10. Using a TFSA like a pro
Transcript:
Hello, and welcome to episode one of season two of the Canadian Money Roadmap podcast. I'm your host, Evan Neufeld. Today we kick off season two, which is focused on your next steps on your financial journey. Season one was all about your financial foundations, like spending, budgeting, insurance and getting a will. Now we look towards the next things like what happens when you get married, buying a house and the number one most requested topics: starting to invest. So we'll start there. For the first episode I'm starting with one of my favorite topics, Tax Free Savings Accounts or TFSA’s. We will look at an overview of how they work, debunk some myths and show you how to use a TFSA like a pro.
Before we go too deep into TFSA’s, I want to remind you of the number one rule when it comes to tax. If you make money, the government will want a piece of it. This is the rule, there are exceptions and I'm going to start there of course. But if you make money, the government will want a piece of it. So using a tax-free savings account is one of the only ways to truly and legally avoid taxes on money you make. A TFSA isn't an investment in and of itself, It's simply an account. Think of it like a bucket. So in your bucket you can hold things like cash, stocks, bonds and other types of investments including mutual funds or ETFs. So TFSA’s are very flexible and open-ended with the options are available. It is not, I repeat, not simply a cash account at your bank. It can be, but this is a misuse of a TFSA in my opinion because, back to that first rule, If you make money the government wants a piece of it. So the TFSA has meant to avoid taxes being paid on money earned, but if it's just sitting in cash, you're not making any money in the first place.
A study from the bank of Montreal recently showed that less than half of Canadians are even aware that a TFSA can be used for things other than cash. It definitely can and should be. So if you take one thing away from this podcast, make sure it is the fact that you can invest and make money inside of TFSA. That's the whole point, because if we're making money, we want to avoid taxes on it.
So now that we know that you can have a wide range of investments in your TFSA, the money you make on those investments, you won't have to pay any tax on the money you make. Okay. It's right in the name tax-free savings account. And remember that rule using a TFSA is the exception to the rule that the government wants a piece of every dollar that you make. So there is a maximum that you can put into a TFSA, but the annual limits have changed over the years so the calculation is a little bit complex. But for anyone who was born before 1991, your current maximum here in 2021 is $75,500. Most recently the annual increase has been $6,000 a year. If you don't use up all of your new space in a given year, it carries forward and definitely to be used in the future. So if you haven't opened at TFSA yet, you can still use that full 75,500. I don't suspect anyone here is under the age of 18, but you must be at least 18 to open TFSA and your contribution room will start at the current annual limit and build annually from there.
There are a number of different ways that people use TFSA’s incorrectly in my opinion. The first one is a mindset thing. A tax-free savings account, I think, should really be called a tax-free retirement account or a TFRA and people would think of it very, very differently. Using the term savings account is confusing in my opinion, because most people think of a savings account as a place to park cash for short term things like a vacation or a vehicle and if it's being used for that purpose, there's no money being made. So many pundits that you might see on TV or reading the newspaper will incorrectly tell people that a TFSA is a great place for your short-term savings. Using a TFSA for short term savings is a major waste in my opinion, because your short-term savings shouldn't be invested in risky assets anyways, where there's an opportunity to make money over the long-term, but there's a risk of losing money in the short term.
So as such, short-term savings wouldn't actually make much, if anything, if they're invested appropriately. So there's no money being made, there's no tax to pay anyways so why would you use a TFSA for short term things? Alternatively, a TFSA should be used to build long-term wealth. Building long-term wealth should start and end with a TFSA in my opinion. So I'll explain that briefly here. It should be the first thing that you maximize when starting to save, and it should be the last money that you ever spend in your life to make sure that you have the most tax-free growth as possible. Looking at your portfolio as a whole, if you're going to invest for the long-term, I would recommend that you focus your higher risk, but diversified assets in the TFSA and your lower risk assets should be in your RSP and other registered accounts. Again, you want the bulk of your growth to be tax-free.
So I'll have an episode coming up here in the future focused on RSPs and the differences. But an RSP, keep it in mind that when you take any money out of an RSP, whether it's before retirement, in retirement or any time, you pay tax on every dollar that you withdraw from the account. Regardless of what you put in, what the investment has earned, whether it's dividend money or anything like that. If you're taking it out of an RSP, you pay tax on every dollar as if it's employment income and the TFSA is the exact opposite. You'll never pay any tax on any money you ever withdraw. If it's your own contributions, if its money made from the investment itself, if it's dividends, it doesn't matter.
So, if you're looking towards the long-term, if you have all of your growth happening in your RSP, all of the growth will then also be fully taxable. So if you think alternatively in the TFSA, if you have your higher growth assets in the TFSA, you can have more of your growth happen on a tax-free basis, and that'll just make your life that much easier.
When we talk about investment growth, it's important to keep in mind that it's not always all about how much you make, but how much you keep. The TFSA is a great tool to make sure that you keep everything you make. Let me just give you a quick example here of a person that might have TFSA money versus someone who has RSP money.
My hypothetical example, each person has $10,000 in their respected accounts. Person A has 10,000 in a TFSA and person B has 10,000 in an RSP. Now as time goes on, 10 or 15 years later, whatever the case is, their $10,000 has now grown to $25,000 because you can invest in TFSA just the same ways that you can invest in an RSP. The same products are available to each. So now that they have 25,000 in each of their accounts, when they go to withdraw their money, who has more leftover? Well in a tax-free savings account, because nothing is ever taxed, person A gets to keep $25,000. Perfect. Now person B, let's say they're in the 30% tax bracket, that means that when they withdraw their 25,000, they only get to keep 17,000 and the government gets the difference. All of that growth that happens in the TFSA is yours to keep forever. The more you save and the longer you wait, the greater the benefit is.
In addition to tax, if you're planning for your estate and passing along your money to the next generation, TFSA’s are great tools for that. You can name a beneficiary and no taxes ever owing on the money, transferred to them. Yes, you can name a beneficiary for your RSPs as well, but you will always have to pay tax on every dollar, whether you're alive or dead. Finally, if you look at things like old age security payments, which is a government benefit you can receive after the age of 65 and many provincial long-term care costs. So we're here in Saskatchewan. I'm not entirely sure about every other province, but a lot of provincial long-term care costs are tied to your income. If you are in long-term care or you receive other government benefits that are tied to your income, the payments that you make will probably be higher if you have a higher taxable income.
So if you have most of your long-term savings in RSPs and taxable places, again when you withdraw from those places, you will have taxable income. That can have an impact on your government benefits, but if your money that you are spending in the later years of your life comes mostly from a TFSA, those things will not be impacted because any money that you withdraw from a TFSA is not considered income and specifically not taxable income.
So in your later years, if you mostly have TFSA money to spend, you're more likely to receive more in government benefits and spend less on long-term care. These are some things that the majority of people listening won't have to worry about for a long time, but the things that you plan for today will be that much easier to achieve later in life by making small adjustments to how you save today.
So I recommend building long-term wealth should start and end with a F. You should start by maximizing your TFSA every year, if possible. And then use that with the mentality of it being a tax-free retirement account, meaning save it for the later years of your life. Hopefully spend any of your taxable money first and let your TFSA grow as long as possible.
In summary:
If you're over the age of 18, you can open a TFSA to invest your money. Any money that's made, whether it's dividends, interest or capital gains, it's all tax free. It doesn't matter when you earn it or when you withdraw to spend it, It's always tax-free.
Don't bother using a TFSA to park cash for short term savings. Use a TFSA to build wealth as early as possible. Using a TFSA for short-term savings or just to park cash is a waste. While you won't get into trouble by withdrawing it for short term savings, meaning you won't have any tax to pay, you also wouldn't have any tax to pay in the first place because it's not making any money just sitting there. The banks often make reference to things like a high interest savings account. Take a look and see what their interest rates are in a product called a high interest savings account. If it's over 0.5%, you might be getting pretty lucky. That's not a lot of interest in my mind and it's not worth it to park money and investment product like that. when it could be doing other things for you, specifically investing for the long-term.
By focusing on building through a TFSA, you could pay significantly less in lifetime taxes, receive more in government benefits and pass along more of your assets to your kids, and finally pay less for your government subsidized costs like long-term care.
The TFSA is the most powerful and most incorrectly used financial tool that we have as Canadians. In my opinion, most of this has to do with the fact that it's called a savings account and not a retirement account. But don't let a couple of words get in the way of your financial success.
Thanks for joining me today on the Canadian Money Roadmap podcast. If you enjoyed today's episode, I'd really appreciate if you left me a review on Apple podcasts with your biggest takeaway. If you have questions or ideas for topics you'd like me to discuss on future episodes, please reach out via my contact info in the show notes.
This podcast is intended to be educational in nature, and you should always consult your financial, tax and legal advisors before making changes to your financial plan. Any rates of return discussed are historical or hypothetical and are to be used for educational purposes only. Evan Neufeld is a Qualified Associate Financial Planner and Registered Investment Fund Advisor. Mutual funds are provided through Sterling Mutuals Inc.