For several months now there has been a buzz about the Tax Free Savings Account (TFSA) from pretty much all financial institutions. Many institutions offered the TFSA as early as October (although you could not fund them until January 2009) the account has created some excitement and confusion among investors, many are not sure how to use TFSA or do not have a strategy to make the most out of the Tax Free Savings Account. There is a lot of information available on the government website about the rules and structure of TFSA so I won’t go into details, but I’d like to share some possible ideas and strategies to use with TFSA.
You can invest $5000/year, if you withdraw you do not get back the contribution room the same year however you do get it the next year. You can hold pretty much any type of investment in the account, the same things you in hold in your RRSP you can hold in your TFSA account. Any growth or income earned within the account is tax free the same way the RRSP is not taxed, BUT and it is a BIG but unlike the RRSP when the investments are sold they are not taxed either (hence the name tax free savings account)! On the flip side the contributions are not tax deductible either. It is not a replacement for the RRSP, but a complementary plan.
How to use TFSA:
Well this is the part that confuses many, “how do I make the most out of TFSA?” has become a very common topic in the last couple months. Here are a couple of ways that I plan on using the account.
The best strategy would be to maximize both the RRSP and the TFSA however not everyone can do so, here are some alternative ideas.
Lower income use TFSA:
If you are in the lower tax bracket, or expecting an increase in the near future you might be better off contributing to the TFSA. You maximize your TFSA while growing your RRSP contribution room, ones your in the higher tax bracket you can sale the TFSA and contribute it to your RRSP. The net result would be that you will get a higher tax return than you would have before (remember that the TFSA will not be taxed when sold). You will benefit from tax free growth while waiting for your raise and you will potentially get a larger tax deduction, win-win.
TFSA for lump sum purchase:
Another strategy would be to use the TFSA for lump sum purchases at retirement while RRSP for income purposes. I plan to use TFSA for large purchases at retirement like a cottage, a new car, world tour etc. If you withdraw from your RRSP you are fully taxed as income, so if you need $60,000 and take it out of your RRSP you will need to withdraw about $120,000 because of the taxes you will end up paying. Since TFSA is not taxed all you need to take out is $60,000.
If you like passive income as much as I do than you could use TFSA for income purposes. Right now if you generate any interest or dividends income you are taxed on it, TFSA could reduce your tax bill hence provide you with a better return. Buy some strong paying dividend stocks (although not as many around as 2007) or good corporate bonds (I think they are more attractive right now than stocks) and enjoy tax free income. If you have a long enough time horizon (5 years at least) you can build a very good dividend portfolio yielding about 6-8%. Even corporate bonds are very attractive right now yielding over 8% for investment grade bond.
These are some of my ideas I am sure there are many more strategies you could use, what are your plans with TFSA?