The tax-free savings account (TFSA) is one of the most popular investment vehicles in Canada. Offering a complete tax shelter on both dividends and capital gains, it lets investors take home more of their returns than taxable accounts do.
Nevertheless, there are situations in which you might be better off holding your stocks in a taxable account than in a TFSA. These situations are not common, but they can and do occur. In this article, I explore the one time when holding stocks in a taxable account is better than holding them in a TFSA.
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When you have a large bond allocation
If you have a large bond allocation in your portfolio, you might be better off putting as much of the bond portfolio in your TFSA as possible, before you put stocks in it.
The reason is that bonds have a very severe tax treatment in Canada, which means that they benefit from being held in a TFSA more than stocks do – especially if you are a low-income earner.
Bonds are taxed at your marginal tax rate. If you pay 30% on an extra dollar of employment income, then you pay a 30% tax on bond income – no ifs ands or buts.
Not so with stocks. Inside taxable accounts, stocks are eligible for the dividend tax credit and capital gains exclusion. The dividend tax credit is a 15% credit on the “grossed up” value of dividends. Capital gains exclusion is the non-taxation of a portion of a capital gain. These special tax treatments mean that stock income gets taxed less than bond income of the same amount, when both are received in taxable accounts.
If you have a bond allocation large enough to eat up all your TFSA room, you should hold the bonds in the TFSA instead of stocks. You could put the stocks in an RRSP, but if they are non-dividend stocks that you plan on holding long term, holding them in a taxable account is fine. Remember that RRSP taxes can be steep if you withdraw funds while still working.
If you are a low income earner, you might even prefer to keep your dividend stocks out of your TFSA, in favour of bonds. The reason is that, when your income is low, the dividend tax credit can often reduce your taxes to zero. This is possible if your tax rate on employment income is 15% or just slightly higher than 15% (the gross up means that the “15% tax credit” is actually a little greater than 15%).
An example of a stock you could hold in a TFSA
If you hold a lot of shares in a non-dividend stock like Shopify (TSX: SHOP), you might not need the TFSA’s tax shelter all that much. First, as long as you hold a stock like SHOP, you pay no capital gains tax. Second, since SHOP does not pay a dividend, you don’t need to worry about dividend taxes for now. Third and finally, even if SHOP does initiate a dividend, you’ll likely pay no taxes on the dividends if you are a low-income earner.
This isn’t to say you should actively prefer to hold Shopify stock in a taxable account. The stock could initiate a dividend; you might want to sell it someday; and you probably will earn a decently high income at some point in your life, if you aren’t already. But if you want to keep, say, 40% of your portfolio in bonds, you should put those in your TFSA before you put Shopify in it. Bonds usually benefit from tax sheltering more than stocks do.
