Are You Using Your TFSA the Right Way? Many Canadians Aren't

Are You Using Your TFSA the Right Way? Many Canadians Aren’t

You pay no taxes on Fortis (TSX:FTS) stock in a TFSA.

Andrew Button

Andrew Button is a freelance financial writer with extensive experience writing about stocks, real estate and managed products. His portfolio consists mainly of blue chip dividend paying stocks and index funds. He has completed the Canadian Securities Course and passed the CFA Level 1 exam. Follow Andrew on Twitter: twitter.com/AJButton2

Published June 21, 8:15 pm EDT

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.

man crosses arms and hands to make stop sign — Source: Getty Images

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.