A Lousy Use of a Great Opportunity

With the Tax Free Savings Account you will pay less tax. I’m a big fan. Who doesn’t want to pay less tax?

I just think that a lot of people aren’t using TFSAs as effectively as they could.

Here’s how it works: With a TFSA you invest your money as appropriate to your objectives. There are lots of investment options; mutual funds, stocks, daily interest accounts, etc. Anything that you can buy in an RRSP, you can buy in a TFSA.

Regardless of whether the investment earns interest, receives dividends, or grows with capital gains, there is no tax on the growth of the investment.

It gets even more interesting. There is also no tax on any withdrawals from the TFSA. You can access the funds for whatever you want, whenever you want, and you can do it without triggering any tax.

Tax free growth and tax-free access to your money creates some nice planning opportunities. TFSAs have been very well received.

TFSAs are only four years old, but already there are about 8.5 million TFSA accounts in the country, with assets of about $54 billion. They are big business.

The banks saw the potential to gather assets via TFSAs early, and got out in front. They even accepted money for TFSAs prior to the official launch, so that they could be first in line to rake in deposits. They offer premium interest rates on savings accounts inside of TFSAs over their regular interest rates.

The proactive efforts of the banks to market TFSAs have paid off. They have the lion’s share of TFSA deposits – with roughly 3 out of 4 accounts in the country held at a retail bank.

The problem is, about 84 percent of TFSAs are invested in savings accounts or term deposits. What a waste!

I say this because these are the types of products that are consistent with short-term needs. And while the TFSA will certainly do a wonderful job of holding short-term assets, it may be an opportunity squandered.

Let’s look at the numbers, and I’ll show you what I mean. Let’s say that you have $10,000 in a TFSA and its paying you 2 percent per year. This means that you will see $200 in tax-free interest each year. This doesn’t mean that you save $200 per year, mind you. It means you save the tax on $200. If you are in a 30% tax bracket, that’s $60 per year in savings

Alternatively, let’s say that you invested the money for something long-term. Since you can put in $5000 per year, it is not unrealistic to think that over time, with deposits and growth on your money, that you might have a significant sum of money in a TFSA. Years from now, holding $100,000 in your TFSA will not be unreasonable. Actually, it won’t even be uncommon.

So what’s better? Saving $60 per year, or being able to lay your hands on $100,000 tax free?

There are so many wonderful things that you can do with a TFSA that go beyond simply a savings account paying 2 percent. Invest in products with long-term returns that exceed inflation. Utilize a tax-free withdrawal strategy to preserve income-tested government benefits. Buy a bank stock with a 4.5 percent dividend and set up a dividend reinvestment plan. Put the money in a Guaranteed Minimum Withdrawal Benefit fund, and have tax-free income for life. Etcetera.

With so many interesting options for your TFSA money, why would you constrain your thinking to mere bank accounts? That’s fine for any short-term objectives, but if your TFSA is long-term money it’s a lousy use of a great opportunity.

This article was posted in All Columns, Income Tax Planning.
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