TFSA Advantage Explained

 

 

Although there are many investing concepts and philosophies for each wealth planning objective I want to draw your attention to an often underutilized vehicle known as a TFSA (Tax Free Savings Account).

TFSA’s act as a container to which after tax money is deposited to shield all growth of that money from taxation. This shield from taxation extends to withdrawal of the funds as well.

Disadvantages:

  • Losses incurred within a TFSA have no tax planning value and cannot be used to offset the account holder’s income.
  • The contribution limit for TFSA’s is quite small ($41,000 as of January 1, 2015) and increases by $10,000 per year (as of April 2015)
  • There are strict ownership rules which prohibit a TFSA from holding shares of small tightly controlled corporations.
  • Excess contribution room created by a withdrawal of money from the TFSA cannot be utilized until the next calendar year.
  • The TFSA is funded with “after tax” income. The contributions do not reduce the account holder’s personal income tax burden.

Advantages:

  • Investment returns earned on assets of any form held within the TFSA are exempt from income tax. This is especially useful for “interest income” which would otherwise be taxed at the investor’s marginal tax rate.
  • Money (including growth) may be withdrawn from the TFSA at any time without incurring any income tax.
  • Mortgage Investment Corporations are a permitted TFSA investment
  • The “size” of the TFSA account grows by increases in contribution limit AND by growth of the investments within it.
  • TFSA accounts can be transferred upon death to a surviving spouse. Doing so preserves the structure to permit further growth of the assets within it without triggering any income tax.
  • money may be withdrawn from a TFSA and recontributed the next year without any penalty or loss of the tax shelter’s size.

Maximize TFSA benefit by holding the following types of investments within the TFSA:

  • The highest earning interest income investments will benefit the most from a zero income tax environment.
  • Shares upon which an exceptional capital gain is expected are good candidates for a TFSA account, however such opportunities often come with an above average probability of investment loss which can be better utilized outside of the TFSA account where it can offset gains on other investments.
  • The key to maximizing the TFSA benefit lies in maximizing the growth of assets within it. Doing so will expand the tax shelter by a much greater rate than the annual contribution limit increases.

Consider the following example:

A TFSA account is opened on January 1, 2015 with a deposit of $41,000 which is then invested in a company offering “interest income” at a rate of 10% annually which is reinvested. The account is topped up with the maximum annual contribution of $10,000 which is also invested in the same company.

Ten years in the future, the above assumptions will lead to a TFSA account to which $91,500 has been contributed and has a total value of $292,829 which is $151,289 larger than the maximum allowed contributions. This account could then become a tax free income source of $29,280 per year.

Growing the same account to year twenty will yield even more impressive results: with $241,000 contributed and a total value of $933,435 which is $692,435 larger than the maximum allowed contributions. This account could then become a tax free income source of $93,435 per year.

Summary:

As you can see, the maximum benefit of a TFSA account is achieved by beginning to grow it as early as possible with strong investment returns. The sooner one starts, the larger the tax shelter will be in the future.

TFSA Growth Examples: