TFSA: A new piggy bank

The new Tax-Free Savings Accounts introduced by the federal government are a welcome piece of good news. But most of us are still trying to figure out how to make the best use of them.

Here are the basics: Anyone over 18 can invest up to $5,000 a year in a TFSA. You can put your money into a savings account, GIC, stocks, bonds or mutual funds. No, you don’t get a tax break for contributing money, as you do with an RRSP, but your money grows tax free inside the TFSA—and, unlike an RRSP, when you withdraw your money, you don’t pay a penny of tax. This can have very nice effects. If you contribute $200 a month to a TFSA for 20 years at an average annual return of 5.5%, you’ll amass $11,045 more than you would in a taxable account. That makes for one fat piggy bank.

Unfortunately, TFSAs have their pitfalls. How do you avoid them? Just follow our TFSA do’s and don’ts:

Do use TFSAs for fixed income investments. David Stewart, a financial adviser at Stewart & Kett in Toronto, recommends using your TFSA primarily for GICs or bonds since the interest you earn on these investments would ordinarily be heavily taxed. It makes less sense to hold equities in a TFSA since capital gains on stocks already enjoy tax advantages. So do dividendsfrom Canadian companies.

Don’t ignore fees. Some brokerage firms are charging hefty fees to manage TFSAs, so it pays to shop around. At BMO Nesbitt Burns and BMO InvestorLine, you’ll pay a $50 annual administration fee as well as withdrawal fees that range from $15 to $25. In contrast, most banks charge no fees if you put your TFSA money into a savings account or GIC. You can find other no-fee deals at E-Trade Canada, TD Mutual Funds and ING Direct.

Don’t treat your TFSA as a rainy-day fund. The big payoff from a TFSA comes in the long run, after your investments have doubled and tripled in value. At that point, a TFSA can save you thousands of dollars a year in tax. On the other hand, if you dip into your TFSA account every few years to buy a car or repair the leaky roof, you blow the benefits. A TFSA “will simply not shelter much of your money from taxes if you use them as an emergency account,” says Gordon Pape, author of Tax-Free Savings Accounts:A Guide to TFSAs and How They Can Make You Rich. Assume you’ve invested $5,000 in a TFSA savings account at 3%. If you take the money out in two years to buy a car, your tax savings add up to, at most, $96. A better way to get that kind of return: just skip that daily coffee at Tim Hortons for a couple of months.