Within our world of investing we certainly have no lack of options. But, when you think of what you should be investing inside your TFSA do all of these options apply or should some have a higher priority?
First let’s list what the primary investment options are for our TFSAs. While I will not list everything possible, I will list the most prevalent choices I’ve seen utilized during the previous three years’ deposits (TFSAs were first made available to Canadians in 2009). They are as follows:
1. Savings Accounts
3. Mutual Funds – low risk Bond Funds, Balanced Funds, Canadian, US, or International Equity(stock) funds, or higher risk Precious Metals Funds or Emerging Market Funds.
4. Individual stocks and/or bonds
Which of these choices are best? Which of these are the right choice for you?
Answer: As always the best answer is that it depends upon your goals and time frame BUT you should keep a few basic principles in mind before deciding on your time frame.
1. If you invest $5,000 every year for 10 years into a Savings Account earning 1%/year how much will you saved in taxes over the 10 years? Answer: very little. You would have deposited $5,000 x 10 years = $50,000. If the TFSA is earning even 1%/year your gain was a total of $50 the first year. Tax on the $50 is at most $23(if you are in the highest tax bracket) or $12 if you are in the lowest tax bracket. So, you would have saved somewhere between $12 and $23 in taxes in year 1. Wow! Moreover, after 10 years of investing in this TFSA your gain was ~$2,800. So, IN TOTAL, YOU SAVED IN TAXES, somewhere between $700 and $1,250, depending on your tax bracket. Keep in mind, this is over a period of 10 years!
2. If you invest in something that averages 6% annually, how much tax do you save?
The growth on this same $5,000 deposited annually over 10 years becomes almost exactly $20,000(instead of $2,800 above). So, now you save somewhere between $5,000 and $9,000 depending upon in which tax bracket you are. The tax savings is more than 7 times as much in just 10 years!
3. If you invest in something that averages 8%/year the tax savings is obviously much greater over 10 years. After 10 years, at 8%/year the gain is ~$28,000. This means the tax savings will be somewhere between $7,000 and $12,600. These numbers do start to have a little significance!!
In addition, if you run the numbers out further, over 15 -25 years the differences become even more substantial.
So, you say, get me 8% Guaranteed and I will heed this advice!! Yes, it would be nice but it isn’t possible in today’s marketplace. But, I reply, where do you even have a chance of getting 6% or 8%? Well, we know with savings rates being as low as they currently are, it is impossible to get even 3% there. Even in GICs, it is very difficult to get 4% unless you lock in for 5 years. Mutual funds and individual stocks or bonds at least present you with the possibility of getting 6-8%, or even more. Yes, granted, they could also get you less if you reflect back on 2007 or 2008. But, I suggest, if you are in TFSAs for the long term, which is the recommended way to really save on taxes, your investment in a mutual fund or individual stock or bond has a much greater probability of earning a decent rate of return, i.e. somewhere between 6 and 8%, assuming it is invested in something that has at least a minimum of 25% stocks inside it.
BUT, you say, you only want to use your TFSA for the short term. Cut this long term discussion. If that is the case, I suggest you consider how much are you really saving in taxes and is it worth it to deposit and withdraw frequently from a TFSA(where there are certain restrictions placed on re-plenishing your TFSA within a given calendar year). Maybe you should just do these shorter term savings outside your TFSA in a simple non registered account and save your TFSA for longer term investments when you have the funds. The $5,000 annual deposit limit carries forward and accumulates even if you don’t use it.