This post is motivated by my belief that a misleading name results in many Canadians holding excessive cash in the TFSA.
So don’t beat yourself up if you think the TFSA is merely a savings account. The average Canadian holds 41% of their TFSA value as Cash.
Plus, I doubt you were ever taught about investing or tax-sheltered accounts, let alone how taxes apply to investment income.
I first examine the differences between a normal savings account and a TFSA. Then I’ll cover how the TFSA makes money.
Table of Contents
How Does the TFSA Make Money?
The first step to grasping the TFSA’s benefit is to look at how investment income is taxed. Investments generate interest income, dividend income, and/or capital gains income.
When you hold investments in the TFSA, you do not pay tax on the investment income generated within the account. That’s the “Tax-Free” nature of the account.
To reap the TFSA’s benefits, you need to generate investment income. And to generate investment income, you need to have investments in the TFSA.
The TFSA does not make money directly. It only prevents taxation of investment income generated within the account.
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The TFSA as a Container
I like to think of the TFSA as a container. Within this container, you can hold cash savings or investments.
Let’s say you transfer cash to the TFSA. The cash sits there, and it does not generate investment income. This case is no different from holding cash in a regular account.
There is another way to hold cash in the TFSA, and that is via a High-Interest Savings Account (HISA). I like to think of the HISA as going inside the TFSA. This is best viewed as an account with an account – a container within the container. The interest income you earn in the HISA will be tax-free because it is in the TFSA.
I encourage you to learn more about how the TFSA works, via this post: How Does the TFSA Work. I hope the name of this post is not misleading.
The Difference Between Savings and Investing
What are Savings?
I define savings as cash accumulation, held in cash-like assets such as a chequing account, High-Interest Savings Account (HISA) or money market fund. These cash savings have two characteristics:
- Cash is accessible (liquid); and
- Cash is stable (low risk).
Your savings are stable in the short term because the banking system in Canada is stable. Cash savings are further insured by the Canadian Deposit Insurance Corporation (CIDC) up to an amount of $100,000. So you will not lose your money in a CDIC-insured savings account should the bank fail.
You are paid interest as your cash sits in your bank account. The bank will lend some of your cash to others for mortgages, car loans, ect.
The bank can make a net profit because they charge higher interest rates on their loans relative to the interest rate they pay you.
What is Investing?
Investing is when you buy assets that are expected to increase in value and pay cashflow. When you invest, you take on risk.
In exchange for this risk, you expect compensation in the form of higher returns. There are three main categories of investments you can make inside the TFSA:
- Business ownership (stocks): A stock is a portion of a business that you own. As an owner, you get to share in the profits and growth of the company. To learn more about returns, check out this post on where stock returns come from.
- Bonds: Where you loan your money to the government or corporations. You are paid interest, and the money is returned to you.
- Real Estate Investment Trusts (REITs): A company that owns income producing property. These generally trade on an exchange.
There are various mechanisms to invest in these asset classes. Mutual funds, Exchange Traded Funds (ETFs), Individual stocks, and Bond ETFs.
I like to keep my investments with high expected returns in the TFSA. This provides the best tax benefit. Therefore, I keep my stocks in the TFSA.
Interest In A Cash Account vs. Interest In A TFSA
A normal cash chequing account will not pay interest, and nor will cash sitting in a TFSA. Because your cash is not generating interest income, cash in the TFSA will offer no benefits.
In fact, holding cash in the TFSA can add complexity. It’s an extra step to transfer the cash to and from the TFSA, and you’ll need to closely monitor the contribution room if you are close to maxing out the TFSA.
We will take a look at a case where your cash does earn a small amount of interest income, via a High-Interest Savings Accounts. Let’s compare two options:
- An HISA outside of a TFSA; and
- An HISA inside a TFSA.
Normal High Interest Savings Account (HISA)
Let’s say you hold $10,000 in a HISA with a 3% rate outside of a TFSA. You will earn $300 per year in interest.
This interest income will then be taxed as regular income, at your marginal rate. So if you make $60,000 per year in Ontario, you’ll have to pay 30% tax on that $300 of income, leaving $210 in your pocket. That’s $90 lost to tax.
HISA Inside the TFSA
Now, let’s assume you hold the same $10,000 in a HISA in a TFSA earning 3%. You still earn the $300 of interest income. But now the interest income is tax-free. You keep the entire $300.
By keeping the $10,000 in the TFSA, you saved $90 per year.
When Does it Make Sense to Hold Cash in a TFSA?
People on social media discuss how “Cash is Trash”. I don’t like this. Personal finance happens to be personal (it has a good name). Cash has a purpose in many cases.
When it Makes Sense to Hold Cash
Firstly, an emergency fund must be held as cash. Cash also makes sense when you need the money within the next 5 years.
Otherwise, your cash can be invested for higher long-term returns based on your willingness and ability to take on risk.
When To Hold Cash In The TFSA
The next logical step is to ask: when does it makes sense to hold my cash in the TFSA?
It makes sense when you have unused TFSA contribution room remaining. You can use the TFSA to shelter you from taxes on the measly interest income.
Cash should not go in a TFSA when the TFSA is maxed with investment assets like stocks and bonds. These investments have better long-run expected returns relative to cash. You want to preserve the valuable TFSA room for these assets.
For example, global stocks have returned an average of 7.3% per year over the past 122 years. While U.S. stocks have done even better, averaging 10.2% per year for the last 100 years.
What if Interest Rates Were Higher?
Holding a HISA in a TFSA (cash in the TFSA) makes more sense as interest rates rise. With higher interest rates, cash in the HISA in the TFSA can earn more interest income. More income means more tax savings from the tax-sheltering effects of the TFSA.
Cash in the TFSA: Inflation
Inflation slowly erodes purchasing power. Since 1921, inflation has averaged around 2.7%. That means the purchasing power of cash decreases by 2.7%, per year.
Recently, inflation has been even higher. You can tinker with historical inflation rates with the Bank of Canada’s inflation calculator.
Because of inflation, holding cash for the long term is risky. Erosion of your purchasing power is guaranteed. This is why I view savings as safe in the short term, but risky in the long term. Vice versa for investing in stocks.
Not Everyone is Ready to Invest
We covered that the TFSA offers maximum value for those that invest in assets with high expected returns.
But this doesn’t mean everyone with available cash should invest. Before investing, I believe it is important for everyone to:
- Have paid off high-interest debt;
- Have an emergency fund worth 3-6 months of expenses;
- Understand stocks and bonds, and where their returns come from;
- Understand diversification, fund fees and index funds; and
- Understand your willingness and ability to take investment risk.
How I Use the TFSA
All of the money in my TFSA is invested in low-cost equity (stock) index ETFs. I hold my emergency fund outside of my TFSA. This allows me to maximize the TFSA room for investments (stock index funds) that have high expected returns.
Under compound growth, the TFSA account value will grow exponentially over time. At some point in the future, I expect to pull tax free dividend or capital gains investment income from the account.
- Cash in a TFSA is usually no different than cash in a chequing account.
- You will not pay taxes on interest income in a HISA that is held in the TFSA.
- Interest payments on cash are tiny due to low-interest rates. The TFSA offers minimal tax-sheltering benefits when rates are low.
- Cash is great when you need the money in the next 5 years.
- Inflation will erode the value of your cash over the long term.
- The TFSA offers maximum benefit for assets with high expected returns, like equities (stocks).