Choosing the right TFSA based on your risk tolerance

Many Canadians who own a Tax-Free Savings Account (TFSA) are well-aware of the fact that the account shelters their savings from taxes, but many don’t recognize how many types of investments a TFSA can actually hold.

The TFSA is an excellent saving and investing tool that possesses extended benefits. TFSAs can help you lessen the income tax on savings interest or investment gains.

Choosing the right type of TFSA account or investment can see you maximizing the use of this incredible financial tool while keeping more of your money where it belongs.

What is a Tax-Free Savings Account (TFSA)?

A Tax-Free Savings Account (TFSA) is a savings and investment account that keeps your savings and investments sheltered from taxes.

How does a TFSA work?

A TFSA works like a regular savings account. However, unlike a savings account, a TFSA can hold various types of investments and securities.

Some investments that are eligible with a tax-free savings account include Guaranteed Investment Certificates (TFSA GIC), stocks, Exchange-Traded Funds (ETFs), mutual funds, and other types of investments. A robo-advisor or financial advisor can manage investments placed within a TFSA, too.

TFSAs are unique to other types of savings and investing accounts because they facilitate tax-free withdrawals. That means you can withdraw your funds without incurring a tax penalty or paying regular taxes.

The TFSA is a government-registered account, and therefore, comes with a yearly contribution limit. This limit increases at the beginning of each year, and any unused room carries over into each new year.

Though withdrawals are free, withdrawn funds remove eligible contribution room for that year. This room resets at the beginning of each new year as well.

TFSAs come with an additional set of rules, concerning contributions and withdrawals.

Unlike high-interest savings accounts (HISAs), a TFSA has a yearly contribution limit. The limit increases each year and allows unlimited withdrawals and contributions at no cost or penalty to Canadians.

You can open a TFSA if you are over the age of 18 or 19, depending on the province or territory in which you reside. The account is available with most credit unions, banks, and investment platforms.

How to choose the right TFSA for your saving and investing Goals

Choosing a TFSA is a fairly simple task—if you know whether you’d like to use one for saving or investing.

Below, we’ll explore three major components of choosing the right TFSA that anyone using this special account should consider.

1. Understand risk tolerance

Risk tolerance is an investor’s ability to deal with variability and the potential loss that their investments may experience. 

An investor’s risk tolerance can be shaped significantly by their income, financial goals, personal wealth, and age.

Additionally, risk tolerance also determines what type of investment a person will put their money into.

Risk tolerance plays a major role in the decision-making process when it comes to investing.

Purchasing investments that do not align with an investor’s risk tolerance profile will likely cause you a world of problems and stress.

In the event that an investment experiences a sharp loss, an investment that does not aptly represent your risk tolerance may result in pulling out of an investment at the wrong time.

There are three levels of risk tolerance: low, medium, and high. They’re also known as conservative, moderate, and aggressive.

• Conservative or low-riskinvesting is investing that poses little risk and smaller returns. Generally, these investments are in GICs or bonds, which often do no typically provide massive returns but are safe and in some cases, guaranteed, and usually keep up with inflation—if the TFSA has a good rate!
• Moderateinvesting, also known as medium risk or balanced investing poses medium risk. Medium risk investing typically is fairly balanced to losses and gains. 
• Aggressive investing or high-risk investing is incredibly risky or volatile investing. High-risk investing generally involves sharp gains or losses. 

When purchasing ETFs or mutual funds, the robo-advisor or financial advisor providing the investment will require you to set your investing profile according to your risk capacity. If you’re unsure what your risk capacity is, it’s always better to start lower and move up when you feel comfortable enough to do so.

You’ve probably read somewhere that younger folk should take a riskier approach to investing since they generally have more time to make up for losses. However, you should invest in what you feel comfortable and confident in—no matter what your age is.

2. Understand your risk capacity

Risk Capacity, also known as Risk Appetite, is the approach to investing that an investor must take to meet their goals. There are five different character types of Risk Capacity: Averse (no risk), Minimalist (minimal risk), Cautious (lower-risk), Open (medium-risk), and Hungry (high-risk).

3. Choose the right TFSA for your investments

You can hold several investments in a TFSA that suit your risk tolerance and risk capacity. Below are some of the options that are currently available to Canadians.

• Guaranteed Investment Certificate (GICs) are an incredibly low-risk investment and a great way to utilize a TFSA. Since GICs are taxed investments, using a TFSA GIC is a move that most investors can take advantage of if they’re planning on purchasing GICs. Though returns on GICs tend to be lower, they are safe, insured, and guaranteed.

• Stockspose as a higher investment risk due to the volatility of the stock market, as many of the events that can affect it are unpredictable. The returns are usually much higher, depending on the amount and duration invested.

Stocks are also susceptible to tax, so using a TFSA to hold shares can save you a hefty chunk of change.

 

• Exchange-Traded Funds (ETFs) combine various stocks, bonds, and investments to create a portfolio for you. You can purchase them through a robo-advisor, which will manage your funds for you based on the risk profile of your choosing.

Wealthsimple is Canada’s leading robo-advising platform, which manages fees at a fraction of the price of a financial advisor.

• Mutual Funds act as a basket of investments, in a similar fashion to ETFs. Mutual Funds are provided by a financial institution and have investors pooling their money into investments with other investors.  Like ETFs, Mutual Funds are managed according to a person’s risk tolerance profile.
• Bonds are lower-risk investments but depend on the strength of the economy. They are not insured but hold steadier risk profiles and lower returns.
• Cash Using a TFSA savings account is a low-risk option for investing. Banks in Canada are usually insured by the Canada Deposit Insurance Corporation (CDIC) at no additional cost. Return rates are generally lower but hold no risk.

 

Why should I use a TFSA for investments?

TFSAs serve as an excellent vehicle to paying less income tax on the interest or gains that your savings or investments earn on returns, but that’s not the only good reason to use them.

TFSA investment options come with a good amount of flexibility and permit unlimited deposits and withdrawals without penalty.

Maxing out your TFSA before using any other account is an excellent way to maximize your earning potential and save money on taxes.

Also, read:

• Online Investing: Robo-Advisors vs. Online Brokerages
• What investments can I hold in a TFSA?
• The best TFSA savings accounts in Canada for 2020