Did you know that the account you choose to invest in could make a significant difference in your investment income? The Canada Revenue Agency (CRA) allows you to grow your investment income tax-free in a Tax-Free Savings Account (TFSA) and Registered Retired Savings Plan (RRSP). What exactly does tax-free growth mean?
Tax-free growth in investment income
Let’s say you invested $2,000 in a particular stock. It becomes $6,000 in five years. If you sell that stock, it brings a capital gain of $4,000. In Canada, 50% of your long-term capital gain is taxable. You add $2,000 in investment income (capital gain) to your taxable income in the year you sell the shares. Considering the minimum tax rate of 15%, you pay $300 (15% of $2,000). Even if you use the $6,000 to reinvest in another stock, you pay the capital gains tax.
But if you invest through registered accounts like a TFSA or RRSP, you won’t incur this tax if the amount stays in the account, idle, or reinvested. And if you invest through a TFSA, you can withdraw tax-free.
Pre-requisites for a million-dollar portfolio
A $300 amount might look small next to a million dollars, but when investments compound, the tax bill becomes bigger and bigger. Imagine paying a 30% tax on half a million in capital gain. Foe this reason, it is imperative to consider the tax implications when building a million-dollar portfolio.
Reasons to choose tax-free withdrawals in a TFSA
The RRSP allows you to invest a higher amount, deduct the contributions from taxable income, and grow your investments tax-free. But the withdrawals are taxable. So, it is a good account to build your passive income portfolio. The TFSA is better-suited to build a million-dollar portfolio for three reasons.
- Tax-free growth of investment income
- Tax-free withdrawals
- Allows you to invest in US stocks without giving up on tax benefits
The CRA allows you to invest $6,000 annually in a TFSA ($6,500 in 2023). You cannot deduct the TFSA contribution from your taxable income. But for a small tax amount, the outcome is several times better. Here’s how.
Investing in US stocks
If you had invested $6,000 in Tesla (NASDAQ: TSLA) in January 2020, you could have purchased 156 shares at US$29.53. In around four years, the share price surged almost tenfold to US$263.62. You not only get the benefit of the share price appreciation but also the dollar-conversion benefit. Your $6,000 invested in 2020 is $55,932 today (after converting to Canadian dollars). If you were to pay 15% in tax, you would prefer paying it on $6,000 rather than $55,932.
But be wary of when you withdraw from the TFSA. Because you can only contribute a limited amount. Any contribution above the threshold will be taxable. And withdrawals don’t increase your contribution room.
Making the most of TFSA’s tax-free growth of investment income
You can book profits from time to time by selling some shares of Tesla and use that money to invest in other growth stocks like Ballard Power Systems (TSX: BLDP) and Hive Digital Technologies. As you did not withdraw the amount from the TFSA, it won’t impact your $6,500 contribution limit for 2023. And you can invest the complete amount without any taxes.
Ballard Power Systems is making hydrogen fuel cells for commercial vehicles. It could become the next big thing through technological improvements and infrastructure. Even electric vehicles seemed like a loss-making venture in 2015. But technology, the ecosystem, and the urgency of controlling carbon emissions made it a reality.
This makes energy security along with low carbon emissions all the more urgent. Ballard Power Systems stock could take off and become the next Tesla in the next 10-15 years if it succeeds in its hydrogen fuel cell venture. But keep your investments limited as the company is still at a nascent stage with no assurance of complete success.
TFSA investing tip
Building a portfolio of high-growth stocks makes good sense in a TFSA. As for an RRSP, an income stock makes more sense because dividend stocks will only give a 5-7% annual yield. And you will be taxed on withdrawals, reducing your overall investment income. Make optimum use of both accounts.
