Canadians need to become familiar with the new tax-free savings accounts, which join our world on January 1, 2009. In the Fall issue, we addressed who can benefit from having a TFSA and briefly introduced the topic of applying tax-smart investing in TFSA accounts. In this issue, we develop that further.
Already, Canadians have been misunderstanding what a TFSA is: it is a new type of investment account, like an RRSP. It is not an investment on its own, meaning that once you put your money in there, you then must decide how to invest it, and your choices are everything that exists in the RRSP investment world.
As a result, many Canadians now will find themselves with three types of investment accounts at their financial institution: a registered account (RRSP or RRIF), an unregistered account and a TFSA. We believe that how you invest in your TFSA account should depend upon what your purpose is and what your overall asset allocation strategy is. The latter should bear in mind tax-smart investing principles, which now have added complexity, thanks to the new tax-free TFSAs. The following chart summarizes the tax treatment of all kinds of investment income across the three types of investment accounts.
*follow this link for full details of BC tax rates
The second chart attempts to rank the relative tax advantages by account type for different kinds of investment income. There are a few practical issues with these observations. First, ineligible dividend income (from a private company) is relatively rare in sheltered and TFSA accounts. Second, dividends, capital gains and capital losses are not easily separated – they tend to come all together.
TFSAs have their highest comparative tax advantage with interest income and their least advantage with capital losses, followed by eligible dividends for those with incomes under $75,000. For the other types of investment income, the comparative advantage ranking varies with income level.
*1 taxable income under approx $75,000; *2 taxable income above approx $75,000
- If you are saving for short term goals, you may be unwise to undertake much risk, if any, in equities, given what can happen in the marketplace. Thus, all of the accounts you have for this purpose should accumulate fixed income.
- For people with incomes under $75,000, the tax advantages are fairly clear that they should focus on earning interest income in their TFSA and their RRSP and use their non-sheltered account, if they have one, for equity investing.
- For pure capital gains plays, non-sheltered accounts are the best, given that the gains are speculative and that losses can net against gains over time.
- For pure eligible dividend plays, e.g. preferred share issues, non-sheltered accounts are the best for incomes under $75,000, because the rich dividend tax credits make the dividend income tax-free, and in fact can even reduce the tax on other income.
- If you have only TFSAs and RRSPs, and are a long term buy-and-hold equity investor who buys mutual funds or ETF indices, then you probably are safe to use your TFSA for equities.
- For conservative investors with small equity allocations, fill the fixed income component of your asset allocation strategy in your TFSA and sheltered accounts, and use your non-sheltered account to fill the small equity component.
- If you are saving for intermediate term goals, like a house, start your fixed income in the sheltered account and your equities in your non-sheltered account, and complete the overall asset allocation strategy in the TFSA.
- For balanced investors with two accounts, start by filling the fixed income component of your asset allocation strategy in a TFSA and then place the rest in your sheltered account. Execute the equity allocation in your sheltered account.
- For balanced investors with all three accounts, start to fill your equity component in your non-sheltered account and complete it, if necessary, in the other two accounts.
In summary, our financial institutions all will be coming forward with their TFSA “products” in the near future. Many Canadians likely will jump on the TFSA bandwagon quickly. The size constraint of these accounts will make them administratively unprofitable for the financial institutions for a long while. Those same size constraints also will minimize and delay the overall impact on Canadians’ wealth picture.
To paraphrase and modernize a saying of 16th Century Sir Francis Bacon: Family finances, to be commanded, must be obeyed. Those who seek to manage their finances need to pay attention to this new “kid on the block” – TFSAs.