How to invest with the new TFSA plan
Having cleared all legislative hurdles last month, Tax Free Savings Account plans are officially a reality and will be available for Canadians beginning in January.
While the financial services industry is scrambling to get products and services in place, the average investor is still in the dark as to how these new savings plans work and, most importantly, how funds in a TFSA should be invested.
A Harris/Decima research report released last week, TFSA Market Assessment, found only 3% of consumers polled knew a "great deal" about TFSAs, while 40% had "absolutely no awareness." More than 2,500 Canadians were polled for the survey this past spring.
So, to recap, starting in 2009, every Canadian older than 18 will be able to contribute up to $5,000 per year into a TFSA plan. Contributions are from after-tax dollars so, unlike RRSPs, no tax deduction is available. But once inside the TFSA, funds grow tax-free and can be withdrawn at any time, for any purpose, also on a tax-free basis. Amounts withdrawn can be recontributed in a subsequent year.
There has been much debate on how TFSA funds, once contributed, should be invested. Some financial experts believe that since the TFSA represents short-term money (a so-called "emergency fund") that can be accessed multiple times during one's lifetime to buy a first car, pay for a wedding, buy a home, etc., the funds are best invested in a highly liquid and safe vehicle such as a high-interest savings account or money market fund.
That thinking was echoed by the Harris/Decima poll, which found 87% of Canadians surveyed expected to hold cash and cash-equivalents inside their TFSAs. Only 39% of those surveyed expect to hold equities in their TFSAs.
But TFSAs might turn out to be the ideal place to hold equities and other riskier assets. Typically, the bigger the risk, the higher the expected rate of return. And if the returns are tax-free, the reward for investing in a riskier asset within a TFSA could prove to be quite valuable.
What if the risky asset crashes? If it is held in a TFSA, you'll lose the ability to claim a capital loss on the decline in value. But that loss (depending on your province and tax rate, worth a maximum of 24%) is only good if you have other capital gains against which to apply it.
However, capital gains are becoming a much rarer commodity given the government's prediction that over the next 20 years, more than 90% of Canadians will hold all their financial assets within a TFSA or other tax-efficient savings vehicle, such as an RRSP or RRIF.