How to Invest in a TFSA

A TFSA (Tax-Free Savings Account) is a valuable investment tool for Canadians. Once you understand the rules, you can incorporate a TFSA into your financial plan in various ways that accelerate growth and avoid taxes.

What is a TFSA?

A TFSA allows you to save and invest after-tax dollars, which grow and compounds in interest tax-free. You can also withdraw this money tax-free, whenever you wish. It’s an incredible opportunity to build wealth and a tool for both long-term and short-term savings. While it’s not complicated, there are some parameters to learn.

Important TFSA investment considerations

Understanding these key TFSA rules will prevent you from being subject to steep penalties while managing investments.

Over-contribution pitfalls

Each year, the government determines the new amount of contribution room added to the current limit. As of 2022, for Canadians who were at least 18 years old in 2009, the total accumulated TFSA contribution limit is $81,500.

Contributing more than the total TFSA limit will result in a penalty of 1% of the excess amount for each month it remains in your TFSA.

You might unwittingly over-contribute to your TFSA in the following situations:

You transfer your TFSA to another institution by manually withdrawing the funds and re-contributing them into your new account. (Instead, allow the financial institution to transfer the TFSA directly).
You withdraw money from your TFSA and re-contribute it in the same year, but you’ve already maxed it out (TFSA withdrawals are added back to your contribution room the following year).

» MORE: A guide to TFSA contribution limits and withdrawal rules

TFSA investment gains and losses

Capital gains, reinvested interest, and dividends do not affect your TFSA contribution room. Likewise, capital losses don’t increase your room. As long as the money remains in your TFSA account, your TFSA contribution limits are not affected by a change in value.

If you withdraw money from your TFSA, the withdrawn amount (regardless of gains or losses to your initial contribution) is added back to your available contribution room the following year.

» MORE: How to hold a GIC in a TFSA

Day-trading is not allowed

You can own stocks in your TFSA as long as they trade on at least one stock exchange. However, if you trade extensively, the CRA may deem you to be carrying on a business by day-trading, in which case all the earnings (interest, dividends, capital gains) will be taxed as income.

TFSA investment options

When opening a TFSA, most investors choose between two main types of accounts.

Regular deposit accounts, which are opened at a financial institution. Since this type of TFSA is registered with a specific bank, investment options are limited to that bank’s suite of offerings, including HISAs, GICs and mutual funds.
Self-directed TFSAs, which are held with a brokerage, so investment options aren’t limited to what a bank offers. A self-directed TFSA can hold GICs, mutual funds, stocks, bonds, ETFs, and more.

Types of TFSA investments

A TFSA isn’t an investment unto itself (like stocks, bonds, or mutual funds), but rather it’s a type of account that can contain these — and other — types of investments.

Interest-bearing investments

Interest-earning investments (like GICs, HISAs and bonds) are generally “slow and steady” in growth, with limited volatility and limited gains.

Pros: Interest income is 100% taxable outside of a TFSA, so a TFSA can shelter this kind of income from taxation.
Cons: Because of limited gains, there will be less compound growth over time. Also, if your money is locked into a GIC or bond, you can’t withdraw it until the investment comes due.

» See our picks: Canada’s Best High-Interest TFSAs

Capital gains and dividend investments

Investments that earn capital gains and dividend income (like stocks, ETFs, and mutual funds) can be more volatile than interest-bearing investments. However, over long periods of time, they tend to perform better (depending on the investment choice).

Pros: Inside a TFSA, capital gains and dividends can compound, which over time can result in dramatic gains, all of which are tax-free.
Cons: If you’re planning to (or need to) make a withdrawal from your TFSA in the short term, and the investment has gone down in value, you may crystallize a loss. And unlike non-registered investments, you can’t deduct that loss from other taxable capital gains.

Important considerations when investing in a TFSA

Consider a TFSA to be a tool in your financial planning toolkit. Here are some ways it can be used.

Short to medium-term investment goals

Unlike Registered Retirement Savings Plans (RRSPs), there’s no penalty for withdrawing money from your TFSA any time, and the withdrawal amount is added back to your allowable contribution limit the following year.

Thus, TFSAs can be used for investment goals like the down payment for a home, a life event like a wedding or big vacation, or even as an emergency fund.

The disadvantage of using a TFSA for shorter-term goals is that you lose out on the tax-free compound growth of a longer-term investment strategy.

Retirement savings

Using a TFSA for retirement savings has many advantages. For example, because your eventual withdrawal in retirement is tax-free, it won’t affect other income-based retirement benefits like Old Age Security or the Guaranteed Income Supplement.

In fact, an argument could be made that TFSAs are more tax-preferential than RRSPs; although you don’t get a deduction for your contributions, 100% of the growth is tax-exempt. RRSPs give you an immediate deduction, but when you withdraw the money (which will presumably have grown significantly), it is 100% taxable.

» Understand the difference: RRSPs vs. TFSAs

Tax planning

A TFSA can be instrumental in your tax planning strategy. For example, in lower-income years, you can invest in a TFSA (when the tax deduction from investing in an RRSP wouldn’t be as large), and you can withdraw TFSA money during higher-income years without affecting your taxable income.

Because TFSA withdrawals aren’t added to income, they won’t affect income-based tax credits or benefits, like GST/HST Credits, Canada Child Benefit, Canada Workers Benefit, and the Age Credit.

How (and when) to use multiple TFSAs

You can have as many TFSA accounts with the same or different financial institutions as you wish, but the contribution limit applies to all accounts combined.

The advantage is that each account can be dedicated to a separate goal. A long-term retirement portfolio would be invested differently than a short-term vacation fund. Having separate TFSAs makes it easier to manage financial plans accordingly.

This depends on your time frame and what you want to use the money for. TFSAs are incredibly flexible and can be used in many ways depending on your financial goals.

How you use a TFSA boils down to asset allocation, which hinges on your personal goals. Your investment choices relate to your time frame and tolerance for risk. If you don’t know where to start, consider consulting with an investment advisor, financial planner, or even a robo-advisor.

Absolutely. TFSAs are one of the best and most flexible tax-preferred instruments for Canadians.

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