The good news is that Tax Free Savings Accounts (TFSAs) are finally garnering wider use, according to a recent study showing that 50% of all Canadians now have a TFSA, up 23% from 2012.*
The bad news is that while 68% claimed to be knowledgeable about TFSAs, only 1 in 10 were able to identify the various types of eligible TFSA investments. Worse yet, 70% of all investments in TFSAs are held in low yielding cash or cash equivalents investments.*
Why is this important? In my opinion, these results prove that the vast majority of people are under-utilizing the tremendous long-term benefits of these TSFA plans.
What is a strategy where you could make much better use of your TFSA?
Like a lot of things in investing, the right strategy sounds simple, but it isn’t easy.
First off, people should be taking a holistic approach to their TFSAs. If for example, someone has low return cash investments in a TFSA, but also has outstanding consumer debt at much higher interest rates, it makes no sense whatsoever to keep the capital in a TFSA. It would be much more beneficial to cash out the TFSAs and pay off the high interest debt.
Second, and more importantly, people should be seeking higher potential return investments in their TFSAs, in order to let the magic of tax-free compounding work to their advantage.
Higher compounded returns lead to greater wealth creation over time
I am not really stepping out on a limb to suggest that higher compounded returns lead to greater wealth creation over time. What I think most people are missing with TFSAs is that this potentially greater wealth, is tax-free. Given this fact and without doing any math, it would only make sense that you would want to maximize the potential return of your TFSA investments.
That being said, there is really no need to be speculative in your TFSA. What really leads to long-term success is consistent and reliable returns.
To illustrate this point, let’s assume that an investor made the maximum TFSA contributions since their inception in 2009. And then compare the returns of holding cash/GICs at 2% per year (as the vast majority of Canadians are doing), versus a balanced approach such as 40% bonds/60% stocks at 6% per year and a more growth oriented portfolio at 8% per year.
At the end of 2013, a cash TFSA would be worth just over $27,000, the balanced TFSA would be worth about $30,500 and a growth TFSA would be worth roughly $32,200. The difference between cash and growth is about $5200 … not bad, but nothing to write home about.
If we project this out for 10 years (indexing the TFSA contribution limits with inflation), the cash TFSA would be worth around $60,000, the balanced TFSA around $75,000 and a growth TFSA would be around $83,300. Notice the effects of compounding? The difference between cash and growth has now grown to over $23,000.
Now let’s look at the effect of this higher compounding over a 30 year time horizon, which is probably more in line with most investors’ timeframes. The cash TFSA would now be worth around $270,000, the balanced TFSA would be twice as much at around $516,000 and a growth TFSA would be almost 3 times as much at over $735,000.
Benefits of Better Utilizing your TFSA
|Strategy||Projected Return||Projected Wealth
after 30 years
|Cash||2%||$ 269,290||$ 68,290|
|Balanced||6%||$ 516,146||$ 315,146|
|Growth||8%||$ 735,297||$ 534,297|
Over a typical investor’s timeframe, the difference between simply holding cash and having a more properly structured portfolio could be an additional $250,000 to $450,000 … tax-free!
“Cash is certainly not king when you factor in the magic of compounding.”
Once you buy into the idea of treating your TFSA as a long-term investment vehicle rather than a glorified bank account, it opens up all sorts of possibilities. Here are a few of the most common:
- Use the accumulated growth for a major purchase. For example, a down payment on a house or home renovation. Remember, you never lose the accumulated value, as TFSA withdrawals can be re-contributed back into the plan the following year or any other time in the future.
- Use the extra-accumulated growth to supplement your lifestyle needs. This is especially important for retirees, as the withdrawals are tax-free, so they won’t affect your tax bracket or be treated as income in calculating OAS benefits.
- Use the accumulated growth for estate purposes. I recently updated a financial plan for a retired couple wanting to use their TFSAs for estate purposes. With a 30-year time horizon and a balanced portfolio, the after tax potential estate value of their TFSAs was almost $1,000,000.
What is the bottom line for TFSA success?
- Treat your TFSA as a long-term vehicle with tremendous planning and tax benefits.
- Invest the money in a properly diversified portfolio that will deliver consistent and reliable returns.
- Take a holistic approach and integrate your TFSA with your other investment accounts to best meet your overall financial goals
Unsure about how you could best utilize your TFSA? Please contact me.