How do you use your TFSA?
There are rare occasions when a government provides it’s citizens with an investing opportunity of significant value. One could say that the introduction of the RSP and RESP could fall into that category although both come with some strings attached.
However with the creation of the Tax Free Savings Account in 2009 (or as the Wealthy Barber puts it, the “Totally Fantastic Savings Account”), Canadians have never had a better option of holding on to their creation of wealth. Yet in all of its glory, I am amazed not only at the poor advice that people get regarding the TFSA but also in the number of Canadians who have no clue how it can impact their future and therefore don’t use it. The key phrase here is Tax Free! And with our ‘friendly’ government always wanting to be a co-partner in our wealth building (read taxes) we should take advantage of opportunities to reduce those taxes.
Given the TFSA option is now in it’s 4th year, some might think this article is just a repetition of what they already know. Yet even with those people I encounter that have TFSAs, they may not be taking advantage of the best use of its functionality. Again the phrase tax free profits comes to mind.
First let’s demystify the TFSA. By itself it’s not an investment. Just like the RSP, it is an account that the investor opens and within it the investor can hold multiple different products. For example you could have a simple savings account, you could own GICs within it, you could have mutual funds or bonds, or you could own shares of publicly traded companies. And it can be a passive account or it can be a self-directed online brokerage account.
Second, the biggest difference between the TFSA and the RSP you may own is in the way money is treated both at time of deposit and at time of withdrawal. For the RSP, the amount you can “contribute” is based on a percentage of your income and the contribution creates a tax credit that reduces the tax you pay. The TFSA contribution limit is fixed at $5,000 per year (retroactive to 2009 making this years total $20,000 if you have never contributed and you were at least 18) and is not associated with your income. However you do not get a tax break by depositing money in your TFSA.
When you take money out of your RSP rest assured you will pay tax on that money as it is treated as income. In many cases, you may find that the tax rate you pay on withdrawal may be higher than the tax rate applied to generate your credit at time of contribution. (that sucks) In a TFSA, you can withdraw your money at any time, for any purpose and not pay a dime of tax on the money no matter how much it has grown over time. Plus any money you remove can be replaced at no penalty and does not affect your existing contribution room.
Many people look at their RSP as a way of saving tax dollars but it is important to understand you are only deferring the tax, which may or may not be less than the tax credit.
The TFSA on the other hand is better to look at as an investment account that can save you tax dollars down the road. In other words, by building capital within the TFSA, you will do so without any requirement to pay tax on that growth. And if you have the ability to generate significant growth, that’s where the awesome comes in.
Here are some of my thoughts when it comes to the TFSA.
Use the TFSA to balance out the other side of your retirement savings within your RSP. For example, if a good portion of your retirement income can be funded by your TFSA, you may only need to supplement that with minimal withdrawals from your RSP translating into a lower tax bracket and less tax to be paid. And withdrawals from your TFSA do not generate clawbacks in other areas of government income like OAS.
Use the TFSA to hold investments that can generate reasonably high returns. For example, let’s say you had purchased 190 common shares of the Royal Bank in 2009 with the first $5,000 contribution. RY was trading at $26 at that time. Today, RY is trading at just over $53, meaning your shares increased by 100%!!. Today your $5,000 would be worth just over $10,000. And that extra $5,000 is subject to zero tax!
Financial institutions will advise you to put high tax income generating products within your TFSA. For example, interest income is taxed at the highest rate so the suggestion is to place your GIC within a TFSA. But do the math. At 2% your $5,000 in your GIC will create a $100 return annually. Sure you save the 38% tax (or whatever tax bracket you are in) on that $100 but who cares! Why not save the 38% tax on the $5,000 profit you made with your shares?
To be fair, you won’t always get a return like the RY shares, but my point is if you can make 15% to 30% on your share appreciation, that is significantly better than the 2% to 5% on other products you may be advised to hold in your TFSA both from a growth perspective and from a tax perspective.
The following table shows the growth of the current allowable amount of $20,000 within your TFSA at various different rates of return.
This table shows you the growth of the $20,000 plus an additional $5,000 per year for the next 10 years.
Once you understand the significance of the TFSA you can then look at how you go about creating the returns of 15% to 30%. Certainly that isn’t with your typical GIC or mutual fund but in no way is it unrealistic with the right strategy.
Bottom line – do your homework, understand the tax implications of the advice you are getting and take the time to learn how to produce better results. You can do the same things within your RSP but remember, the tax man cometh!
Happy investing.
This entry was posted on Wednesday, February 15th, 2012 at 9:38 pm and is filed under Investment Training, Investment Training FAQ's, RSPs, Self Directed Investing, Tax Free Savings Account (TFSA), Traditional Investing . You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.
February 26th, 2012 at 10:20 pm
Thanks Dave. I will when I’m trading live try to use this info.
February 27th, 2012 at 6:56 am
Again – excellent