Sometimes, the TFSA is misunderstood. One common misunderstanding is how many people think the Tax Free Savings Account (TFSA) is just a savings account. After all, the ‘SA’ in TFSA stands for ‘savings account’. If the TFSA was called the Tax Free Investment Account (TFIA), would people then mistake it for just a savings account with no tax? Would more people invest in their TFSA differently?
What can you invest in your TFSA?
The bottom line is investment options you have for the RRSP, you also have for the TFSA. You can choose from a wide range of investment options. Here's a basic primer explaining some of the most common choices for investing your TFSA:
- Savings Accounts – When the TFSA was first introduced in early 2009, I remember the barrage of advertisements from financial institutions promoting savings accounts as the prime investment vehicle for the TFSA. High interest savings accounts are perfect investments for a TFSA especially if you need liquidity and safety. Since there is no tax consequence to taking the TFSA out, the TFSA is a great place to save to spend. If you are planning to buy a car or do some renovations or even go on a trip, the TFSA can be a great place to invest some money and high interest savings accounts might be a great way to keep things liquid.
- Guaranteed Investment Certificates (GICs) – GICs are also a safe way to play but you might get a higher interested rate than a saving account by investing for a longer period. Basically with a GIC, you decide how long you want to put the money away for (like 1 to 5 years) and usually the longer you are willing to commit, the higher the interest rate you will get. Essentially GIC investors lend the financial institution money with the plan that they will get their money back plus some interest. GICs are ideal for conservative investors wanting to play it safe which is important the closer you get to retirement.
- Bonds – Bonds come in many shapes and sizes. There are government bonds and corporate bonds. There are short term bonds (less than 5 years) and long term bonds (as long as 30 years). Bonds are similar to GICs in that the investors lend money with the idea they will get their money back plus interest. The difference between a bond and a GIC is that bonds can be traded on the open market before maturity where a GIC is typically locked-in for the term. Because the bond can be traded or sold, bond values can fluctuate and could increase or decrease in value. Some investors like bonds because they can be cashed at any time but there is some risk in that the value of a bond could go down. Although bond prices could fall, they are still considered to be safer types of investments.
Adding some risk
- Mutual funds – For investors who want to seek higher returns than savings accounts, GICs, and bonds, it may be a natural progression to shift to mutual funds. Mutual funds are really pools of money where investors bring their money together and give a mutual fund manage the ability to buy and sell investments on a larger scale. Just like bonds come in all shapes and sizes, mutual funds come in all shapes, sizes, colors, options and prices. There is no shortage of mutual funds with over 7000 choices. You can find a mutual fund for pretty much any investment need. Mutual funds are riskier because they have no guarantees and can fluctuate in value. There are conservative mutual funds as well as aggressive ones. Choosing the right mutual fund can be very confusing and complicated. One of the biggest criticisms of mutual funds are the management fees investors pay as a percentage of the asset value.
- Segregated funds – Segregated funds (Seg funds) are like mutual funds except they are offered by insurance companies. Since segregated funds are offered by insurance companies, seg funds have some unique benefits over mutual funds. They can provide ‘insurance’ guarantees on the capital at death or maturity and some have reset privileges. It’s important to keep in mind these benefits do not come free. Segregated funds tend to have higher management fees that mutual funds.
- Exchange traded Funds (ETFs) – Exchange traded funds are similar to mutual funds and seg funds from the perspective that they are pools of money that allow investors to access a portfolio of investments. ETFs differ in that most are passive where there is no manager buying and selling investments. Instead they typically mirror indexes or benchmarks. As a result, ETFs have exceptionally lower fees than mutual funds. The ETF market has come a long way and there is more choice than ever and many do-it-yourself investors like investing their TFSA in ETFs.
In the case of mutual funds, Seg funds and ETFs, you can invest in safer, fixed income options like bond funds or bond ETFs. Not all choice are risky but some choices are riskier than others.
- Individual stocks – With your TFSA, you could also buy individual stocks. Those that did so back in early 2009, bought stocks at rock bottom prices and are looking at great gains inside the TFSA. As cumulative TFSA limits increase and TFSA portfolios get bigger and bigger, there will be more people investing directly in stocks. There is a certain economy of scale to buying individual stocks so it can be less cost effective (but not impossible) to buy a lot of stocks with a few thousand dollars.
While this list is not exhaustive, it does represent the types of investments that most Canadians will use for their TFSA. Some prefer to work with guaranteed investments and others will seek higher returns despite having some risk attached to it. Choosing which type of investment will really depend on your time frame, personal objectives, involvement, experience, risk tolerance and financial position. The great things about the TFSA is the universal appeal and benefit to different types of people.
As contribution limits grow, you will start to see more and more opportunities available in the market place from different companies. Regardless, it's important to be aware of how you are investing your TFSA.