The Tax Free Savings Account (TFSA) is a great tool for Canadians to save and invest. So, it saddens me to find out that only one in five Canadians maxed out their TFSA. Perhaps people simply do not know what to do with it.
TFSAs can hold cash, mutual funds, exchange traded funds (ETFs), stocks, guaranteed investment certificates (GICs), and bonds. First, create a TFSA with your bank to hold the kind of savings or investments that you’re comfortable with. Then, you can start earning tax-free interests, income, and growth for your lifetime!
There are lots of books out there to help you take advantage of TFSAs, including Gordon Pape’s Tax-Free Savings Accounts: How to Profit from the New TFSA Rules and The Ultimate TFSA Guide: Strategies For Building A Tax-free Fortune.
Books take longer to read, so here are 5 quick TFSA investment tips to get you started in securing your financial future and reducing your taxes.
Shelter Dividend Stocks in a TFSA
I start the discussion with holding dividend stocks in a TFSA even though eligible Canadian dividends are taxed favorably in a non-registered account because dividend stocks generally experience higher growth than interest-producing vehicles (that will be discussed at Tip 4).
Imagine you can get tax-free income from a blue chip dividend growth company such as Bank of Nova Scotia (TSX:BNS)(NYSE:BNS) that has been paying dividends for 183 years. The bank actually started paying dividends 35 years before Canada was founded!
At $58 per share, you can start earning a yield of 4.8% from Bank of Nova Scotia. That is, if you invest $5000 at that price, you will receive at least $240 in income every year. That 4.8% yield beats the 2% interest rate that most savings accounts are paying.
What’s more to like is that Bank of Nova Scotia tends to increase its dividends every year, so your income will likely continue to grow year after year. There are other stocks just like Bank of Nova Scotia so that you can build a portfolio of solid blue chips to start generating passive income.
A TFSA will not only shelter your dividend income, but also the growth from the dividend stocks as well. There’s no reason not to use a TFSA.
Shelter REITs in a TFSA
I’m discussing Canadian REITs separately because they pay distributions that are not like dividends even though REITs are bought and sold just like stocks. Real estate investment trusts (REITs) are companies that own, operate, and manage a portfolio of hundreds of real estate properties.
By buying REITs, you essentially have a team of professionals to take care of the properties and tenants, and you only have to sit back and relax to receive monthly rental income from a diversified portfolio. Indeed, most Canadian REITs pay out monthly distributions to unitholders.
REITs’ distributions can be made up of other income, capital gains, foreign non-business income, and return of capital. Other income and foreign non-business income are taxed at your marginal tax rate, while capital gains are taxed at half your marginal tax rate.
If REITs are bought in a non-registered (taxable) account, extra work is needed to figure out the taxes you need to pay for the distributions you receive. At the same time, the return of capital portion reduces your cost basis of the REIT and is not taxed unless the cost basis goes below zero.
Simply put, there’s less hassle to buy REITs in a TFSA (or RRSP for that matter). Similar to dividend stocks, good REITs should consistently pay you a monthly income with the potential of capital growth.
Most Canadian REITs do not increase their distributions every year; however, they typically pay higher yields than typical dividend stocks. For example, RioCan Real Estate Investment Trust (TSX:REI.UN) is the Canadian retail REIT leader. Under $24 per unit, it yields 5.9%. Another example is Northern Property REIT (TSX:NPR.UN) that yields 8% around $20 per unit.
Just like investing in any stocks, you should understand the business behind the stocks. At the very least, understand how they make money. For instance, Northern Property’s yield is historically high for the REIT because its residential properties are located in resource areas, and the oil price has plummeted and remains to have a negative outlook.
Shelter Mutual Funds and ETFs in a TFSA
You might not be comfortable buying individual stocks. In that case, there are many mutual funds and ETFs to choose from. By buying mutual funds or ETFs, you are gaining exposure to a basket of things.
For example, Toronto-Dominion Bank offers a Dividend Income Fund that mainly holds the Big Five Canadian banks (making up about 30% of the fund), Enbridge Inc (TSX:ENB)(NYSE:ENB), Manulife Financial Corporation (TSX:MFC)(NYSE:MFC), TransCanada Corp (TSX:TRP)(NYSE:TRP), Canadian National Railway Company (TSX:CNR)(NYSE:CNI), and Telus Corp (TSX:T)(NYSE:TU).
The difference between mutual funds and ETFs at a high level is that there’s a human manager behind mutual funds (and therefore they charge higher fees), while ETFs typically follow the action of an index. For example, Energy Select Sector SPDR (ETF) (NYSEARCA:XLE) is an ETF that follows the movement of a basket of energy companies.
Many mutual funds and ETFs pay a dividend. By buying them, you get immediate diversification compared to buying individual stocks one at a time.
Shelter Interests in a TFSA
If you earn interests in an open account from savings accounts, GICs, or bonds, you can do the same thing in a TFSA. Interests are taxed at your marginal tax rate, so that’s why it makes sense to shelter interests from taxes if these interest-producing vehicles are already a part of your portfolio.
Conclusion and the Last Tip
There’s no right or wrong way to invest in a TFSA. The only wrong way is not using one. The most important tip of all is to replicate in a TFSA the success that you’ve already achieved in an open account.
Stick with what you know and are comfortable with. For example, you cannot write off any losses in a TFSA while you can do so in a non-registered account. And the whole point is to earn more money. So, as Warren Buffett would say, the number one rule to investing is to “Never lose money”.
If you like what you've just read, consider subscribing via the "Subscribe Here" form at the top right so that you will receive an email notification when I publish a new article.Disclosure: At the time of writing, I am long BNS, NPR.UN, ENB, TRP, CNR, T.
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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