, says Uri Kraut, a certified financial planner and senior wealth professional with Credential Securities and Assiniboine Credit Union in Winnipeg.
Most 30- and 40-something investors, however, should put their cash reserve elsewhere – in an account where interest earnings may be taxable, keeping in mind that in the current low-rate environment, the tax impact is insignificant anyway.
Instead these investors should take the long view with their TFSA and consider securities that have the biggest positive impact on their portfolio. That usually means equities, says Ted Rechtshaffen, wealth adviser and president of TriDelta Financial Partners in Toronto.
“With longer-term time horizons, the TFSA should focus on total return,” Mr. Rechtshaffen says.
Canadian equities likely offer the most benefit because capital gains and dividends can grow tax-free.
Investors should think carefully before investing in foreign markets because many jurisdictions do not recognize the TFSA’s tax-free status, says Cynthia Kett, an accountant with Stewart and Kett Financial Advisors Inc. in Toronto
Dividends from foreign stocks can be subject to withholding taxes. For example, on U.S. dividends, a 15-per-cent excise tax would apply. When held in an RRSP, however, a tax treaty makes those dividends exempt. (When held in a non-registered account, investors can apply for a tax credit that offsets the U.S. levy when filing their income tax return.)
“If you’re going to own foreign content, you generally want to have in a TFSA investments that would not pay substantial dividends,” says Mr. Kraut. He adds that capital gains are not subject to a withholding tax.
For the most part, Canadian equities are best suited for a TFSA because no potential tax snafus exist. But not all Canadian stocks are equal. Most investors are probably best served holding blue chip, dividend-paying securities in their TFSA.
Mr. Rechtshaffen recommends stable, long-term performers with high dividends such as Toronto-Dominion Bank or BCE Inc. that can be fully sheltered from tax in a TFSA.
Even investors who have well diversified portfolios – those with an even mix of bonds and equities – should consider holding their investments with the greatest potential for highest growth in their TFSA, Mr. Tetrault says.
“This isn’t saying that you should increase your asset allocation or change risk tolerance. It’s simply saying that in the context of the overall portfolio, the highest growth sector should be moved to the TFSA to benefit from a higher compound growth,” he says. “The TFSA will have more volatility over time, but will grow faster due to the higher compound rate.”
Investors looking to try something more speculative and risky might choose to hold that kind of an investment in a TFSA as well. For instance, someone trying to hit a home run might buy $1,000 worth of a penny stock of a company involved in the burgeoning marijuana industry. Just keep it a small investment, Mr. Kraut advises.
“If it works to your favour, great, and if it doesn’t, it’s only $1,000 of your contribution room that’s gone. But you’d hate to see $15,000 get wiped out.”
Although withdrawals can be replaced the following calendar year, contribution room that disappears as a result of capital losses is not recoverable inside a TFSA. Moreover, losses cannot be used to offset taxes on capital gains, such as those in a taxable, non-registered account.
“For that reason, you really want to have a high probability of success in a TFSA,” Mr. Kraut says, adding a steady dividend payer like a Canadian bank is a much more likely suspect for the TFSA.
“It could still be volatile, but it doesn’t have the same risk as the pursuit of the penny-stock, get-rich-quick approach of trying to turn your TFSA from a $40,000 account into a $1-million one.”Report Typo/Error
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