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tax-free savings accounts

'We have a lot of people with TFSAs as their online savings account, earning 1.4 per cent,' says Paul Shelestowsky, a senior wealth advisor at Meridian Credit Union in Niagara-on-the-Lake, Ont.Glenn Lowson

Canadians love their tax-free savings accounts and exchange-traded funds. More than 12.7 million people had a TFSA in 2015, an increase from the previous year of about 1 million.

At the same time, Canadians are putting more money into ETFs: $26-billion last year, a record-breaking figure that pushed total ETF assets in Canada to $147-billion, according to research by the National Bank of Canada.

But put the two together? The idea of investing in ETFs inside a TFSA is "still not top of mind" for most people, says Paul Shelestowsky, a senior wealth advisor at Meridian Credit Union in Niagara-on-the-Lake, Ont.

Perhaps it's the name that makes many Canadians think of TFSAs simply as a place to earn a bit of interest income on cash, he adds.

"We have a lot of people with TFSAs as their online savings account, earning 1.4 per cent," says Mr. Shelestowsky. "I tell them that they really want to be maximizing returns in their tax-free account, and anything that's not paying big interest they can have outside a TFSA."

There's good reason to load up a TFSA with ETFs, says David Kletz, vice-president and portfolio manager at Kelowna, B.C.-based Forstrong Global Asset Management Inc. With their ready-made basket of assets, ETFs provide a quick way to diversify investments within a TFSA.

It's also a cheaper way to build a diversified portfolio, says Mr. Kletz.

"You get access to so many companies in one fell swoop, which can mitigate trading costs," he says. "Diversification really is key to successful investing, and with ETFs, you can diversify your TFSA not just in terms of concentration on a stock-by-stock basis, but also in terms of diversifying globally and across asset classes."

For investors who have yet to open a TFSA, the accumulated maximum contribution room of $57,500 is a good starting base for a portfolio, says Mr. Kletz. Those who have maxed out their RRSPs can use the TFSA for investing with the added benefits of tax-free returns and withdrawals.

Because of the tax-free nature of a TFSA, it makes sense to choose ETFs with higher growth potential, says Mr. Kletz.

"For example, you might want to look at ETFs that are focused on small caps or on a riskier side of the tech industry – stocks that have a lot of upside but might be highly risky," he says. "These would be ideal in a TFSA to tax-shelter the gains."

Larry Berman, chief investment officer at ETF Capital Management in Toronto, says putting riskier ETFs in a TFSA can be a smart move for Canadians who have other investments, such as those held in an RRSP, to support their retirement strategy. "You don't want to speculate in your RRSP, but if a TFSA is another source of retirement savings for you, then yes, it makes sense to put the riskiest part of your portfolio in your TFSA," he says.

In such cases, investors should consider globally focused ETFs with strong growth potential, says Mr. Berman. As examples, he points to emerging-markets ETFs from BMO, iShares and Vanguard. "Emerging markets are quite undervalued relative to the U.S. market, which is overvalued," he says. "Any one of those ETFs would provide an ideal, broad-based exposure to emerging markets."

ETFs that focus on niche sectors such as health care and biotechnology would also be well suited to a TFSA, says Mr. Berman. "I love ETFs because one of the hardest things to do in investing is getting rid of idiosyncratic or company-specific risk," he says. "When you're investing in a niche sector within an ETF, you don't have to worry about being an expert who's having to choose one or two companies to invest in."

Canadians who have been using their TFSAs as a haven for cash and are now ready to push the envelope might consider a bond-based ETF, says Jay Nash, senior vice-president and investment advisor at Toronto-based National Bank Financial Wealth Management. A few examples are Vanguard's Canadian Short-Term Corporate Bond Index ETF (VSC) or Horizons' Active Corporate Bond ETF (HAB).

"A TFSA will offer the same tax shelter for fixed-income securities," says Mr. Nash. "There are those who might be wanting to get as much growth as they can out of the ETFs in their tax-free savings account, and there's nothing wrong with using your TFSA that way if you favour high yield, but it all depends on your risk profile."

Ed Rempel, a fee-for-service certified financial planner in Toronto, says a TFSA should not include U.S.-listed ETFs that pay dividends. Because TFSAs are not recognized by the income tax treaty between Canada and the United States, dividends from these funds are subject to a withholding tax of 15 per cent. A double whammy applies to TFSA-housed, U.S.-listed ETFs with international equities that pay dividends; these would be subject to an additional withholding tax.

"So it's better to have these funds in your RRSP, which is recognized by the tax treaty," says Mr. Rempel, who writes the blog Unconventional Wisdom. "But if you do want to buy international equities for your TFSA, then you should buy Canadian-listed ETFs that hold international stocks."

While TFSAs continue to attract more investors because of the tax-free benefits, Mr. Rempel cautions against letting the "tax tail wag the investment dog."

"There are certain ETFs that work better within a TFSA than others, but usually where you put your investments is the last decision you should make," he says. "Decide first how much you want to invest, what's your risk tolerance and goals, and how you want to allocate your assets. Then once that's all determined, then you decide which type of account you should put your investments in."