In a previous article, I wrote an introduction on the Tax-Free Savings Account (TFSA). In that article, I talked about who is eligible for the TFSA, what are the benefits, and how contributions and withdrawals work in the Tax-Free Savings Account. This article follows up with using the Tax-Free Savings Account as an investment tool.
Which Investments are Best Placed in the Tax-Free Savings Account?
A) Tax-Advantaged Consideration
If you place money in high interest savings accounts, bonds, and GICs, you should place those in a Tax-Free Savings Account first. Interests earned are taxed at the marginal tax rate. On the other hand, capital gains for stocks are taxed more favorably. Canadian eligible dividends are also taxed more favorably.
For US stocks, there’s generally 15% withholding tax applied to its dividends. If you have those stocks in the Tax-Free Savings Account, you can’t get the withholding tax back. That said, some investors argue that it’s still better to place US stocks in the Tax-Free Savings Account versus a non-registered account. In a non-registered account, you end up paying your marginal tax-rate for the foreign US dividends. Most of the time, the marginal tax rate is higher than the 15% withholding tax rate.
B) Higher Total Returns Consideration
Other than tax-advantaged considerations, an investor should consider which form of investment gives the higher return. Currently, interest rates are still at historical lows, so keeping money in “high” interest savings accounts and GICs actually causes us to lose purchasing power. Remember that inflation rates are averaging about 3% a year. So, any investments which yield less than 3% causes us to lose purchasing power. If you stash $1 in your drawer, and the inflation rate is 3%, next year, that $1 can only buy $0.97 of goods. Value dividend stocks (versus non-dividend stocks and growth stocks) is a good starting point for new investors. For high quality value Canadian dividend growth stocks, check out the big 5 banks, and the 3 telecoms.
The big 5 banks are Royal Bank of Canada (TSX:RY)(NYSE:RY), Toronto-Dominion (TSX:TD)(NYSE:TD), Bank of Nova Scotia (TSX:BNS)(NYSE:BNS), Canadian Imperial Bank of Commerce (TSX:CM)(NYSE:CM), and Bank of Montreal (TSX:BMO)(NYSE:BMO). The telecoms are BCE Inc. (TSX:BCE)(NYSE:BCE), Telus Corporation (TSX:T)(NYSE:TU), and Rogers Communications Inc. (TSX:RCI.B)(NYSE:RCI). These companies have historically paid a growing dividend (although the Canadian banks froze their dividends for a couple years during the financial crisis between 2008-2009). In comparison to the US banks which cut their dividends, I see the Canadian banks as higher quality for freezing dividends at that time, as it was a cautionary move.
C) Risk Consideration
There’s risk of losing capital if you buy stocks. But there’s a risk of losing purchasing power if you put money in savings accounts or GICs. So, there’s a risk of not having enough money for your everyday expenses when you need it. That’s why I mentioned earlier to learn investing in stocks in your non-registered account first (so you could write it off in the case you get a capital loss).
Summary of Using the Tax-Free Savings Account
Generally, investors place highly taxed items in their Tax-Free Savings Accounts, such as investment vehicles which pay interests. These vehicles include savings accounts, bonds, and GICs. Alternatively, others place income-generating assets such as dividend stocks which pay a growing dividend.
If you’re buying stocks in your tax-free savings account, make sure you know what you’re doing. Do not experiment in your TFSA because you can’t write off a capital loss in there. Start with Canadian dividend stocks, particularly the banks and telecoms.
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Disclaimer: I am not a certified financial advisor. This article is for educational purposes, so consult a financial advisor and or tax professional if necessary before making any investment decisions.
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