The 2021 Tax-Free Savings Account (TFSA) limit has been announced. As expected, it’s $6,000, bringing the total amount of cumulative contribution space to $75,500 next year. If you were 18 or older in 2009, you’re entitled to all of that space. If you’re younger, the total amount depends on how many years you’ve been eligible to open a TFSA. In this article I’ll be exploring what you should do with your new $6,000 in 2021 TFSA space.
The easy part: Investing the money
The most obvious thing to do with your TFSA contributions is to invest them. The TFSA has no benefits if you don’t invest. Unlike an RRSP, there’s no tax break just for contributing. And you don’t pay taxes on cash. Technically bank account interest is taxable, but the amount is negligible due to low interest rates. Really, you need to invest your money to benefit from contributing to a TFSA. That way you can avoid the taxes you’d normally have to pay on dividends and capital gains.
The hard part: Choosing your investments
Deciding to invest in a TFSA is a no-brainer. The hard part is actually deciding what to invest in. While you’d think any investment is a good TFSA investment, the truth is that some investments are better suited to the account than others. Also, some investments aren’t eligible for the account at all.
There are two types of investments that really take advantage of the TFSA’s tax benefits:
- Dividend stocks/interest-bearing bonds
- Growth stocks you plan to cash out of quickly
A classic example of a dividend stock is Royal Bank of Canada (TSX:RY)(NYSE:RY). With a 4.14% yield, it pays out $2,070 a year on a $50,000 investment made today. High yielders like that are always good TFSA picks. The reason is that when a stock pays automatic dividends, you instantly have to pay tax on it. It doesn’t matter whether the dividend is paid in cash or stock.
With capital gains only stocks, you can avoid tax by not selling. With a dividend stock like Royal Bank, you can’t do that. So it pays to hold such stocks in a TFSA. Especially when the yield is very high–as is the case with Royal Bank.
Next, we have growth stocks like Shopify Inc (TSX:SHOP)(NYSE:SHOP). If you own stocks like SHOP, there’s a good chance you’re hoping to cash out quickly at large gains. If that’s the case, then you should hold these stocks in a TFSA. Technically, capital gains-only stocks are less suited to TFSAs, because their lack of dividends make them easy to avoid tax on anyway.
But if you hold a stock like SHOP that’s been returning 100% or more a year, there’s a very good chance you’ll want to cash out soon and spend the proceeds. At that point the taxes kick in. The TFSA is ideal for this scenario, because it eliminates taxes in the account, and on withdrawal. You don’t get that latter benefit with a taxable account or even an RRSP.
Foolish takeaway
In 2021, you’ll have new TFSA space to play with. If you want to make the most of it, your best bet is to spend the money on bonds and dividend stocks, because they automatically benefit from the TFSA’s tax treatment. The second best bet is growth stocks that you plan to cash out of quickly, because the TFSA also helps you avoid taxes on realized capital gains. Whatever you buy with your TFSA space, make sure to diversify broadly, and play for the long term.
