We just entered August this week and you haven’t opened your TFSA account? What are you waiting for? The TFSA (Tax Free Savings Account) has been in place since the beginning of 2009, sponsored by the Canadian Government. While I had already described the program in a previous post, here are the major things to remember:
– You are allowed to invest $5,000 per year regardless of your income (must be 18 year old to participate).
– You are not restricted in the type of investment (CD’s, mutual funds, stocks, Canadian and International assets, etc.)
– All gains within the TFSA are, quite obviously: Tax Free.
– Contributions and withdrawals have no tax implications (therefore no tax deductions and payments are not tax deferred… simply tax free).
Actually, the only bad thing about the Tax Free Savings Account is the size of the contribution at first. It’s fun to save $5,000 with all growth free of taxes but what can you really do with such small amounts? If you buy a certificate of deposit, the interest earned will be insignificant (especially considering the current low interest rate environment!). With a 5 year rate at 3.5%, you would actually earn $175 per year of interest. Meaning, you actually save an astonishing $70 a year with a 40% marginal tax rate. That’s it; you could retire 5 years earlier with this new strategy… NOT! The good news is that amount will increase over time (the $5,000 yearly limit will be eventually be adjusted to match the inflation rate). In the meantime; here’s what I would do with my TFSA:
#1 Holding liquidity in your TFSA
As you already know, I am not a big fan of emergency funds. I prefer the use of a line of credit instead of “freezing” 5K to 10K. Since personal finance has no absolute, if you feel more comfortable seeing a monthly statement showing you have an emergency fund, the TFSA is definitely an answer to your need.
Liquid and secured assets will generate interest income. And interest income is fully taxable at your marginal tax rate. So if you want to protect your emergency fund from inflation, consider investing in a TFSA so the interest income remains tax free. Since you can withdraw this amount at any time, this fulfills all the requirements for a good emergency fund.
Since interest rates are pretty low right now, I would be tempted to look at mortgage-based mutual funds to allow for better investment returns. They usually offer a 3 to 5% expected investment yield and show small to no negative fluctuations. Currently many of them may, within a 12 month period, show a negative return. However, this should not exceed 3 to 4%. What is 4% of $5,000? $200. You should be able to support a temporary loss of $200 even in a case of an emergency. On the other hand, if chances of using your emergency funds are low over the next 2-3 years your investment yield will be far better than regular certificates of deposit.
#2 Following an index
If you do not need your money right away and you want the potential for even better returns, you are running out of options. With $5,000, you would be limited when looking at stocks, buying 2 – 3 stocks (of 100 shares each). In fact, you could barely buy a basket of Canadian bank stock!
On the other side, you could easily find an ETF or an index mutual fund that replicates the market. I like them since they get you the best from the market (growth!) without cutting returns with astronomical management fees. Depending on the amount you want to place, index mutual funds may become your best option at the beginning.
Since there are no transactions fees (no commission on the buy or sell side of the product) and relatively low MERs (usually around 0.50%), it may be the best solution for a $500 to $5,000 investment. You can also contribute to it with a systematic investment plan as well (which you wouldn’t want to do with ETFs as they charge a commission for each transaction). Unfortunately, you will also have to live with the fluctuation of both types of products. When the market is down 35%… your investment will reflect it as well…
Do you have any other investments you would like to include in your TFSA?
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