The biggest mistake the Government made when introducing the TFSA in 2009 was calling it a tax-free-savings account.
They should have called it the TFIA: tax-free-investing account.
By using “savings” instead of ‘investing” they’ve misled Canadians who are now confused on how to best take advantage of this sort of tax-sheltered account.
Too often I hear of people “having a TFSA.” As if that means anything. It only matters what you do inside of a TFSA.
You can save anywhere. Under your mattress, at a Big5 (ughhh please don’t), in the freezer.
There’s nothing special about saving in a TFSA except that the interest you earn on your savings and its subsequent withdrawl is sheltered from tax.
This is completely meaningless with today’s rock bottom interest rates.
Simply parking your money in a TFSA is no different to parking it anywhere else.
So how do you best take advantage of the TFSA?
Let’s look at three different investing scenarios: interest income, dividend income and capital gains and determine which one of these situations makes opening a TFSA worthwhile.
Premise: Contributed $5500 at the beginning of the year. Assuming the lowest Ontario tax bracket at 20.5%.
Scenario #1: Investing in a high-interest TFSA savings account
Rate of return: Let’s say you found a high-interest TFSA savings account at 2%. Inflation is 1.7% leaving you with a real rate of return of .03% (always forget about that nasty inflation f*#&#r dontcha?!)
Spending power next year: A grand total of $1.75.
TFSA advantage: You would have paid $0.36 to the CRA, but it’s all yours to keep since you have a TFSA!
Congratulations? Thumbs up all around. You can buy one load of laundry at a very cheap laundromat next year!
In the most optomistic scenario in all of Canada— the highest interest rate, the lowest tax rate — by simply “saving” and parking money in a TFSA you’ve come out ahead by:
THIRTY SIX CENTS.
Now look what happens if you maxamize the true function of the TFSA, i.e., protecting growth.
Scenario #2: Buying blue-chip dividend stocks in a TFSA DIY brokerage
Rate of Return: Let’s say you open a TFSA account at Questrade. You buy 55 shares of CIBC for $100 each.
CIBC pays you a dividend yield of 4.57%, with your real rate of return after inflation thus being 2.87%
Without even paying any attention whatsoever to the share price (even though it has gone up 16.24% this year already), you’re already of ahead of the previous scenario.
Spending power next year: $154.94 from dividends alone (I subtracted the $5 it cost to buy the shares).
TFSA advantage: Canadians only pay 15% on dividends, so you’re coming out ahead of a non-sheltered brokerage account by $23.24
Double points: when you decide to sell (hopefully when you’re old and wrinkled!) you won’t have to pay any capital gains tax on your CIBC shares. This could save you thousands and thousands of dollars. Of course, in the unlikely event that the share price drops in the long term (we’re talking like 30 years here), you can’t offset your losses either.
But stock picking is too terrifying, you say. Not to worry! We all have to be comfortable with our investment choices.
Scenario #3: Investing in a fund
Rate of Return: You decide to invest in Tangerines Equity Growth Portfolio, since the bank makes it really easy for you and it seems fine. Since it’s inception it’s returned around 7% a year, the real rate of return being 5.3% (you’re getting a hang of this now!)
Spending power next year: Your investment will have grown by $289.69. Unrealized, of course, since you haven’t sold it yet.
TFSA advantage: Let’s just say you did decide to sell in one short year (highly discouraged, buy and hold people!) Capital tax is half the marginal rate, 10% according to our premise, so you’re saving $28.96 by holding this type of investment in your TFSA.
What about in 5 years?
Over 5 years, your initial investment of $5500 would have grown to $8.25 versus $835.87 versus $1620.4, respectively.
Again, for scenario #2, this doesn’t even take into account yearly dividend increases or any rise in share price. Over a lifetime investing in your TFSA is going to save youa significant amount of tax, both because you are likely to move into a higher tax bracket and also because your investments will hopefully, on average, continue growing.
But isn’t saving important?
Cash is handy to have on hand, especially if you’re saving for something like a downpayment or a vacation, and emergency funds are generally recommended by most personal finance experts, but it’s almost totally useless to waste precious TFSA room on mere stockpiling.
Keep the cash you may need in the next five years in a normal high-interest savings account — preferably a branchless Manitoba credit union like Hubert Financial.
Save your TFSA room for investing.
Unfortunately, the S in TFSA has made Canadians feel that they’re doing something when they put money in a TFSA, but they’re not doing anything. They’re saving literally pennies a year and wasting room that could have gone toward growing their money far more significantly.
Which is why I believe there needs to be an I in TFSA.
Join me in my quest to get the government to remain the TFSA the TFIA!
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