How to Get the Most out of Your TFSA

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Many Canadians are still failing to take advantage of a fairly new savings tool: The tax-free savings account (TFSA). It's designed to help Canadians their savings.

The TFSA differs from other savings accounts in three key ways. First, the amount of cash you can contribute is limited. Second, you don't need to hold just cash in your TFSA, you can hold mutual funds, exchange-traded funds (ETFs), stocks, and bonds. And third, any profit from those investments you get to keep tax-free.

So how to make the most of this account? Here are some tips to ensure you are getting the most out of your TFSA:

Start saving early: Younger Canadians should start contributing to their TFSAs as early as possible, even in small amounts. The younger you are, the longer your time horizon. The longer your money is in a TFSA, the more time it has to compound and produce a higher investment return.

For example, a one-time contribution of $5,500, which is the limit for 2017, would turn into $8,141 if you average a return of 4% over 10 years. Keep in mind, interest rates for regular savings accounts are usually between 1% and 2% so it's possible you can earn a better return.

Diversify your portfolio: You've heard the expression "don't put all your eggs in one basket." The same applies to your investments. Diversity within a portfolio simply means ensuring you have a variety of investments so that if one falters, you have others to soften the blow. For instance, you can do that by holding different investments (mutual funds, GICs, stocks, or bonds), investing in different sectors (healthcare or technology, to name a few), or investing in a number of different countries. A truly diverse portfolio will incorporate a mixture across all of these spectrums.

The good news is a TFSA is very flexible and you can hold just about any investment in one. If you're looking to invest for a longer period and can handle a certain amount of risk, you have a huge number of options. Shares in a particular company, equity mutual funds and ETFs are all options you can consider. If you're looking for guaranteed returns because you're not comfortable with much risk, a GIC is a better choice, especially since GIC rates of 2% are easy to find.

Understand you limit: One thing many Canadians find confusing is the TFSA contribution limit. Each year after you turn 18 you earn more room, no matter whether you have a TFSA open or not. If you turned 18 this year, your contribution limit is $5,500. But if you were 18 or older in 2009 (the year the TFSA was introduced) and never contributed to a TFSA, your contribution room has been building ever since and currently sits at $52,000.

Where it can get tricky is when you start to use up the contribution room. For example if you turned 18 in 2016, and open a TFSA today, you have $11,000 in contribution room. If you put $10,000 in your TFSA today, you have $1,000 of room left until next year.

The most you can then still put in your TFSA until next year is that remaining $1,000. However, if you don't use that $1,000 worth of room, it will carry over to next year and be added to the new contribution room you'll get in 2018.

There are also rules about re-contributing money to a TFSA once it's withdrawn. If you decide to withdraw that $10,000 from your TFSA, you don't have $11,000 in contribution room again this year. Instead, you have to wait until the next calendar year before you can re-contribute the amount withdrawn. If you do re-contribute that amount early, you'll have to pay a penalty.

The contribution limit has changed several times over the years, as the chart below shows. Simply calculate your contribution room by finding the year you turned 18 and adding up all the years since from there.

The bottom line
A TFSA is a great option for your short- or long-term savings goals. There are many investment options available and best of all, you won't have to pay any tax on interest income or capital gains.