Having a tax-free savings account means you’ve done something right with your money.
There are good, better and best ways to use TFSAs, but just having one is 90 per cent of the battle. Keep this in mind if you hear criticism of people for using their TFSA to hold savings.
You best exploit the tax-free aspect of these accounts if you hold investments that deliver bigger growth than savings accounts. But protecting your savings from tax in a TFSA has its benefits. Calling out people for using their TFSAs the “wrong” way ignores this, and it feeds the continuing problem of shaming in personal finance.
Since before the pandemic, polls and surveys have consistently shown that many people feel bad about their finances. This isn’t just about debt, high interest rates and ridiculous food prices. There’s a widespread feeling of making the wrong choices and not measuring up to people who are good with money.
The reality of personal finance is that everyone blows it now and again with their money decisions. Focusing on mistakes is helpful to some extent. But all the negativity around money these days suggests some positive reinforcement is needed with TFSAs and more.
The beauty of TFSAs is their simplicity – you make contributions with after-tax dollars and then you’re done with the Canada Revenue Agency if you follow the rules. Money in a TFSA compounds tax-free, and there’s no tax on withdrawals. You can replace the money you withdraw at a later date.
A wide variety of financial assets can go into TFSAs, similar to registered retirement savings plans. Bank branches offer savings accounts, guaranteed investment certificates and mutual funds for TFSAs, and advisers and brokers offer access to exchange-traded funds, stocks, bonds and more.
Ideally, you’d have your savings in a regular, unregistered account and your long-term growth investments in a maxed-out TFSA and RRSP. But in real life, people have lots of empty space in their TFSAs. The latest data from the Canada Revenue Agency, for 2020, shows the average amount of unused TFSA contribution room is $40,782. People made an average five withdrawals from their TFSAs that year, which tells us these accounts are in no way being used strictly for long-term investing.
What you choose to put in your TFSA depends a lot on your financial goals, and how long you’ll leave your money in the account. A savings account TFSA is ideal for short-term goals, say anything up to three or even five years if stock market crashes scare you.
That’s not the case with your basic low-paying big bank savings account, though. If you deal with an alternative bank or credit union, you can get as much as 3 to 4 per cent on TFSA savings accounts. But interest from a regular savings account is considered regular income, which means after-tax returns can be significantly reduced. With a TFSA, 4 per cent is 4 per cent.
Before interest rates started to soar in 2022, a low rate on savings was part of the bargain you made. But today, it’s possible to get an inflation-beating return from savings in a TFSA with zero risk to your money if you stay within deposit insurance limits.
For longer-term goals, you do get more juice from a TFSA if you add diversification into stocks and bonds directly or via ETFs and mutual funds. On an average annual basis, expect to get an after-fee 5 to 6 per cent from a diversified portfolio with the default balanced mix of 60 per cent stocks and 40 per cent bonds. More risk means a higher potential return.
The 4 per cent return from a savings TFSA looks comparatively good if you adjust for the complete lack of risk. But 4 per cent won’t last indefinitely. As soon as the Bank of Canada starts cutting interest rates later this year, the return on savings accounts will start to move lower.
Lower rates on savings should prompt some fresh thinking about TFSAs. If your TFSA is for long-term saving goals like retirement, you’ll get better results from stocks or funds that hold stocks. The lower return from savings will feel disappointing as interest rates decline, but would still be acceptable for TFSAs for short-term goals.
Much is made of the use of the word savings in the TFSA name, as if it leads people into the mistake of choosing savings accounts over investments. The TFSA nomenclature is appropriate, though. It sends the message that this is an account that can be used to put money to work without ever having to worry about taxes.
TFSAs are hugely popular for this very reason, and just having one is a win. It matters what you put into a TFSA, but there are no “wrong” choices between saving and investing.
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Rob Carrick