Every week, I talk to a lot of people who don’t really understand the benefits of a TFSA. One common misunderstanding about the TFSA is many people think the TFSA is just a savings account. After all, the ‘SA’ in TFSA stands for ‘savings account’. I wonder if the TFSA should have been called a Tax Free Investment Account so more people would invest in their TFSA differently?
What can you invest in your TFSA?
The bottom line is that the investment options you have available for the RRSPs are the same investment options 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:
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 withdrawing money from the TFSA, the TFSA is a great place to save to spend later. 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 a high-interest savings account might be a great way to keep things liquid, accessible and safe.
Guaranteed Investment Certificates (GICs)
GICs are also a safe way to invest in the TFSA but you might get a higher interest 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 instead of investing in the ups and downs of the stock market.
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 entire 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
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 manager 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, colours, 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 is the higher management fees investors pay as a percentage of the asset value.
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 than 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 they are traded like stocks on a stock exchange. ETFs tend to have lower fees than mutual funds and segregated funds. Some of the most popular ETFs are passive where there is no manager buying and selling investments. Instead, they typically mirror indexes or benchmarks. 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 is risky but some choices are riskier than others.
Related article: 3 ETFs I own for income
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.
How to invest your TFSA?
Talk to a Bank or Financial Advisor
If you are not sure where to start, you will likely want to talk to a financial advisor or a bank to get the process rolling. One of the problems that I have seen in the past is that if you go to a bank to open a TFSA, the default is often a savings account unless you ask about other options.
Because the greatest benefit of the TFSA is the tax-free growth, you might want to consider some investments that have greater growth opportunity.
Open a trading account and do it yourself
If you prefer to try investing on your own, you can open a trading account. I happen to use Questrade for my trading account for both my RRSP and my TFSA as they allow you to buy ETFs commission-free. There are lots of other options available through your banks. Many Do-It-Yourselfers will typically buy ETFs or individual stocks.
Robo Advisors are newer options that help investors lower the fees but still provide advice and help on a service on-demand model. All the Robo Advisors in Canada allow you to open up a TFSA account option. Robo-Advisors will typically manage investment portfolios using low-cost ETFs to keep the fees as low as possible.
Related article: Battle of the Best Robo-Advisors
As you can see, there is no shortage of investment options for the TFSA. Think about how you are going to use the TFSA before you invest. If you are going to use the TFSA as an emergency account or a future spending account then you might want to go to the bank and look at safer options. But if you want to really take advantage of the tax-free growth in the TFSA, then look to invest the money through either a trading account like Questrade or through a Robo-Advisor.