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The Tax-Free Savings Account (TFSA) was introduced in 2008 by the late Jim Flaherty and came into effect on January 1, 2009. When it was created, the Conservative government boasted that it was a new tax-advantage account to allow Canadians and Canadian permanent residents who are 18 or older to set money aside to grow tax-free throughout their lifetime. The idea is to use the TFSA to save money for the large purchases you may have down the road.
In case you want to know more about the TFSA, please take a look at The Millennial’s Ultimate TFSA Guide I created a few years ago.
I applaud the Conservative government for creating a new tax-advantage account for Canadians to help us grow our money. Unfortunately, many Canadians aren’t fully utilizing their TFSA’s.
Stop investing in GICs in your TFSA
I am sure that you have seen those bank TFSA ads before. So and so bank states that you’d get a 2.5% interest rate if you open a TFSA GIC where the rate is much higher than the normal GICs you’d get.
If you open a TFSA GIC and put in $6,000 at a 2.5% interest rate, at the end of the year, you’d get $6,150, or $150 in interest without having to pay any taxes.
But I’d argue that GICs are terrible ideas for your TFSA. If you were to invest in an index ETF instead, you’d get a much higher return. The historical stock market return rate is roughly 8%. So, if you were to invest $6,000 in an index ETF, like the Vanguard Canada All Cap ETF, VCN.TO, you could potentially end up with $6,480 at the end of the year.
I realize that with index ETFs, the return is not guaranteed. You can certainly end up losing money at the end of the year whereas GICs are guaranteed (hence the name Guaranteed Investment Certificate). But we are only looking at this analysis with a short term view. We should be using a long term view.
Say we leave that $6,000 for 10 years. For GICs, let’s assume that the interest rate stays at 2.5% each year, and for the stock market, let’s assume that the annual rate of return for the 10 years are: 4%, 6%, -30%, 15%, 20%, 12%, -5%, -5%, 15%, and 5%.
For GIC, you end up with $7,680.51.
For index ETF, you end up with $7,798.66. An extra $118.15.
Hold on, that’s not a lot of extra money in comparison and I took on a way higher risk with index ETF. What’s wrong with investing in GICs, you may be thinking…
Well, for the index ETF scenario, the average rate of return for 10 years is only 5%, which is much lower than the historical stock market returns.
What happens if we use 8%? You’d end up with $12,953.55, you have more than doubled your money!
If you are “saving” your money inside the TFSA for an expense within a year or two, it may make sense to invest that money in GICs. Otherwise, I believe you are better off investing that money in an index ETF (and dividend stocks if you wish) for longer terms.
Use a TFSA as a retirement account
For many Canadians, the default tax-advantage account for retirement saving is the RRSP (Registered Retirement Savings Plan), but there are many great reasons why you should start looking at your TFSA as a retirement account as well.
Unlike RRSPs, TFSAs do not have any withdrawal restrictions. When you withdraw money from your TFSA, it’s completely tax-free. Meanwhile, RRSPs have many restrictions, such as withdrawal tax, having to convert RRSP to RRIF by age 71, withdrawals are taxed as normal income, and once converted to RRIF, there’s a minimum withdrawal amount.
I don’t know about you but I don’t like restrictions and being told what I need to do, especially when it comes to my retirement.
And since the money you withdraw from a TFSA is tax-free, it doesn’t count as income. That means you don’t have to worry about making too much money and getting subjected to the OAS (Old Age Security) and other income benefit claw backs. All that means is more money in your pocket at the end of the day.
That’s why in our financial independence assumptions, we estimated that 37% of our dividend income comes from our TFSAs. If we can generate more dividend income from our TFSAs, that’s even better.
One thing to be careful is that you need to make sure you don’t over contribute to your TFSA. If you do, you will get a letter from the CRA and need to pay the TFSA over contribution penalties.
Use a TFSA and RRSP together
For retirement savings, it makes sense to use a TFSA and RRSP together. If you can, max out both the TFSA and RRSP every year. If you can’t, you will need to look at your tax situation and determine whether to invest in an RRSP or TFSA to allow for the most tax efficiency. For us, we try to keep things simple, so every year our goal is to maximize our TFSAs and RRSPs.
So, stop thinking that TFSAs are just for short term savings. Start looking at the big picture and start using your TFSA as a retirement vehicle. Your future self will thank you later.