Why Your TFSA Is Perfect For Investing
How are you feeling about your money these days? Have you started investing yet?
If you’re one of the people who sent me a DM on Instagram about future money topics, thank you so much! This is one of the requested topics, and I’m going to cover all of them over the next few weeks.
I’m so excited to continue on our wealth-building journey. So far, we’ve discussed things like why you need to start investing now, why to invest with a robo-investor, and how to make your future wealth a priority.
Today, I’m going to share an investing tip that could save you thousands of dollars in taxes. It’s my favourite four-letter acronym: TFSA!
Do you have a Tax-Free Savings Account? Do you know just how ideal this account is for investing purposes? Let me tell you why.
What is a TFSA?
The Tax-Free Savings Account was introduced in 2008 as a savings option for Canadians over 18 years old. There’s a limit to how much money you can put in a TFSA, but one of the great things about it is that every year, your limit increases by a few thousand dollars more.
If you were 18 or over in 2008, your contribution limit in 2019 would be $63 500. If you turned 18 in any of the years following, you can use this calculator to see what your limit is, based on your age.
For example, my current contribution limit is $43 500. This is well beyond what I have contributed to it so far, so not only do I have room to fill it out now, but I’ll keep acquiring more room in the future.
Now, the name Tax-Free Savings Account is a bit misleading. And no, it’s not the “tax-free” part. There’s no deception there, and it’s actually as amazing as it sounds. It’s the “savings” part that can be confusing.
We usually think of our savings accounts as static containers for our money. We don’t always consider investments as part of our “savings” because their value fluctuates.
But you can and absolutely should use your TFSA to invest. Why? Because all the compound interest you earn is tax-free!
Why You Need to Invest through Your TFSA
Remember a few posts ago when I illustrated how you can make $1 million out of less than $100 000 if you start investing at 25?
If you’re making those investment contributions through a TFSA, not only will you avoid tax on your contributions of up to $100 000, but you also won’t be taxed on the other $900 000 that you earn from interest.
You get to have $1 million tax free!
By investing, you’re giving your money a full-time job. And by investing specifically with a TFSA, your money is performing that job without any (investment) income tax!
Your TFSA and investments are truly a match made in heaven. With this combo, you’re optimizing your wealth-building potential by having your highest earning financial vehicle in your lowest cost account. Basically, you’re earning as much as you can, while giving away as little as possible.
What If I already have a tax-Free Savings Account?
Like I mentioned, the TFSA is often thought of as just a savings account, so you might have opened one for regular savings, without realizing that you can use it to invest. Here are some other ways you might take advantage of the TFSA.
Your Emergency Fund
As I’ve mentioned before, your emergency fund should never be in investments.You can keep your emergency fund in one TFSA and open up an additional TFSA that’s just for investments.
You’re allowed to have more than one TFSA, and you can even have them under different institutions, as long as the sum of the money you put in all of them doesn’t exceed your limit.
Let’s say you have a $10 000 emergency fund. If your TFSA limit is $22 600, you can potentially keep that emergency fund in one TFSA and invest up to $12 600 through another TFSA.
What if you want to invest more than your limit allows? Go down to the heading, “What If I Max Out My TFSA,” to find out what to do in this situation.
Savings Goal Accounts
Alternatively, what if your financial picture is a bit more complicated than just having emergency savings and retirement investments?
Maybe you’re saving for a different goal, but one that’s not as long-term as retirement — like a new car or a major trip or a wedding.
Again, you can keep these savings in a TFSA, as well. However…
If your emergency fund + your retirement investments + your other savings accounts = above your TFSA limit, then you have to be strategic about which money stays in it and which money gets moved elsewhere.
So how do you choose what kind of account to put your money in? Keep reading!
What If I Max Out My TFSA?
If you have enough savings/ investments that you end up exceeding your TFSA limit, you’re going to have to look for different options.
One option is allocating some of your investments into a Registered Retirement Savings Plan or RRSP. The thing about the RRSP is you have to be absolutely sure that money is going to be used for retirement because if you withdraw early, you face penalties. The RRSP is not as flexible as a TFSA, from which you can withdraw freely at any time.
I’ll discuss RRSPs more in a later post because I figured that introducing two different accounts at once might be a little overwhelming. So, without getting into RRSPs, what should you do with money that exceeds your TFSA limit?
Remember, the TFSA has a special perk — it saves you tax on the money that your money makes,. e.g. the $1 million you get out of $100 000.
So, it makes the most sense to use your TFSA for higher interest rate accounts and money that you plan to grow over time.
The trick to choosing which savings should be moved out of your TFSA again has to do with the function of the savings: whether they’re for keeping money or making more money.
If the function of a particular savings goal is to keep the money (for a period of time), you probably don’t need it to be tax-free.
If the function of the goal is to make money, then you want it to be tax-free, or at least tax-advantaged in some way.
Here are examples to show when a TFSA is not necessary or ideal, i.e. situations in which you’re keeping, not making money.
I open a new savings account for a car that I want to buy in about a year. In this case, I’m not really expecting to make that much interest on it. There’s not enough time for interest to make a huge difference on my money, anyway. I just want the account as a container to keep the car money, so I’m not tempted to spend it.
You see how keeping money is different from trying to make money?
As another example, your emergency fund doesn’t need to be in a high-interest account because its goal is not to make interest. Moreover, you don’t really need it to grow beyond that 3-6 months of living expenses.
My emergency fund is in a savings account that makes almost negligible interest — I think the rate is 0.05%. I’ve decided not to have my emergency fund in a TFSA because it’s not worth it. I’d rather use the perks for money that’s making me money.
If you exceed your limit by keeping all of your savings in TFSAs, your emergency fund should be the first to be moved to a normal savings account. I’m not a big fan of low interest accounts, but when it comes to an emergency fund, the interest doesn’t really make a difference on the purpose of the account. And the lower interest you make, the less you have to worry about taxes.
How Do I Make Sure I’m Investing Through My TFSA?
Now, how do you get started?
Most online discount brokers and robo-investors have a TFSA option. So, when you do open your investment account, make sure to select it. It’s a good idea to make sure your broker or investor has that option before you open an account. For reference, my account with Wealthsimple has a TFSA option, which I absolutely use.
If you’re working with a financial professional, make sure they know that you want your investments to be tax-free.
And in general, if you do have a complicated financial picture, or just don’t have the confidence to decide how to allocate your money, always speak to a financial professional. I give advice based on my own research and experience (and my desire to help!), but I don’t know your situation. Please make sure you understand what you’re doing with money before you do it.
Stay tuned for more on TFSAs and RRSPs.
Have a great week and happy money making!