When the Tax Free Savings Account (TFSA) was introduced in Canada in 2009, it was the rarest of things; a genuine financial gift from our federal government. Overnight, a TFSA investment became the must-have financial asset for millions of Canadian savers, and people flocked to their banks and credit unions to take advantage.
Of course, like many things the government does, it was a little clunky and hard to figure out at first. The treatment of withdrawals was confusing. Many people failed to appreciate that having multiple TFSAs at different institutions didn’t automatically multiply their contribution room. And over the years, the contribution limits kept changing, which further muddied the waters.
But despite these shortcomings, the TFSA shines as a wonderful investment opportunity. Unlike RRSPs and RESPs, the TFSA is not an account that simply defers taxes, or moves them to someone else. As the name suggests, investing in a TFSA is truly “tax free”. You pay no tax on earnings within the TFSA, and no tax on withdrawals from the TFSA.
What’s not to like?
What I Don’t Like About The TFSA
The Tax Free Savings Account is probably the worst-named investment account of the century. As soon as you use the term “savings account”, that’s what people’s minds tend to focus on. Indeed, a recent IPSOS survey conducted for RBC Royal Bank found that a whopping 42% of TFSA holders use their account for just that: a savings account. It holds nothing but cash and liquid savings.
Now in some cases, there may be good reason for this. Perhaps some holders are very high income earners and all of their available long-term investment money goes to RRSPs. Certainly, using the TFSA for liquid savings is better than not using it at all, right? But 42% is a huge percentage of TFSA holders. I can’t accept that this scenario applies to most of them. What I suspect is really to blame is more a lack of imagination and planning.
When the TFSA was introduced, the original contribution limit was just $5,000, and $5,000 additional room was to be made available each year. Now being realistic, that’s not a lot of money. A lot of people couldn’t be bothered playing around with a sum that was, to them, insignificant. So they stuffed some cash into a savings account inside the TFSA and kept on doing that, year after year, often without much further thought. It simply became an ingrained habit.
But now, a lot of years have gone by. The lifetime maximum contribution room for a TFSA is $63,500. A couple can have, between them, $127,000 in TFSAs, plus whatever growth they have received through the years. By anyone’s standards, that’s a pretty significant amount of money. It’s well past time to break out of the cash savings habit and integrate your TFSA into a complete portfolio strategy.
A Savings Account Is A Poor Choice of TFSA Investment
Since the TFSA has no negative tax consequences and very few restrictions on its use, it is a more flexible account than other tax-advantaged programs. For instance, the RESP has been designed to make it quite inefficient for anything but education savings. And the tax-deferral mechanism of RRSPs make them really only useful for retirement savings, with the exception of the Homebuyer’s Plan and Lifelong Learning Plan programs.
The TFSA’s fewer constraints, however, make the uses far more wide ranging. But the core concept is to make the tax savings worthwhile.
Let’s say you invest your full $63,500 into a TFSA on January 1. Looking at the websites for the big five banks, I see advertised TFSA savings rates between 0.75% and 1.05%. That means, best-case scenario, at the end of the year your TFSA investment will have earned $667 in interest. Congratulations. If you are in a 30% marginal tax bracket, you have saved yourself a whopping $200 in taxes.
Now $200 is not nothing, granted. But it’s not much either. When the government hands you a tax freebie, you should really grab a hold of it with both hands and make the absolute best use of it.
And here’s the rub: not everyone is aware of this, but you can put almost anything you want into a TFSA.
The absolute best-case TFSA scenario would be an investor (a very brave investor) who contributes his full $63,500 to his TFSA and immediately buys 6,350,000 shares of a penny stock, at one cent each. Over the next couple of years, the share price then goes to, say, $10 per share and the investor cashes out. Congratulations! You just made $63.5-million in tax-free income. Now THAT is something to celebrate.
Obviously, this is neither a recommendation, nor a particularly likely scenario, but it does nicely illustrate the point.
Ways To Better Put Your TFSA Investment To Work
Knowing all of this, a TFSA is much better put to use as part of a longer-term investment strategy. This will allow an individual to move away from short-term savings products and into assets that have the prospect of making a much better return, and thus realizing greater tax savings. Stocks, Exchange Traded Funds, mutual funds; all are better options than a humble, low-yielding savings account.
An excellent way to use the TFSA is for retirement savings that will be used for income in an investor’s early retirement years. For retirees without employer-sponsored pensions, it may be possible to postpone Canada Pension Plan (CPP) payments and RRSP withdrawals and live off of TFSA withdrawals until age 70. This would have the effects of: 1) increasing the amount of CPP received at 70 by 42%, 2) potentially qualifying the individual for valuable Guaranteed Income Supplement benefits; and 3) cutting the tax burden during those years to potentially zero. This is a great strategy for maximizing government benefits and minimizing the amount of retirement income that needs to be funded from individual savings, especially in the case of unforeseen longevity.
For younger people, unless you have very high income already, investing in a TFSA may be a much better choice than an RRSP. In your 20’s and even 30’s it can be hard to know what your retirement is going to look like. Without that clarity, RRSPs can actually end up being detrimental. Further, as your career progresses your income will likely increase. This makes the accumulated RRSP contribution room more valuable given the increased tax advantage. Starting with a TFSA investment gives you more flexibility, and you can withdraw from a TFSA to contribute to an RRSP at any time in the future when the advantages become greater and more certain.
The TFSA can also be invested for insurance against future job loss or disability. Or you could be saving to buy a special property later in life. Maybe you are focusing on providing an inheritance for your heirs. The options are, literally, endless.
Wrapping It Up
The tax benefits of a TFSA investment are too good to waste, and letting your TFSA funds sit in a low-yielding savings account is not the way to take full advantage. Integrate your TFSAs into your full investment strategy and use them for longer-term goal funding. Finally, to the best of your financial capacity, make sure you are contributing the full amount available to you.
A gift like this is simply too good to pass up.
Important Disclaimer: the information above is for general informational purposes only and does not in any way constitute an offer for the purchase or sale of any security and is not intended to be considered comprehensive or personalized financial or investment advice. themoneygeek.info assumes no responsibility for the use or application of this information. Always consult a tax, investment, or other appropriate professional before adopting any new financial strategies.
I am an accredited Financial Planner with 23 years of experience in the financial services industry. During the course of my career I completed hundreds of financial plans and recommended and sold hundreds of millions of dollars of investment products. I believe that financial independence is a goal anyone can aspire to and I am passionate about helping others to live life on their own terms.