Helping Do-It-Yourself Investing Beginners

When Canadians are just getting started managing their own investments at an online broker, their pre-existing ideas create a lot of confusion.  Here I go through several of the most common misconceptions I encounter in a conversation format.

Novice Investor:  Ok, so I’ve opened a TFSA with my online broker, and I’m ready to put my $50,000 in.

Michael James:  Great.  We just have to transfer the money to your new TFSA from some external account, like a chequing account at your bank.  Just a few clicks and we’re done.  The money will be there in a day or two.

NI:  Wow! That was easy. So, we’re all done?

MJ:  Not quite.  All we’ve done is fill your TFSA with dollars.

NI:  That’s all I did with the TFSA I used to have at the bank.  It’s closed now.

MJ:  Yes, but that TFSA was just a savings account earning a little bit of interest.  You said you want to put this $50,000 away for the long term in an all-in-one ETF.  A TFSA is just a container that holds qualified investments (CRA has rules for investment types).  You still have to buy an investment with your dollars.  Most online brokers don’t pay interest on the dollars held in their accounts, so you need to invest in something. Here’s a picture of what we’ve covered so far.

[A day or two pass.]

NI:  Ok, I’m ready to invest my money.  But I was thinking.  I only have $50,000 of TFSA room, and I used that up with my TFSA contribution.  When I buy an all-in-one ETF, won’t that put me over my limit?

MJ:  No, it won’t.  Only transfers from external accounts count as TFSA contributions.  When you use the dollars inside your TFSA to buy an investment, this all takes place within the TFSA.  Nothing enters or leaves the TFSA, so it doesn’t affect your TFSA contribution room.  Just a few clicks and we can buy your ETF.  When this trade settles, your TFSA will hold a few hundred ETF units and a few leftover dollars.

NI:  This seems more confusing than it was when I invested with the bank.

MJ:  Yes, you need to get the right picture in your head to understand how this works.  I promise it’s not that complicated.  The main thing to understand here is which actions take place entirely inside your TFSA.  Here’s another picture of what’s going on so far.

[Several months pass.]

NI:  I noticed that the cash part of my TFSA has been growing.

MJ:  Yes, your ETFs pay dividends quarterly.

NI:  Am I going over my TFSA limit now?

MJ:  No, dividends flow from your ETF to the cash part of your TFSA.  That happens entirely within your TFSA, so it doesn’t affect your contribution room.  

NI:  You told me once before that the dollars in my TFSA don’t collect any interest.  Can I put this money in my ETF?

MJ:  Yes.  It’s not a lot of money, so it’s not a big rush.  Since your online broker doesn’t charge commissions on ETF purchases, we can buy a few more ETF units without too much overhead.  And remember, this doesn’t affect your TFSA contribution room.  Just a couple of clicks and it’s done.

[Months pass.]

NI:  I need to take $20,000 out of my TFSA.  I started to make a TFSA withdrawal, but something went wrong.

MJ:  Let’s see.  Here’s the problem.  You only have 28 dollars in your account.

NI:  But it says over here that I have over $54,000.

MJ:  That’s the total value of everything in your TFSA at this moment if you sell it all.  But you don’t have actual dollars.  Most of what you have is ETF units.  If you have an old car worth $5000, you don’t actually have $5000; you have a car.  You can’t break off the bumper to buy dinner.  You have to sell the car first, and then you can buy dinner.

NI:  I think I’m starting to get it, but how do I make the withdrawal?

MJ:  First you need to sell some of your ETF units.  All we do is figure out how many units to sell to increase your cash holdings to a little over $20,000.  Ok, that’s done.  The money will be there in one business day.

[The next business day.]

NI:  Now that I’ve made my TFSA withdrawal, how do I get the money?

MJ:  You haven't actually made a TFSA withdrawal yet.  You sold some ETF units and you have a lot more dollars in your account, but all that happened inside the TFSA.  It doesn’t count as a withdrawal.  When we move the TFSA cash to your external chequing account at your bank, that will count as a TFSA withdrawal.  Just a few clicks here and we’re done.  The money should get there in a day or two.

[A year passes.]

NI:  I’ve been adding more money to my TFSA for a while now, but I’m planning to buy a car in a few months.  I’m going to need $40,000.

MJ:  Ok.  Because you’ll need this money in the short term, it’s best not to have it in the stock market.  You wouldn’t want to have a stock market drop affect the money you need for a car.  So, we should sell some ETF units now.  That will bring the cash in your TFSA up to a little over $40,000.  But this will just sit there earning no interest if we don’t do anything else.  You could put the money in a HISA (high-interest savings account) inside your TFSA.  Each online broker has an investment that looks like a savings account that pays decent interest.  Under the covers, these HISAs are usually structured as ETFs or mutual funds.  As far as CRA is concerned, they are just another type of investment inside your TFSA.  You can take the $40,000 from selling ETF units and invest it in a HISA.  You have the option to have interest reinvested into the HISA or to have this interest added to the cash part of your TFSA.  Here’s a picture of what you have in your TFSA now.

[A few months pass.]

NI:  I’m going to need the money for my car in a week.  So, now I make my TFSA withdrawal, right?

MJ:  Yes, but it takes two steps.  You first need to sell the contents of your HISA to create dollars in your TFSA.  This will complete in a day or two, and then you can make the TFSA withdrawal.

NI:  It seems like just about everything I do has an intermediate step of becoming dollars inside my TFSA.

MJ:  That’s right.  There’s such a thing as an “in-kind” contribution or withdrawal, but you don’t need to worry about that in most cases.

[Two years pass.]

NI:  When I got that big raise a while back, I opened an RRSP and made some contributions.  Everything seemed similar to my TFSA, and I bought some ETF units.  But it’s the same ETF.  Are my TFSA and RRSP investments mixed up now?

MJ:  No.  Your online broker and the ETF manager record your TFSA and RRSP investments separately, even though you bought the same ETF.  In addition, the cash parts of your RRSP and TFSA are separate.  The same is true of any other investments you make.  This won’t cause you any trouble.

NI:  The cash from dividends has been building up.  Can I spend this money?

MJ:  Let’s start with a picture of how your RRSP works.

MJ:  When your ETFs pay dividends or your HISA pays interest, it adds dollars in the cash part of your RRSP, but nothing has left your RRSP.  When you look at your account online, the cash part of your RRSP looks similar to your chequing account at your bank, but it’s not the same.  You can spend the contents of your actual chequing account at your bank without tax consequences because it is non-registered money.  However, the dollars in your RRSP are part of your RRSP contents.  If you withdrew these dollars, that would count as an RRSP withdrawal, and the money would be added to your income for this year.  I’m guessing that’s not what you had in mind.

NI:  I thought there had to be a catch.  I’ll just reinvest those RRSP dollars into more ETF units.

MJ:  Good idea.

[Years pass.]

NI:  I got an inheritance!  I’ve made some contributions, and I’ve used up all my RRSP and TFSA room.  But I still have more money I’d like to invest.

MJ:  That’s a great problem to have.  You could open up a non-registered account.  These accounts go by many names, so check with your online broker.  The mechanisms for making contributions and withdrawals and for buying and selling investments are similar to your TFSA and RRSP.  However, there are tax implications for each investment you sell, and every dividend and interest payment.

NI:  Tax rules sound like a bigger lesson for another time.  Thanks for the help.

MJ:  You’re welcome.