How to make the most of your tax-free account

I have always had an interest in finances, and more importantly on how to increase mine. Recently I decided to educate myself on others ways of making money other than real estate. I decided to read a book by David Foster entitled, “Stop Working! Here’s how you can.” In this book he explains a strategy on how to make money with stocks and to build up a nice nest egg for your future. The following article takes what he is saying a step further and gives you an idea of how to use your TFSA along with the same concepts maximize your return on investment. Both are a good read and are routes that I am going to try and explore.

By Gordon Pape | Sun Sep 2 2012 

Almost half of all Canadians have opened a tax-free savings account, according to a survey released last week by CIBC. That’s a remarkable take-up considering that TFSAs haven’t even been around for four years. That’s the good news. The bad news is that about half of those people aren’t actively contributing. According to the survey, 47 per cent have not put any money into the plan this year.

What’s more, a large number of TFSA holders — 41 per cent — say they have no clue what they will do with the money.  The take-away is that although we think TFSAs are a good idea, many of us haven’t made any serious commitment to making them work. 

Part of the reason is that a lot of people don’t understand how to use TFSAs effectively. I was reminded of this at a dinner recently. One of the guests, a well educated professional, became very attentive when I mentioned I was doing an update of my tax-free savings account book.  He was frustrated with his own TFSA, he said. He made contributions every year but it wasn’t growing very quickly.  What was it invested in? Guaranteed investment certificates. His rationale was that since interest is taxed at the highest rate of any form of investment income, GICs would be the most tax-effective way to use his TFSA.

In one sense, he’s right. The marginal rate of a top-bracket Ontario resident is 46.41 per cent. If the GICs were held in a nonregistered account, he would only keep $53.59 out of every $100 earned in interest. Holding the GICs in his TFSA enables him to keep the whole amount.  But here’s the problem. With interest rates so low, GICs are paying almost nothing. The major banks offer only 2.15 per cent on five-year terms. TFSA contribution limits are $5,000 annually which means that even if you put in the maximum each year you would only have $20,000 to invest. At 2.15 per cent, that would generate only $430 a year. And most people won’t have anywhere near $20,000 in their plans.

“OK, I understand,” said my new acquaintance. “But what’s the solution?”

You need to adopt a different investment philosophy. Instead of aiming to save the highest percentage of tax the goal should be to shelter the maximum possible amount in dollar terms.

Several numbers from the CIBC survey speak to this problem. The first is that 30 per cent of those polled said they are using their TFSA as an emergency fund. That’s fine — ideally, everyone should have such a fund. The money should be invested in cashable assets, such as a high-interest savings account, which are risk-free and readily accessible. The interest earned will be very low but in this case that is not the main goal.  The survey also found that 44 per cent of Canadians say they have all their TFSA money in a savings account while another 21 per cent have some of their funds there. That’s 65 per cent of respondents who have at least some of their money in low-interest accounts, far more than say their main objective is to build an emergency fund.

These people are wasting the main advantage of a TFSA. The amount of interest they are tax-sheltering hardly makes it worthwhile opening a plan.

If your goal is anything other than an emergency fund, you need to think more creatively. Look for ways to increase the investment income your TFSA will produce, consistent with your ability to tolerate risk.

Begin by checking what type of plan you have. If you are limited to a savings account and/or GICs, ask to switch to a more flexible plan, such as one that enables you to invest in mutual funds. If you want even more investment options, open a self-directed plan with a brokerage firm. This allows you to invest in almost any type of security you can think of.

Next, consider how much profit you are actually sheltering inside the TFSA. Let’s look at dividends. The marginal tax rate on eligible dividends from Canadian companies is 29.54 per cent in Ontario. So for every $100 you earn, you save $29.54 in tax. That’s less than the amount saved per $100 of interest but you can earn a lot more in dividends.

As we saw, $20,000 invested in a major bank’s GIC earns $430 a year at current rates. You save $199.56 in taxes at the top rate. If the same $20,000 was invested in BCE stock, it would buy about 450 shares based on the price at the time of writing. Those shares pay annual dividends of $2.27 each, thus generating $1,021.50 for your TFSA. The tax saved is about $302 and the return on your investment increases from 2.15 per cent to 5.11 per cent, not including any capital gains.

Yes, you have added some risk but BCE is a solid company and any stock market losses should be temporary. The reward more than offsets the additional risk.

So if you’re unhappy with your TFSA’s performance, take a fresh look at it. Maybe you need to try a new approach.

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Roger Townsend

Roger Townsend

CENTURY 21 People's Choice Realty Inc., Brokerage*
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