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Highest growth investments such as stocks should be tax-sheltered in TFSAs, says one expert.

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Tax-free savings accounts (TFSAs) are a great way to save money, but many Canadians aren’t taking full advantage of the investment tool and focus too much on the “savings account” aspect, some advisors say.

While TFSAs seem simple enough – put money in and it can grow tax-free – there are many rules surrounding the program that continue to confuse Canadians.

The account was created in 2009 as an incentive to encourage people to save more money for the future and retirement. But more than a decade later, many investors “are not really clear how the rules work… and then there’s confusion with how the deposits and withdrawals rules work,” says Sophia Ito, wealth advisor and client relationship manager at Nicola Wealth Management Ltd. in Vancouver.

A recent Bank of Montreal survey found that cash is the most popular asset in TFSAs, with more than half (56 per cent) of participants holding cash in their accounts. About a third (29 per cent) say it makes up at least three-quarters of their holdings, and 43 per cent say they use their TFSAs as a savings account.

But the survey also finds a knowledge gap about TFSAs. Although almost three in four survey participants (73 per cent) say they considered themselves knowledgeable about TFSAs, only 49 per cent were aware that the account can hold cash and other investments like stocks, bonds, mutual funds, or exchange-traded funds.

Advisors say there are several strategies that clients can use to maximize the return on investments in TFSAs.

Ms. Ito says advisors must track yearly contributions carefully, and if any withdrawals have been made from TFSAs. That’s because clients don’t get this information in their notice of assessment like they do for a registered retirement savings plan (RRSP) after filing their taxes every year.

In 2022, those aged 18 or older can contribute $6,000 to a TFSA. However, if they were aged 18 when the federal government created the TFSA and haven’t made any contributions yet, they could contribute a maximum of $81,500 – the sum of contribution room available.

If the maximum contribution of $81,500 has been made and a client withdrew $20,000 in 2021, they must wait until 2022 before being able to put that $20,000 back into the TFSA. That’s in addition to the annual $6,000 contribution allowed for 2022.

“But this step is often where a lot of tripping up happens because it’s not well communicated,” Ms. Ito says.

The penalty for overcontribution is 1 per cent a month or 12 per cent a year, “which takes away all the growth [in a TFSA].”

The other issue is the treatment around holding an investment in a TFSA that has decreased in value. For example, if an $81,500 investment has fallen to $60,000 in a TFSA and that money is withdrawn, only $60,000 can be re-contributed in the next year – not the original contribution of $81,500.

That’s why clients need to be careful about the investments they choose and when they withdraw funds, Ms. Ito says.

“We want to make sure that we take a planning approach when we’re looking at the plan, not just an investment strategy approach,” she says.

Why it’s important to hold investments for growth

As the assets held in a TFSA are tax-sheltered, many advisors believe interest income, which is taxed at a higher rate than other investments, should be kept in a TFSA. But Laurie Bonten, senior investment advisor with Wellington-Altus Private Wealth Inc. in Winnipeg, disagrees.

“For most cases, the highest-growth investments, an example might be stocks, should be tax-sheltered,” she says.

If a client contributed the full $81,500 allowed and kept it in interest-bearing investments since 2009, it may have grown to about $95,000 by now, she says.

Yet, a balanced portfolio of stocks and bonds at that amount might have risen to about $125,000 by now. If the client had invested mainly in stocks, the TFSA might now be worth about $150,000.

“So, you’re sheltering that amount, which is very important,” Ms. Bonten says. “That’s how we use them effectively [to] plan so that they will be the longest-term asset that a client owns.”

However, for a younger client who is aiming to save over the short term for a car or a down payment for a home, using a TFSA to shelter the growth of the money isn’t a bad plan, she says. “Don’t sit it in a bank account, put it in a TFSA.”

Ms. Bonten also advises clients to have just one TFSA at one financial institution, not several or it gets too hard to track carefully.

What’s wrong with trading in a TSFA

While a TFSA should be used to hold investments that have the potential to grow significantly over time, it shouldn’t be used to hold the riskiest investments, says Jason Pereira, partner and senior financial consultant at Woodgate Financial Inc., a financial planning firm under the IPC Securities Corp. umbrella in Toronto.

“Don’t use them for speculative gambles because if you’re going to do that kind of trading, do it outside of the RRSP and TFSA,” he says. “If [the investment] goes wrong, you’ve lost the room to compound, you’ve lost a tax-sheltered investment and can’t take advantage of that loss. [Furthermore], if it’s in a taxable account, a capital loss can be used to offset capital gains in the future.”

The Canada Revenue Agency also dislikes heavy trading in TFSAs because the tax-free growth is meant for longer-term savings. There have been rulings in which a tax-free status has been erased for an investor doing heavy trading within a TFSA, he adds.

Mr. Pereira says it doesn’t make much sense for clients to use a TFSA as a rainy-day fund that might be kept in a high-interest savings account, which at most is earning 2 per cent in interest or less. The tax savings on that amount is minimal, he says.

“TFSAs aren’t and shouldn’t be as easily accessible as a bank account [with the ability] to transfer money in and out of them,” he adds.

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