All earnings in Tax-Free Savings Accounts (TFSAs) are tax free if you don’t run a day trading business in the account. So, it comes to shielding investment income that would otherwise be taxed big by the Canada Revenue Agency (CRA) in non-registered accounts or taxable accounts.
Think of interest income (from high-interest savings accounts, traditional Guaranteed Investment Certificates (GICs), and bonds), cash distributions from stocks, and price appreciation from market-linked GICs, bonds, and stocks.
In Canada, interest income is taxed at your marginal tax rate. So, Canadian investors may choose to shield their interest income in the TFSA. Notably, when you earn foreign dividends in your TFSA, there could be a foreign withholding tax that’s not recoverable.
Stocks have historically generated the highest returns in the long run compared to other asset classes.
Growth stocks
Ultimately, half of your capital gains are taxed at your marginal tax rate when you sell investments with price gains in your non-registered account. The idea to hold growth stocks in the TFSA is to book hefty capital gains at some point.
I’m cherry-picking here, but imagine having a stock like Constellation Software (TSX:CSU) that grows your money 15-fold in 10 years through price appreciation from $6,500 to north of $97,500. You would pay zero taxes on the +$91,000 capital gains if you decide to sell.
Today, the tech stock maintains its price strength while the Canadian stock market and many other interest rate-sensitive stocks have experienced a landslide. Constellation Software management has been superb in its capital allocation, which drove high five-year returns on invested capital and returns on equity of about 25% and 45%, respectively.
You can imagine that the growth stock is not cheap today. At approximately $2,825 per share at writing, it trades at about 36.5 times adjusted earnings. However, for its anticipated double-digit earnings growth rate, analysts don’t think it’s an expensive stock. Essentially, it’s a wonderful business trading at a fair price for TFSA investors who have sights set on long-term price appreciation.
Dividend stocks
Canadian dividends are taxed at favourable tax rates in non-registered accounts. Still, if you have room in your TFSA after allocating room for growth stocks, you might as well hold dividend stocks in there to pay no taxes on the dividends.
Big Canadian bank stocks have corrected over 20% as a sector, using BMO Equal Weight Banks Index ETF, as a proxy. The Big Six Canadian bank stock holding in the exchange-traded fund that offers the biggest dividend yield is Bank of Nova Scotia (TSX:BNS), which corrected north of 30% from its peak in 2022.
The most international bank in Canada is viewed to be riskier in this macro environment. Otherwise, the market wouldn’t price it with an eye-popping dividend yield of 7.2%. This could be an opportunity for income investors.
However, let’s not understate the risk involved. The bank stock may be depressed for some time, as there’s heightened uncertainty in the economy. This is why Bank of Nova Scotia has been increasing its loan-loss provisions, resulting in lower earnings and a higher payout ratio than normal.
For example, its trailing 12-month payout ratio is close to 70% of net income available to common shareholders. Its payout ratio is estimated to be about 60% of adjusted earnings this year, whereas normally, it’s under 50%. The bank also has a treasure chest of retained earnings that can help protect its dividend.
