Shelter your savings

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This article was published 26/01/2019 (2494 days ago), so information in it may no longer be current.

The tax-free savings account is a government gift for investors that just got ever better.

The annual contribution limit for 2019 climbed to $6,000 from $5,500 in 2018. Now any Canadian age 18 when the tax-free savings account (TFSA) began in 2009 has a lifetime maximum contribution limit of $63,500. (If you’re uncertain what your limit is, you can check your Canada Revenue Agency online account or your Notice of Assessment from this past year).

The reason behind the new maximum is the annual contribution limit is indexed to inflation, rounded to the nearest $500. As such, it can take a few years before inflation is enough to round up to $500. This latest increase was six years in the making, with the previous maximum sitting at $5,500 from 2013 to 2018 (with the exception of 2015 when it was $10,000, which the Liberal government reversed after coming to power following the federal election that year).

Prior to 2013, the maximum was $5,000 a year.

Undoubtedly, with every passing year, the TFSA becomes a financial tool of growing importance. While most experts agree it should not be the focal point of a financial plan, they also note many Canadians don’t use the TFSA as effectively as they should.

“A lot of people still look at it as a savings account,” says Amy Dietz-Graham, portfolio manager and investment adviser with BMO Nesbitt Burns in Toronto.

“However, the whole point of the TFSA is that any growth on your money is going to be completely tax-free.”

It’s been said before in this column, but to those managing other people’s money, it’s worth saying again.

The TFSA should be an account for investments — like stocks — rather than a simple savings account.

“Everyone’s situation is different, but for long-term goals, the real advantage is to invest the money inside the tax-free savings account,” she says.

“Because that growth is completely tax-free.”

Yes, interest earnings in a TFSA are also tax-free. And a good argument can be made that interest is best tax-sheltered because it does not receive as favourable tax treatment in an open account as capital gains, of which only half is taxable, and dividends, which receive a special tax credit. That said, few people have investments outside their RRSP and TFSA, so discussions about tax efficiency in non-registered accounts are pointless for most.

Moreover, interest rates are still relatively low — though GIC rates are looking more attractive these days. Consequently, for those with a long horizon for their money, it’s hard to argue against a stock-based strategy for a TFSA.

“This is not a bank account,” reiterates Doug Nelson, money manager and investment planner with Nelson Financial Consultants in Winnipeg.

Putting contributions to work in a portfolio of stocks, or in stock-based funds — particularly equities that pay dividends — is more likely to result in your money growing into a significant source of wealth over several decades than lumping your money into a high-interest savings account or GICs.

For example, someone starting fresh today contributing $500 a month to a TFSA into a dividend fund that returns around six per cent annually would have more than $500,000 30 years from now while saving more than $158,000 on tax.

And because this is a tax-free sum, it can be used for any need: major repairs to the home, a travel slush fund in retirement or even an inheritance for loved ones.

“The TFSA can be an excellent longer-term investment account, and should ideally be used as your ‘capital buffer’ in retirement,” says Nelson, author of Master Your Retirement: How to Fulfill Your Dreams with Peace of Mind.

“By that, we mean the TFSA is ideally your secondary source of retirement income that will help to smooth out your overall retirement income picture over time in a very tax-efficient manner.”

Rather than having to draw more taxable income from your RRSP or RRIF (registered retirement income fund) for larger discretionary expenses, with a TFSA, you always have a tax-free well of cash for those needs.

Arguably, the TFSA could end up being some Canadians’ main retirement savings account, particularly young individuals starting their careers. Twenty-somethings who land good jobs with defined benefit pensions (e.g. government gigs) could have just one retirement-savings strategy: putting $500 a month into a TFSA. By the time they are eligible for a full pension in their mid-50s, they’d be ready to retire with their pension covering the basic living costs and a TFSA worth a few hundred thousand dollars for travel and emergency needs.

The problem with that plan is few people can afford to set aside that much, statistics show. While more than 13 million Canadians have a TFSA, on average we have each contributed about $7,000 since its inception, according to data for 2016, the latest available from Statistics Canada.

This statistic is hardly a surprise. Most people have more important financial priorities: paying down the mortgage, topping up the RRSP and contributing to an RESP for the kids.

And “it is important to focus on these other things first,” Nelson says.

What’s more, is young adults starting out often struggle paying the bills — a mortgage, car loan and student debt. It is not until later in their careers that they have free cash flow to save more. Yet, by then, their income is likely high enough to focus on an RRSP savings strategy because those contributions are deducted against income, reducing income taxes paid and often resulting in a refund.

That’s money that can be re-contributed to an RRSP, contributed to a RESP, or paid against the mortgage. Or — let’s not forget — to a TFSA.

In most cases, though, the other financial goals still take priority over a TFSA. Once the RRSP is maximized, and arguably the RESP if you’ve got kids, then you can focus on the TFSA. The same goes with the mortgage. Once paid in full, use the money once designated for the mortgage for your TFSA. (Yes, admittedly, a strategy that addresses all these goals at once is ideal, albeit likely not realistic.)

At this point it might be late in the game… like you’re already retired.

If that’s the case, Dietz-Graham suggests a balanced strategy with some money in GICs for near-term needs and the rest in stocks for use 10 or more years from now.

“It’s about finding that middle ground.”

For some, that might mean investing in blue-chip dividend stocks that grow slowly in value over time and pay you to hold them along the way.

If you’re at a loss for investment ideas, simply follow the lead of the rest of your portfolio — like your RRSP, says Tom Bradley, president of Steadyhand Investment Funds in Vancouver.

“The first place to look should be the existing portfolio,” he says. “New contributions are a great way to re-balance portfolios back to their intended asset mix.”

And these days, a lot of people’s portfolios are likely out of whack in that respect because of the market volatility from the past few months.

“Their portfolio is likely underexposed to stocks relative to their long-term target,” he adds. So investing in a “security or fund that’s down the most may be their best bet” because it increases the chance of buying low rather than the opposite (which might then precipitate you to sell low a few months later).

Investment choices aside, what’s important is making the TFSA as part of your overall plan. Maybe that means delaying contributing while you address more pressing needs, but that’s OK, because all that contribution room may come in handy, Dietz-Graham says.

“As the contribution room grows, the TFSA becomes ideal destination for lump sums of cash for people who sell their house or receive an inheritance.”