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

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.

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.

The post Are You Using Your TFSA the Right Way? Many Canadians Aren’t appeared first on The Motley Fool Canada.

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More reading

• The ETF I Keep Buying and Plan to Hold Forever — Here’s Why
• 2 Dividend Stocks I’d Feel Good About Holding for the Next 2 Decades
• How to Keep Investing Wisely When the TSX Keeps Climbing
• What the Fine Print Really Says About U.S. Stocks in Your TFSA
• 2 Dividend Stocks to Hold Comfortably for the Next 5 Years

Fool contributor Andrew Button has no positions in the stocks mentioned. The Motley Fool has positions in and recommends Shopify. The Motley Fool recommends Fortis. The Motley Fool has a disclosure policy.