A great deal of financial success comes down to executing the basics well. In this series called Investing Basics, we review some of the fundamental tools that can help you and your family build and protect wealth over time. In this installment: using a TFSA
For more than a decade, advisors and financial planners across the country have been pushing clients to open and invest in one of the greatest tax strategies Canadians have at their disposal, the Tax-Free Savings Account (TFSA).
Many have followed this advice, but a recent study conducted by Pollara showed that 31% of Canadians plan to use their TFSA as an emergency fund. While the TFSA is well-suited for this purpose, we want to outline why you should consider making the TFSA a part of your larger wealth management strategy.
TFSA or RRSP?
This question comes up often, but for most of our clients, the answer is to take advantage of the benefits of both types of investment accounts.
When you make an RRSP contribution, it’s usually tax-deductible in the current year. However, both your original contribution and any gains you’ve earned will be fully taxable when you withdraw them in the future. The idea is that you’ll be in a lower tax bracket once you retire, and therefore will benefit from having deferred the taxes until then.
When you make a TFSA contribution, it’s not tax-deductible, but your future withdrawals are not taxed – including any dividends, interest or capital gains that you may have earned. That means you can grow your investments for as long as you want and withdraw funds whenever you need them with zero tax consequences.
Generally speaking, the RRSP is great for long-term, tax-deferred retirement savings, and the TFSA is a flexible way to invest for short- and long-term goals while avoiding taxes. They work very well together.
Maximize TFSA contributions
The first thing you want to do with a TFSA is make the most of your available contribution room. To illustrate the reason why, let’s look at a case study.
John is a 50-year-old entrepreneur who has built up a sizable RRSP. However, he has never opened a TFSA. That means he has been accumulating unused TFSA contribution room since 2009, and now has a total available limit of $75,500.
If John made the full $75,500 contribution this year, contributed $6,000 (the current maximum) in every subsequent year until age 80, and achieved a 6% annual return, he’d be on track for some pretty impressive results:
|John’s Age||Projected TFSA Value|
By age 90, John would have accumulated well over $1.6 million, tax-free. If his spouse followed the same strategy, his family could have about $3.3 million tax-free set aside.
Don’t forget the kids
Now imagine John wants to provide some financial assistance to his 18-year old daughter – say to buy her first home several years down the road. Why not take advantage of her tax-free investing potential too? He could gift her $6,000 per year which she could invest in her own TFSA. If she achieved the same 6% annual return as John, she would have over $100,000 tax-free put away before she turned 30.
Take advantage of estate planning
Now what happens to John’s TFSA after he passes away?
If he elected his spouse as his Successor Holder, they could inherit his TFSA without tax, and it could continue to remain invested and earn income on a tax-free basis. This is an extremely valuable feature of TFSAs that is not available with regular investment accounts.
Alternatively, if he intended to have his daughter inherit his assets, he could name her as his Beneficiary, and she would receive the proceeds of his TFSA tax-free. Because the TFSA would not pass through his estate, the delays and costs associated with a legal process known as probate would be avoided. These fees vary by province, but in John’s case, would likely amount to tens of thousands of dollars.
While it is true that your TFSA can make a great emergency fund, it can also be a powerful way to accumulate tax-free wealth for your retirement, your growing family and your future estate.
If you have unused TFSA contribution room or questions about whether you are maximizing the opportunities available to you, please speak with your Portfolio Manager.