Mutual Fund Tax-Free Savings Accounts (TFSA)

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When Tax Free Savings Accounts (TFSAs) were first introduced in January 2009, a common misconception was that they were simple savings accounts. That’s wrong.

TFSAs by their very nature allow investors to hold a wide range of investment products. From the cash he puts into his high-yield savings account within the TFSA, to the stocks and bonds he can purchase with the self-administered TFSA, to his GIC within the TFSA offered by many banks and trust companies, the options seem endless. If you have a long-term investment strategy, you should also consider purchasing a mutual fund with TFSA.

What are mutual funds?

In its simplest definition, a mutual fund is a collection of investments (bonds, stocks, etc.) owned by a group of investors (you’d be one of them) and managed by a financial institution and/or portfolio manager. When you buy a mutual fund, you’re basically just pooling your money in with all the other investors, so you can own units of the fund.

Traditionally, many people are used to the idea of buying mutual funds in their RRSP. The length of time you have to invest as well as your risk tolerance are used to determine which type of mutual fund you should purchase (explained in more detail below). The only difference between buying mutual funds in an RRSP or a TFSA is that the money in your TFSA can be withdrawn tax-free. This is because TFSA contributions are made using after-tax dollars, whereas RRSP contributions are tax-sheltered by the government (up to a certain point, of course!).

What are the advantages of buying mutual funds in your TFSA?

Some of the reasons you may want to buy mutual funds in your TFSA include:

• They are diversified, meaning your money is in multiple investments versus just a few individual stocks or bonds. This is not only easier to manage, it also comes with slightly less risk (depending on the fund you choose).
• They are managed by a professional portfolio manager. The manager’s job is to decide where to invest all the money in the fund, as well as to actually buy and sell the investments.
• You have a large number of funds to choose from, depending on the length of time you have to invest, your risk tolerance, portfolio performance and fees.
• They’re easy to buy and sell.
• Your withdrawals are tax-free.

What are the disadvantages of investing in mutual funds?

While there are advantages, there are also disadvantages:

• They’re not as transparent as you might think. Your portfolio will come with a fund fact sheet that usually lists the top 10 to 20 investments in the fund, but not all of them.
• You don’t have any influence or control over which investments are included in the portfolio.
• You have to pay fees, known as the management expense ratio (MER), for the portfolio manager’s services. A typical MER may be between 1.00% and 3.00%. Depending on the value of your portfolio, these fees can be much more expensive than what you’d pay in fees for ETFs, even if you pay someone to manage your ETFs for you.
• There is no guarantee you’ll make money. Depending on when you withdraw your money from the fund, you may get back less than what you invested.
• Mutual funds are not CDIC-insured.

How are mutual fund management fees calculated and paid?

As we mentioned above, one of the disadvantages of investing in mutual funds is that you have to pay the fund’s MER. The MER is expressed as an annual percentage of the total value of the fund. For example, you may choose a portfolio that has a MER of 1.50%. In that 1.50%, you’re paying for the portfolio manager’s time in overseeing the fund, making investment decisions and covering their operating expenses. Theoretically, higher fund performance is supposed to more than cover the MER, but that’s not always the case. Fortunately, you don’t actually pay this fee directly, but it does reduce your fund’s return. Let’s look at an example.

Case study: High-interest savings account vs. mutual funds in a TFSA

Alex has $5,000 sitting in a regular savings account and decides he wants to make a contribution to his TFSA. He’s never invested in mutual funds before, but is trying to decide between putting his money in a high-interest savings account with an annual interest rate of 2.00%, and a mutual fund that has historically seen a gross return of 5.00% each year but with a 2.20% MER. If he only made a one-time investment, and didn’t contribute anything more to the account in the first year, which option would give him the best return on his investment?