TFSA or RRSP? There are only two options for withdrawing funds early from your RRSP without penalty: the Home Buyers Plan and the Lifelong Learning Program. If you would like to have greater access to your money or are saving for something other than your first home or a return to school or retirement, you may want to consider a Tax Free Savings Account (TFSA).
It's time for Canadians to stop playing it safe when it comes to the tax-free savings account.
When the TFSA was born in 2008, it was celebrated as a way to stash some cash into a piggy bank that the taxman could never touch. It increased the appeal of saving up for a rainy day, or for a major purchase a few years down the road.
But the initial maximum contribution of $5,000 that could go to a TFSA has now ballooned to $25,500 for every Canadian over the age of 18. And it'll keep growing by at least another $5,500 every year. (Keep in mind a person can only make a one-time contribution of $25,500 if they've never made a contribution, or if that person had earlier withdrawn that amount. For someone who has steadily been socking away $5,000 for the last four years, they would only be eligible to contribute the $5,500 limit of 2013.)
That's quickly adding up to much more than just an account to draw from for a new sofa, European vacation or even an automobile. To put it in perspective, a 25-year-old who started making a full contribution into the plan when it premiered, and continued to do so every year until he or she retires at age 65, would have socked away more than $215,000 that could grow and later be withdrawn without any tax implications.
If we assume a five per cent annual rate of return from the investments held in the TFSA, that would add up to close to $750,000 by retirement, thanks to the power of compounding. A couple who diligently saved over that 40-year period could have $1.5-million in retirement savings by age 65 – and not a penny of that would ever go to government coffers.
That differs greatly from registered retirement savings plans. All contributions and investment income earned in RRSPs are subject to tax once withdrawn. And those withdrawals from RRSPs could trigger clawbacks for Old Age Security (OAS) or other federal government-funded programs, depending on income level and other factors.
Achieving a 5 per cent return shouldn't be hard. History strongly suggests, for instance, an investment in equities could well exceed that; consider that stock markets in the developed world annually returned 8.5 per cent over the last 112 years, according to the Credit Suisse Global Investment Yearbook.
The problem is that many Canadians aren't taking full advantage of TFSAs, because they are choosing to put those funds into ultra-safe investments, like guaranteed investment savings and high-interest savings accounts. Little risk, but piddly returns – one, maybe two per cent if you're lucky.
Data from Canada's largest bank, RBC, shows its clients have a whopping 65 per cent of their TFSA holdings in either a high interest saving account or GICs.
For Canadians who simply want to save for near- or medium-term needs, that's probably a good thing. But those who are not planning to withdraw their TFSA funds for years to come need to look at other strategies.
One that I like: buy investments that offer two ways for bulking up a portfolio. Dividend stocks, for instance, provide income as well as the potential for capital gains. There's some volatility associated with this, but investing in blue chips and broad-based exchange traded funds help to level off this risk. And it's reassuring to know that when stock and unit prices fall, the income streams will help to offset losses.
One downside is you can't write off capital losses in a TFSA. But that shouldn't be a huge issue when constructing a well-engineered, balanced portfolio for the longer haul.
And here's another idea: spread out the risk. Hold different baskets of TFSA investments based on future needs, broken down by short-, medium- and long-term goals. The longer the timespan, the more aggressive the investment.
Planning to take an extended period off work in a couple years? Think about how much you'll need, and then invest conservatively for that portion of your TFSA, perhaps with GICs or a high-interest savings account (and ones that offer above-average returns, such as a Manitoba credit union.)
For the longer term, consider equities, exchange traded funds or mutual funds that are much more likely to significantly bolster the size of your savings in the long run.
Of course, many of us simply have too many other demands on our income to sock money away into a TFSA. And RRPSs and RESPs can certainly have their advantages based on such individual circumstances as income and retirement goals.
But even modest contributions into TFSAs can grow into rewarding figures. The ability to save can also rise considerably later in life, when personal incomes tend to go up with increased job experience, and the monetary demands of raising children diminish.
The TFSA can pack a powerful punch when it comes to wealth building. But it's up to us to realize its potential. The time to do so has arrived.
READERS: What do you think is the best way to invest money in a TFSA? Do you think Canadians are being too conservative when it comes to investing in these funds? Do you prefer using a TFSA or an RRSP?
Darcy Keith