Do you have an emergency fund or an expense coming up in the next five years?
Naturally, the TFSA may come to mind as a savings location.
But is the TFSA the right place for short-term savings, or should the TFSA be left for other investments?
If you have TFSA room, you may be wondering how to use the TFSA to meet short-term savings goals.
This post exists to answer these questions so that you can make good decisions. First, I’ll do a quick overview of how the TFSA works.
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The TFSA's Benefit: Tax Sheltering
I hate the name TFSA. It’s a bad name.
It implies it’s primarily a savings account. Instead, its benefits are maximized as an investing account.
The TFSA shelters you from income generated by assets inside the account. That’s the benefit.
So, there is no benefit to using the TFSA if no income is generated in the account.
This is poorly understood, as reflected by the fact that the average Canadian holds 42% of their TFSA assets as cash.
Cash in the TFSA offers zero value unless that cash earns income. I talk more about how the TFSA works in the following posts:
You can have multiple TFSAs. Two, three, four. The limit is based on the administrative burden you are willing to take on.
As long as the total contribution room of all accounts doesn’t exceed your total TFSA limit.
Why would you ever want more than one TFSA?
Maybe you have a High Interest Savings Account TFSA to save for short-term goals, while also having an investment TFSA where you hold risker assets like stocks and bonds for long-term growth.
Many HISA products are registered TFSA accounts. This is best viewed as a HISA placed inside the TFSA. An account within an account.
Assets For Short-Term Savings
Assets for short-term savings must be stable (low risk) and easily converted to cash when needed (liquid).
I define short-term savings as money you are accumulating for an expense coming up in the next 5 years.
If you are sane, you want to avoid loss of purchasing power to inflation during this time.
Here are low-risk assets that provide some returns, via interest payments, to limit the impact of inflation:
- Straight cash. Either in a checking account or under a mattress.
- Cash In A High-Interest Savings Account (HISA)
- Money Market Funds
- Short-Term Bond Funds
Finally, you can learn about expense smoothing techniques to effectively build up savings using sinking funds. I like sinking funds, they keep me investing a consistent amount each month.
Taxes on Interest Income
Except for cash under your mattress, all short-term savings options above generate interest income. And interest income is taxed at your marginal rate.
You can find your marginal rate by using a tax calculator such as this one from Wealth Simple.
Or just type your pre-tax income into google with your province. It should spit out your combined federal/provincial tax marginal rate.
That’s tough because interest income has the highest tax rate of all investment income types. It’s taxed higher than Canadian dividend income and higher than capital gains income.
You can learn more about this topic by reading Taxes On Investment Income: A Guide For Canadian Beginners.
I like to avoid taxes. I’m sure you do too. Interest income is tax-free if it is produced by assets inside the TFSA.
Your HISA, GIC, or money market assets produce tax-free interest income when the assets are within the TFSA.
Example: Tax on Interest Income
George hates consumer debt, so he is saving for a new car ahead of time to prevent financing. Note that George has good money habits.
He tosses his $10,000 in a money market ETF held within his TFSA. It pays a 3% yield. George earns $300 per year of interest income.
With a salary of $75,000/year, his marginal rate is 30.5%.
George would normally pay $91.50 of tax on that $300 of interest income. But because his money market fund is held in the TFSA, he pays a whopping $0 in tax. The interest income is tax-free.
Note that George used the TFSA for savings since he has unused TFSA contribution room.
Short-Term Savings In the RRSP
There is little use for savings in the RRSP unless you are close to retirement. As this blog is for millennials, you probably don’t fall into this category.
But there are two exceptions that may merit short-term savings in the RRSP. Both options let you withdraw early from the RRSP without penalty:
- The Home Buyers Plan (HBP), where you have short-term savings in the RRSP to buy a home.
- The lifelong learning plan (LLP) allows you to withdraw money for qualified education.
TFSA Priorities: Savings or High Return Assets
No one cares about pre-tax wealth. It’s all about after-tax wealth.
With compounding, higher-returning assets will balloon to large amounts in the future, especially when you consider the compound effect.
Higher returns mean higher investment income, and higher investment income means higher taxes.
For example, 30 years of investing $6,500 per year at an 8% return will grow to $778,000, with total contributions of $195,000.
The $583,000 of income will be tax-free because it was produced in the TFSA.
You can estimate the after-tax wealth of investing in stocks based on your current and future tax rates using my RRSP vs. TFSA vs. Taxable Comparison calculator.
To learn more about the TFSA and taxes, you can read TSFA Maxed Now What.
Higher Return Assets Have Higher Risk
But I want to be clear that I’m not advocating for you to place high-return assets in the TFSA.
Higher returns come at a cost. That cost is risk. Financial markets compensate you for taking on risk. If you want safety, expect low returns. There is no free lunch.
Before you invest in risky assets like stocks, you need to:
- Be ready to invest.
- Have sufficient risk tolerance.
When To Use The TFSA For Short-Term Savings Goals
The TFSA is ideal for short-term savings goals when you have available contribution room.
It makes sense to use that room to shelter you from taxes on the interest income produced by your short-term savings assets.
But the TFSA is irrelevant for cash that does not generate interest income.
Similarly, it does not make sense to displace high-returning assets to make room for short-term savings options in the TFSA.
I don’t use the TFSA for short-term savings because my TFSA is full of 100% stock index funds. Since I expect higher long-run returns from stocks, I want to keep them tax-sheltered in the TFSA.
When To Keep an Emergency Fund in a TFSA
An emergency fund can be kept in a HISA TFSA if you have a TFSA room that is not being used for high-returning assets.
Many HISAs exist with the TFSA “label”, sheltering you from taxes on the interest generated in that account. This can be viewed as an account within an account, where the HISA resides in a TFSA.
There are various HISA TFSA products floating around. With rates rising, the returns are looking better than in the past.
Because you need to be responsive to emergencies, quick access to emergency funds is key
An emergency fund in a money market ETF or any tradable security is a big no-no. It takes two business days to settle a sell order.
That means you’ll be sitting without cash for two or more days in the event of an emergency.
A HISA, checking account, or cash stashed in a drawer are the only options left for your emergency fund.
What Happens When I Withdraw Savings From The TFSA
Unlike when you remove money from an RRSP, the money removed from the TFSA is not taxed. In addition, you don’t lose your TFSA contribution room in the long term.
Instead, the amount you withdraw from the TFSA gets added to the contribution room in the next calendar year.
You can tinker with my TFSA Contribution Room Calculator to see exactly how withdrawals will affect your contribution room.
The calculator also helps you estimate how your TFSA will grow if invested over the long term.
- Short-term savings needed in the next five years must be in low-risk assets. These assets generate interest income and provide low expected returns relative to riskier assets.
- Assets that generate interest income belong in the TFSA when you have unused contribution room.
- When your TFSA is maxed with high-returning assets like stocks, your short-term savings are best kept outside of the TFSA.
- The TFSA is useless for cash that doesn’t generate investment income.