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Tax saving gets serious

The Tax Free Savings Account, better known as the TFSA, is now a serious tool in your wealth management toolkit.

The Tax Free Savings Account, better known as the TFSA, is now a serious tool in your wealth management toolkit.

When introduced in 2009, the limit was 5,000 per person and most people invested their contribution in low yielding savings accounts yielding around two per cent. The income tax saved could buy half a tank of gas.

Today, you can shelter $20,000 tax-free and currently your overall limit grows by $5,000 per year. The income tax saved on that investment income could buy a return ticket to some place warm, depending on how you invest it.

Ay, theres the rub! In the mad rush to deposit into these accounts, many people fail to realize that TFSAs work best when invested for long term gains rather than settling for one to two per cent interest rates.

Yes, I know that the stock markets have done a lot worse than that, so lets not even start that rant. Risk is the price for long term returns and bad markets will always punctuate the good ones. History and logic tells us that equities outperform bonds, GICs and savings accounts in the long run. Key words are in the long run.

Lets instead look at a hypothetical comparison between two neighbours, the Bonds and the Greens. Both couples decide to invest their maximum contributions annually into their TFSAs. Currently that means $10,000 per couple per year.

The Bond household has no confidence in the fact that over 20-year rolling periods, stocks have outperformed fixed income investments. Hence, they invest their TFSAs into one year GICs. The average long-term rate of return for one year GICs over the past 20 years has been approximately 3.2 per cent.

The Greens invest in a portfolio that is equally invested into Canadian and US Stocks, represented by the S&P TSX Composite Index and the S&P 500 Index. The average long-term rate of return for the Canadian/US Portfolio over the past 20 years has been 9.09 per cent.

For this oversimplified illustration, we will assume that these rates of return continue.

After 20 years of contributing, the Bonds end up with $141,507 while the Greens have $281,887.

The Bonds were able to sleep every night and during the years when stocks did poorly, were able to thumb their noses at the Greens.

However, the Greens were able to enjoy their wealth a lot more, see a return substantially ahead of inflation, enjoy some fine vacations and help their grandchildren avoid student loans. The Greens also have the comfort of knowing they will leave behind a more substantial tax-free estate when their days are done.

Get the picture? TFSAs work best when planning for the long term. Between you and your financial advisor, they deserve some serious attention.

The opinions expressed are those of Richard Vetter, BA, CFP, CLU, ChFC. Richard is a Senior Financial Advisor and Branch Manager with WealthSmart Financial Group / Manulife Securities Incorporated in Richmond, BC. Manulife Securities Incorporated is a Member of the Canadian Investor Protection Fund.

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