NB: The federal government has upped the annual TFSA contribution limit by $500 to $5,500 per year starting Jan. 1, 2013. This article first ran in print before the announcement was made. The change means Canadians can soon grow even more of their money tax-free.
Young people today have it tough. From huge student loans to double-digit unemployment rates, parents have to wonder if their children’s generation will ever catch a financial break. Luckily, they have: the Tax-Free Savings Account (TFSA) introduced four years ago by the federal government for people who want to build wealth. TFSAs let you save and invest your money without paying any tax on the growth—that is, no tax on Canadian dividends, capital gains or interest earned in the plan. Not now, and not when you withdraw the money.
Since 2009, all Canadians aged 18 or older can contribute up to $5,000 a year to a TFSA. That’s good news for savers. But what young adults and their parents may not have considered is the golden opportunity TFSAs present for young people who want to become millionaires. How? By helping young adults start a TFSA as early as possible and having the whole family adopt a focused saving and investment strategy from the day the account is opened. “The basic rules for TFSAs are the same but the strategies you can adopt for investing in them is what’s overlooked,” says Gordon Pape, author of the forthcoming Tax-Free Savings Accounts: How TFSAs Can Make You Rich. “Using the right strategy makes all the difference in the world to building wealth in your TFSA.”
How can you make TFSAs work wonders for your children? Simple—by making sure they open a TFSA early, and by helping them choose the right investments. “The real benefit of putting money into a TFSA at a young age is the power of compounding,” says Marc Lamontagne, a fee-only adviser with Ryan Lamontagne in Ottawa. “It’s exponential. If you have 25 years or more, your returns will be substantial.”
Even if your kids have little earned income at age 18, it makes sense to gift money to adult kids or grandchildren so they can contribute the maximum $5,000 a year to their TFSAs. Left on their own, a child’s contribution room may pile up unused year after year if they have little money of their own. By making TFSAs a family wealth-building tool with contributions made earlier rather than later, the power of compounding is extended over longer time horizons. This can add up to millions of dollars for the child in the long term.
“The key is for kids to understand the payoff at the end of the savings,” says Diane Dekanic, a Certified Financial Planner with Financial Health Management in Calgary. “Sure, having kids pay down consumer debt and their mortgage are important goals, but if you can help your child see how crucial TFSA savings can be between the ages of 18 to 35, they’ll be very motivated to stick with the plan.”
MoneySense thought your family would be interested in finding out how you, too, can build wealth through your child’s TFSA. We’ve come up with four investment strategies with expected returns and figures showing how $5,000 a year invested from early adulthood can grow over a lifetime. And we’ve profiled four young adults who shared strategies ranging from conservative to supercharged growth.
Start by getting your kids involved and help them put together a small saving and investing plan. It can be as easy as showing them how a small portion of their annual earnings—even just 5% or 10%—adds up quickly as earnings increase over time. But be careful. Pape emphasizes the importance of avoiding the common mistake of opening a simple savings account TFSA and parking the $5,000 contribution with no regard to how it’s invested. “Your child is not optimizing their account if they’re simply earning 1% or 2% interest in a savings account.”
Pape’s right. Most young people who have TFSAs open ones that work like savings accounts. They like the idea of putting aside money for future emergencies but while this provides peace of mind, it won’t make your child a millionaire. It’s easy to see why. Say from the time your son (we’ll call him Shawn) turns 20, he (along with gifts of money from parents and grandparents) puts $5,000 annually into a TFSA. It’s invested conservatively in ultra-safe investments that average 2% a year. Would Shawn be a millionaire by age 65? Absolutely not. He’d have about $367,000—barely a third of the way there. Would he be a millionaire by 90? Again, no. Shawn would have about $765,000 in his TFSA—and after 70 years of inflation, that won’t be worth anything close to what it is today.
“Opting for this very safe strategy will probably make your child a good saver, but it won’t make him a millionaire,” says Dekanic. “He needs to adopt a more aggressive strategy and get his money working for him to boost his returns.”
The TFSA name is a bit of a misnomer and might better have been named a TFIA or Tax Free Investment Account. That’s how Dekanic believes it should be viewed. Parents who want to help their kids grow wealth must give them guidance. Start by doing what I did: take your child to the bank and open a self-directed TFSA. For most kids, opening investment accounts is intimidating, so having mom or dad there makes it smoother.
The key to success is motivating your child to invest for the long term. Show them how quickly money accumulates with regular $5,000 annual contributions. “Kids are like me—they get excited over getting rich,” says Bridget Casey, 26, a University of Alberta recruiter who started contributing to a TFSA four years ago. “Right now, I’m excited about my TFSA. I’ve learned if I save from an early age and stay out of debt, I’ll be really happy and wealthy in life. If I can do it, anyone can.”A self-directed TFSA gives your child the flexibility to hold stocks, bonds and exchange-traded funds. Low-fee mutual funds, including index funds, also work well for beginning investors because they minimize trading commissions. Focus on equities to power their money’s growth over time. “In their early 20s, kids with a long-term perspective can ignore fixed-income investments,” says Nancy Woods, associate portfolio manager with RBC Dominion Securities in Toronto. “They get better returns with solid growth stocks or blue-chip stocks that pay healthy dividends.”
Show your child the importance of establishing the habit of contributing regular set amounts—preferably monthly. The truth is young people don’t have much money but that shouldn’t hold you back. A structured savings program started at an early age guarantees success.
Take my daughter Laura, 21. She’s a full-time forensic accounting student at Seneca College and works part-time as a cashier at a local pharmacy. When I helped her open a TFSA three years ago, saving money was the last thing on her mind. To entice her, I promised to match every dollar she contributed, up to $2,500 a year. Believe me, it didn’t take long for Laura to realize a matching amount of free money for her TFSA is a wonderful thing.
But there’s no point maxing out TFSAs if you have consumer debt. Pay that off first, then look into TFSAs. “TFSAs work best when you’re debt-free,” says Jason Heath, a fee-only adviser with Objective Financial Partners in Toronto. “Young people living at home with no debt and few expenses who are also working part-time or full-time are at the perfect time in their lives to make their contributions count.”
It’s also important to encourage kids to learn about investing. “My son Tyler started contributing to his self-directed TFSA in 2010 when he was 18,” says Woods, the RBC portfolio manager. “I helped him open the account, and although he has a small part-time job and hasn’t been able to contribute the maximum of $5,000 a year, he’s contributed $1,400 to date and is anxious to open his statement every month.”
What’s important is he’s learning to invest his savings wisely to build wealth. “It’s very motivating for him. Today, his TFSA is worth $2,030. The small amounts of money shouldn’t hold kids back,” says Woods. “You can always buy one share of a stock to get started.”
How large can you expect a TFSA to grow if you begin as a teenager and stay invested 50 years or more? That depends on two key things: how much is contributed and how it’s invested. In the four examples we look at, we’ll assume a child—perhaps aided by gifts from parents or grandparents—contributes $5,000 a year beginning early in adulthood, ideally by 18.
The asset mix is also important. Aggressive investment strategies with 60% equities should grow faster than conservative approaches with 40% equities. “Equities have done best historically and if you and your child can live with the volatility, relax about your holdings and not worry, holding an equity portfolio for the long term probably works best,” says Rick Coyle, an adviser with Financial Bistro near Halifax. “It can be like a snowball. As kids watch their money grow they get motivated to keep saving and it grows even more. The better the growth, the more determined they’ll be to stick with it.”
All that’s left is to pick a suitable plan and start contributing. The lesson? Your kids don’t have to be well-off to build wealth in TFSAs. Let them contribute what they can and top it up when you or grandparents want to give them money. Starting early puts them on the steady road to wealth building.
“Putting money in my TFSA really lets me see that I’m paying myself first,” says Casey. “And even though my parents never helped me out with any contributions because of their modest incomes, they’ve been really encouraging throughout the whole process. I know I’ll be wealthy at some point later on in my life. For me, that’s all the motivation I need to keep saving and investing in my TFSA.”
*For details on how four young Canadians are investing and growing their TFSA into the seven-figure range pick up the DEC/JAN issue of MoneySense magazine on newsstands now through mid-January 2013.