Financial Friday 167: Does Your TFSA Pass the Test?

Does Your TFSA Pass the Test?
Almost everyone in Canada has heard of the Tax-Free Savings Account (TFSA) and approximately 16 million of us have one, but simply having one won’t do much for your financial situation. You need to analyze the details of your TFSA (if you have one!) and probably make a few tweaks if you really want to maximize the amount of tax-free money you could be earning. Here are the five biggest pitfalls and fails to look out for with a TFSA.

1. Not having one... because you don’t know what they!
You may believe a TFSA is something to start when you get older or mistakenly think that it is something for locking away long-term retirement savings. The fact is that TFSAs are actually quite flexible when it comes to deposits and withdrawals, they can save you a lot on your taxes, and you can use one to save for a house or a car, or yes, even your retirement.

Although a TFSA is unlike your regular savings account and isn’t for daily banking, you can open a TFSA at most banks and credit unions as well as online brokerages. You have to be at least 18 years old to get one, but there is no fee and usually no minimum amount required to get started.

2. Choosing to fund your RRSP over your TFSA.
The fact is that most of us would have trouble coming up with the $6500 annual TFSA contribution limit as well as the 18% of income that you can drop into an RRSP, so which one is best given the funds you have available?

For many of us, the lure of that immediate tax break from contributing to an RRSP is hard to resist and can easily cloud your decision-making process. However, the actual decision can be pretty complicated and depends a lot on your projected working and retirement incomes and the associated tax rates, which can be hard to nail down with any degree of certainty.

Just don’t forget that big and juicy RRSP-generated tax refund cheque is not a windfall, you are simply receiving the money right now to pay the taxes on that money when you eventually remove it from your RRSP down the road (in retirement for example). On the other hand, your TFSA uses after-tax money right now, but it will spit out tax-free cash down the road, regardless of how much other income you earn in your retirement years.

3. Starting late.
Chances are you won’t be able to max out your TFSA contributions, especially when you are young. Only 10% of Canadians of all ages actually max out their TFSA. However, this doesn’t mean that a TFSA is for rich people. If you could only come up with $100 monthly for your TFSA from the time you were 18 until you retired at 65 and received historical average stock market returns of 7%, you would have $438,643. If you upped the monthly amount to $225 you would retire a millionaire!

Of course, 47 years is a long time to wait and things will cost a lot more in 2070, but don’t underestimate the power of compounded investment returns. There are a number of self-directed investing options (like broad-based index funds or all-in-one ETFs) you can use to invest your TFSA that require little time or investing savvy. Of course, some funds will do better than others, but the real secret is to get started early! Unfortunately, only around 5% of TFSA are held by Canadians under 25.

4. Getting robbed by high MER fees on the mutual funds in your TFSA.
Seeking professional help to invest the funds in your TFSA can be money well spent — a financial advisor can save you time, they can explain investing options and the risks involved, and they may even deliver market-beating returns! Just make sure you understand all the costs involved including their commissions, transaction fees for buying/selling, and the annual (built-in) fees on the funds they sell you.

These annual fees can seem insignificant and a 2% Management Expense Fee (MER) probably sounds like a bargain to most people — try tipping the pizza delivery guy 2% and see how that goes!

What most people don’t realize is the effect of these seemingly small annual fees over time. If you invested $10K in a mutual fund today with a 2% annual MER fee, that investment would grow to $23,864 in 25 years time at an annual return of 7%. If you passed on the mutual fund and invested $10K in a a broad-based index fund ETF using a self-directed online brokerage account with a 0.25% annual fee, you would have $41,191 in 25 years time at an annual return of 7%.

The point is that financial advice can be expensive. If you investigate and feel your advisor delivers above average returns and great service, and you fully understand the cost, then you don’t need to do anything.

5. Not understanding how to get money out of a TFSA.
If you don’t want to wait until your 65 to start spending those TFSA investment gains, you don’t have to. In fact, you can take as much money as you want out of your TFSA anytime you want. You won’t have to pay any tax and the only downside is that you may have to wait until the following year if you want to put that money back into your TFSA — you cannot re-contribute the amount of the withdrawal until the following calendar year, unless you have available contribution room.

Withdrawals from an RRSP can be much more punishing. The funds are fully taxable at your marginal tax rate in the year withdrawn. In addition, up to 30% is held back by your financial institution at the time of withdrawal to cover the tax. You also can’t replace that money back in your RRSP — that contribution room is permanently gone.

If you've already opened a TFSA and have investments sitting within your account, you're on the right track. Make sure the money is invested and confirm your annual return (net of fees) to ensure your investments  are performing up to expectations. If you haven't yet opened a TFSA, get out there and open one today! A few years from now you will be happy you did.


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