TFSA: Our number-one tax shelter

Investing in a Tax-Free Savings Account should be a priority for most Canadians.

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One of the first acts of the new year for our family was topping up our Tax Free Savings Accounts or TFSAs. You’ll see a number of TFSA stories running this week on this web site, some of them from the most recent edition of the magazine. Julie Cazzin’s feature story on the Great TFSA Race should whet your appetite on the potential of this vehicle, with the winner racking up an incredible $300,000 in his TFSA, and runnerups at $72,212 and $61,700.

Of course, such returns can come only from capital gains on shrewdly picked stocks, and probably concentrated positions in relatively risky smaller stocks. If you make the mistake of parking your TFSA in GICs or some version of cash, your growth will be negligible. Assuming you put in $5,000 in January 2009 and maxed out every year thereafter, with $5,500 a year ago and $5,500 early in 2014, you would now have $31,000 cumulative contribution room: six years worth. Of course, if you’re one half of a couple, then your spouse also has $31,000 room for a combined $62,000. That’s what I would call significant money: enough to buy a luxury new car or to put a down payment on a first home.

TFSAs are too good to use on spending

However, the tax allure of TFSAs is such that it seems a terrible shame to have to actually spend the money, when its potential to grow into a huge nest egg is such an enticing alternative. Fortunately, the bitter pill of breaking into capital is sweetened somewhat by the fact you can replenish the TFSA, so you’re not actually losing contribution room. Because you can’t repay until the following year, however, you’ll keep more tax-free growth by cashing out towards the end of a calendar year, rather than early in the new year.

Note that in the case of the big winners of the TFSA Race, the bigger the TFSA when you cash out, the more contribution room you’ll eventually have when you recontribute. So in the case of Jim Nykyforuk, if he were to take his entire $300,000 out this year, in 2015 he’d be able to recontribute the same $300,000, plus of course the new $5,500 room he and everyone will qualify for by January 2015.

Those are big numbers but as I wrote in the editor’s note for the current issue (Dec/Jan 2014), it’s unlikely that most TFSAs will have grown anywhere near that much, even if they are in stocks. The risk-takers who won the contest had plenty of other money in other vehicles and they were willing to risk the TFSA capital for a big win, fully understanding it’s as easy to strike out as hit a grand-slam home run.

Diversified equities more prudent

I wouldn’t even recommend that most people emulate those aggressive strategies. From my correspondence with the kind of readers who gravitate to a “Couch Potato” portfolio so often seen in the pages of MoneySense, a typical all-equity TFSA would have grown from the original $25,500 contribution room to somewhere in the low $30,000 range at the end of 2013. In our family, for example, our TFSAs ranged from $32,000 to $34,000 and as of the January 2014 top-up would be just shy of $40,000 each. (This includes our daughter, whose aggressive investing strategy was unveiled in MoneySense in an earlier feature by Julie: How TFSAs can make your child a millionaire; Dec/Jan 2013)

The temptation to dip into such growing nest eggs must be considerable for younger people but when you consider the power of tax-free compounding, I’d still urge most to keep their hands off their TFSA for 30 or 40 years. Yes, those who have maxed out to this point now have enough to buy a brand new car, but I’d urge them to instead go with a used vehicle or take advantage of zero financing or ultra low interest rate deals on new cars. The other big temptation would be to dip into TFSAs for a down payment on a home but here again, I’d look first at the Home Buyer’s Plan provision of RRSPs first, or perhaps hit parents up for a down payment.

TFSAs should be priority for those with modest incomes

I’d think most MoneySense readers are in a position to do BOTH an RRSP AND a TFSA contribution but for those who aren’t, the TFSA should probably get the nod. If you can’t do both, odds are your income is relatively modest, in which case you may be in a lower tax bracket, which in turn makes the RRSP argument less compelling. By the same token, if your salary is relatively low and you want to maximize future sources of government retirement income like Old Age Security and/or the Guaranteed Income Supplement, then again the TFSA is compelling: all withdrawals will be totally tax free and not trigger dreaded “clawbacks” of OAS or GIS. Say you’re currently 47 years old and have $10,000 saved in a TFSA. In 20 years, you could contribute $5,500 20 times, for another $110,000 (and probably more if the government keeps adjusting the limit to inflation.) Even if growth was negligible because it’s invested in laddered 5-year GICs or a bond ETF equivalent, let’s assume you can get 2.5% interest (a figure that will likely be much higher 20 years from now.)

Even with no employer pension or other sources of income, someone living on some combination of CPP, OAS and GIS taken at age 67 would be able to generate some $3,250 a year of safe interest income from a nest egg that (conservatively) might have grown to $130,000 over that time. That’s almost $300 a month, guaranteed and tax free.

If you put it into Canadian blue chip stocks, you’d have a much bigger nest egg but either way, it’s nice to have an emergency fund and a source of regular income that’s independent of what government authorities provide — my idea of a modicum of financial independence even for those with modest means. Yes, I realize it’s tough for some to put aside even $5,500: if that’s the case, then at least shoot for $2,000 or $3,000 a year, even if it means going without expendable luxuries like alcohol, tobacco, fine dining, lottery tickets or even the much maligned daily latte habit at your local coffee shop. Find just $50 a week for your future and you’ll be on your way!

As for dual-income couples making good money, to me it’s a no-brainer that the TFSA should be maximized each and every year, and managed for maximum (or balanced) growth. The moment you make your January contribution, you should start accruing for the next year’s installment, even if it means parking in short-term cash vehicles and paying a little tax for the balance of the calendar year.

 

 

 

10 comments on “TFSA: Our number-one tax shelter

  1. If you put the maximum in your TFSA every year and at the end of 2013 your portfolio is down $5000…… can you top up your TFSA in 2014 a total of $5000 loss and $5500 for a total of $10,500.
    This is the opposite of your example in your article ie: withdrawl of the $300,000

    Reply

    • No, you can’t. That’s the one drawback of a TFSA, you can’t claim capital losses like you could in a non-registered account.

      Reply

      • I don’t want to claim a capital loss

        What I want to do is , since my TFSA has actually dropped in value by $5000 is to contribute what I have lost plus my contribution limit for this year of $5500. If I withdrew 5000 from my TFSA last year I would be able to contribute $10,500 in 2014. Since my account has dropped in value by $5000 why cant I contribute that amount plus the amount I am allowed this year

        Reply

  2. I wonder if you would be able to feature someone who took the big gamble like your high winners did and had the opposite effect ie lost almost everything they put into the TFSA, There is a risk to gambling and the loss within the amount could not be recovered without most significant high risk. This would be a huge learning experience for your readers….I am one of Dan’s couch potatoes so it wouldn’t be me…

    Reply

    • Guys name is Jim Nykyforuk, and his initial investment was $20k. Obviously, there is a risk, the editor clearly pointed this out. And the editor clearly stated many times that Jim was an outlier.

      Reply

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  5. After reading several articles in MS on TFSAs
    and learning about the couch potato investment approach,
    A couple of years ago, I took a deep breath and jumped in as a DIY investor.

    Each year i maximize my annual limit allowed for TFSAs.
    I m delighted with the slow and steady profit I ve made.

    I contribute by arranging automatic withdrawals deposited into a TD Waterhouse
    Account for pre-authorized index fund purchases bi-weekly.
    It has become a forced saving account. It works!

    Now that my car is paid off,
    I m also using some of this extra money I have to catch up
    To where my TFSA savings should be, had I started my
    Contribution when TFSAs were first introduced.l

    Believe me if I can do this, anyone can.
    Thank you Money Sense magazine for writing easily understood
    Articles on investing !

    Reply

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  7. My TFSA briefly hit $59k, now back to $55k… It is far better than any other form of serious savings that there is, entirely without inflation taxes and tax free like homes but no property/utility tax costs, so in technical point other than needing a place to stay, its better than real-estate.

    And anyone recommending RRSP over TFSA, is well, not working for you. If you hear this, do not walk away, run. I don’t have the space here to explain, but RRSPs larger than $80k/per person or $120k/couple in retirement is a tax trap.

    What kills RRSPs is they are fully taxed on inflation gains, gains, dividends and gets the full punitive rate.

    TFSA not being taxed on inflation and real gains is a 100% winner. People spend more on credit interest per month than what it takes to make a million dollar TFSA in 35+ years. Its really about priorities.

    Very good article this is. Me, I am retired early and RRSP tax trapped (guaranteed to pay a higher percentage of taxes out than deferred in). I let it get far too big and wish I could have had TFSA when I was younger, it would massively save me taxes to have prepaid taxes and use TFSA.

    I wish Canada had a economical convention method like USA has with IRA to ROTH conversions. Bit Canadian benefits are always half baked less benefits than Americans get.

    Reply

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