The good news is that Tax Free Savings Accounts (TFSAs) are finally garnering wider use. According to BMO Financial Group’s 2013 Annual TFSA report, nearly half of all Canadians had a TFSA, up 23% from the year prior. And acceptance continues. BMO’s most recent 2014 report estimated that contributions were expected to increase by 34% by year-end 2014 – and that was before the April increase on allowable contributions.
The bad news is that the series of surveys also indicate two important gaps: first, many participants were unfamiliar with the maximum contribution limit and were incurring penalties by exceeding it. (Hopefully this is something that will be rectified by the now-increased limits.) Worse, most contributions – to the tune of 70–80 percent of them – are sitting in low-earning cash or cash-like investments, instead of being put to better use in our capital markets.
Why is this important? In my opinion, these results prove that the vast majority of people are under-utilizing the tremendous long-term benefits of these TFSA plans as an important way to build durable wealth for their retirement years.
Putting your TFSA assets to work for you
Like a lot of things in investing, the right strategy sounds simple, but it isn’t easy.
First off, people should be taking a holistic approach to their TFSAs. If, for example, someone has low-return cash investments in a TFSA, but also has outstanding consumer debt at much higher interest rates, it makes no sense whatsoever to keep the capital in a TFSA. It would be much more beneficial to cash out the TFSA and pay off the high-interest debt.
Second, and more importantly, people should be seeking higher potential return investments in their TFSAs, in order to let the magic of tax-free compounding work to their advantage. It’s a common misperception that cash is the “safe” investment and THE best place for all critical retirement assets. In reality, even though its face value may stay reliably the same, cash loses its purchasing power over time. For example, just try buying a litre of milk (or nearly anything else) at the same price you paid 20 years ago. Clearly, cash entails its own form of risk that also needs to be managed. That’s where a measure of market investing becomes so important.
Higher compounded returns lead to greater wealth creation over time
I am not really stepping out on a limb to suggest that higher compounded returns lead to greater wealth creation over time. What I think most people are missing with TFSAs is that this potentially greater wealth, is tax-free. Given this fact and without doing any math, it would only make sense that you would want to maximize the potential return of your TFSA investments.
That being said, there is really no need to be speculative in your TFSA. What really leads to long-term success is consistent and reliable returns.
To illustrate this point, let’s assume that an investor makes the new maximum TFSA contributions of $10,000 per year for the next 5 years. Now, let’s compare the returns of: (1) holding cash/GICs at 1.5% per year (as the vast majority of Canadians are doing), (2) adopting a balanced approach of 40% bonds/60% stocks at 6% per year, and (3) building a more growth-oriented portfolio with expected returns at 8% per year. (Note: These returns are for illustration purposes only and are by no means predicted or guaranteed. Actual returns may vary widely.)
In this illustration, after 5 years, an all-cash TFSA would be worth $52,296, the balanced TFSA would be worth $59,753 and the growth TFSA would be worth $63,359. The difference between cash and growth is about $11,063 … not bad over 5 years.
If we project this out for 10 years, the cash TFSA would be worth $108,633, the balanced TFSA would be worth $139,716 and a growth TFSA would be worth $156,455. Notice the effects of compounding? The difference between cash and growth has now grown to almost $48,000
Now let’s look at the effect of this higher compounding over a 30-year time horizon, which is probably more in line with most investors’ retirement planning timeframes. The cash TFSA would now be worth $381,018, the balanced TFSA would be more than twice as much at $838,017 and a growth TFSA would be worth over 3 times as much at more than $1.2 million.
Benefits of Better Utilizing your TFSA
|Strategy||Projected Return||Projected Wealth after 30 years||Potential Tax-Free Growth|
|Cash||1.5%||$ 381,018||$ 81,018|
|Balanced||6%||$ 838,017||$ 538,017|
|Growth||8%||$ 1,223,459||$ 923,459|
Figure 1: Numerical comparison of projected returns
and wealth, and tax-free growth over 30 years
Figure 2: Graphical representation of projected returns
and wealth, and tax-free growth over 30 years
Over a typical investor’s timeframe, the difference between simply holding cash and having a more properly structured portfolio could be an additional $500,000 to $900,000 … tax-free!
“Cash is certainly not king when you factor in the magic of compounding.”
Once you buy into the idea of treating your TFSA as a long-term investment vehicle rather than a glorified bank account, it opens up all sorts of possibilities. Here are a few of the most common:
- Use the accumulated growth for a major purchase. For example, a down payment on a house or home renovation. Remember, you never lose the accumulated value, as TFSA withdrawals can be re-contributed back into the plan the following year or any other time in the future.
- Use the extra-accumulated growth to supplement your lifestyle needs. This is especially important for retirees, as the withdrawals are tax-free, so they won’t affect your tax bracket or be treated as income in calculating OAS benefits.
- Use the accumulated growth for estate purposes. I recently updated a financial plan for a retired couple wanting to use their TFSAs for estate purposes. With a 30-year time horizon and a balanced portfolio, the after tax potential estate value of their TFSAs was almost $1,000,000.
What is the bottom line for TFSA success?
- Treat your TFSA as a long-term vehicle with tremendous planning and tax benefits.
- Invest the money in a properly diversified portfolio that will deliver consistent and reliable returns.
- Take a holistic approach and integrate your TFSA with your other investment accounts to best meet your overall financial goals
Unsure about how you could best utilize your TFSA? Please contact me.