Are you using your Tax-Free Savings Account (TFSA) the right way?
You might think you are, but if you’re like many Canadians, you’re not.
Simply stashing cash in a TFSA is pointless and confers none of the benefits the account was designed to provide.
The point of a TFSA is to stash away cash-flowing assets that pay you over the long term. The more heavily taxed the asset (i.e., high-yield bonds), the better it is for inclusion in the TFSA. The less it is taxed (i.e., zero-interest deposits), the less sense it makes to put it in a TFSA.
In this article, I will share some rules for using a TFSA, so you can maximize your long-term tax savings.
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Rule #1: The more it’s taxed, the more it should go in the TFSA
The big rule of TFSA investing is that the more heavily a thing is taxed, the more it ought to be put in a TFSA. The reason for this is that the TFSA spares investments from taxation; the more something is taxed outside of a TFSA, the more the TFSA boosts its after-tax return.
So, high-yield bonds are classic candidates for inclusion in a TFSA. Bonds do not benefit from either the dividend tax credit or the capital gains exclusion rate. So, if you have a junk bond yielding 12%, that’s a classic asset for inclusion in the TFSA. It’ll be taxed very heavily outside of a TFSA.
Rule #2: Dividend stocks for high-income investors
Dividend stocks are also pretty good candidates for inclusion in a TFSA if you have a high income and the dividend tax rate won’t save you that much in percentage terms.
If your tax rate is 15%, the dividend tax credit will reduce your dividend taxes to zero. There’s not much need to put your dividend stocks in a TFSA in this scenario, especially if you don’t expect your income to increase much in the future.
If you have a 50% tax rate, however, the dividend tax credit won’t save you as much money in percentage terms. Even with the gross-up, the 15% cut here still leaves you paying quite a bit of tax if your dividend stocks are not held in a TFSA.
Imagine you’re holding $100,000 worth of Fortis (TSX:FTS) stock and have a 50% marginal tax rate. Fortis is a dividend stock with a fairly hefty 3.26% dividend yield. Even after the gross up and 15% tax credit, a person with a 50% marginal tax rate is going to a hefty tax on that. Such a person holding FTS in a TFSA will not. So, holding Fortis in a TFSA can make sense if your marginal tax rate is high.
Rule #3: Active trading
If you plan on holding non-dividend stocks for the long term, holding them in a TFSA is not so crucial: such stocks aren’t taxed if they aren’t sold. However, if you’re buying and selling such stocks regularly, then you’ll be paying taxes on them — and frequently too! True, you’ll get 50% of your taxes slashed by the capital gains exclusion rate, but if you’re a day trader buying and selling something like Shopify every day, you’ll end up with a big tax bill. Certainly, you shouldn’t be trading frequently at all — and you definitely shouldn’t be day trading in a TFSA. But if your trading frequency is a little higher than average, then even with non-dividend stocks, holding in a TFSA makes sense.
