This year’s sharp interest rate hikes have finally made a tax-free savings account (TFSA) “saving” worthwhile.
Until now, the TFSA served as a tax-free investment account.
In the year When it took effect in the wake of the global financial meltdown in 2008, the world’s major central banks conspired to keep benchmark interest rates close to zero to prevent the collapse of the financial system. As a result, yields in fixed income remain rock bottom until early 2022.
Before the S&P 500’s 18 percent pullback this year, TFSAs were the most effective tool for investors and speculators, paying seven times the value of the stock market during a bull market driven by cheap money.
New year for savers
Times have changed. While stocks have fallen, annual yields on fixed-income products such as money market funds, guaranteed investment certificates (GICs) and government bonds have risen by more than five percent in some cases.
That allows TFSA owners to grow their savings over time without taking on equity market risk or having to pay income taxes on those gains. Synergy occurs when the product itself produces its own product in addition to the original investment, etc.
To learn how compounding works, if you start with $50,000 and add $10,000 every year at five percent, after 10 years you will have $197,224. That adds up to nearly $50,000 in interest alone.
We expect the five percent return to come in above inflation, assuming the central bank’s initiative to combat high spending by raising interest rates. If this is not the case, further additions should result in higher yields.
A TFSA has better tax advantages for income.
All TFSA contributions, other than US dividends, are never taxed, but interest income is taxed in full outside of the TFSA, so it has a better advantage.
In contrast, only half of equity investments made outside of a TFSA are taxed when sold. Holding stocks outside of a TFSA allows investors to offset losses on the stocks they sell against gains three years ago or indefinitely into the future.
Even dividend income from qualified stocks held outside of a TFSA can generate a tax credit.
TFSA as a retirement investment tool
Starting January 1, 2023, the total TFSA contribution limit for an individual will increase by $6,500. This means an additional $6,500 in contribution room for most Canadians who have not contributed the maximum amount allowed in previous years. Allowable amounts are carried forward.
The total contribution area varies depending on individual contributions and funds over the years. To give you an idea of how important the TFSA can be, when it was introduced in 2009, the total allowable amount for those 18 or older will be $88,000 in the new year.
Originally funded as a short-term savings vehicle for a vacation or home renovation, the TFSA has evolved into a tax-efficient retirement planning tool that can complement a Registered Retirement Savings Plan (RRSP).
Their difference is their strength. RRSP contributions can be deducted from taxable income (unlike a TFSA), but those contributions and the returns they generate over time are fully taxable at the individual’s marginal rate.
With the right planning, RRSP withdrawals can be compounded at a low marginal tax rate in retirement and topped up with tax-free money from a TFSA – significantly reducing the overall tax bill.
Both RRSPs and TFSAs can hold any type of investment, including stocks traded on major exchanges, bonds, mutual funds, or exchange-traded funds (ETFs).
The biggest difference is that any amount can be withdrawn from the TFSA at any time without taxes and penalties.
Anyone looking for an effective New Year’s resolution can contribute to an RRSP before the March 1 deadline and deposit their tax refund into a TFSA.