We advise you to use some contributions to a TFSA (Tax-Free Savings Account) to build an emergency fund. Then use the remaining TFSA money to invest in potentially very lucrative stocks. You’ll face no capital gains taxes on any of your share price gains.
We advise you to invest through a TFSA (Tax-Free Savings Account) when you expect one of your investments to become a ‘home run’. That’s because you can take some or all of the share price gains based on the stock’s outlook without worrying about capital gains taxes.
In 1999, one of our subscribers called us to tell us about all the money that he was making on his ‘new economy’ dot-com stocks. We advised him to sell some of his shares. That is, to ‘take some money off the table’. That way, if his stocks kept on rising, he could continue to profit. But if the stocks declined sharply, he would lose less and at least still have his initial investment.
Tax concerns should take a back seat
Our subscriber said: “I can’t do that. If I sell, I’ll get a big tax bill.” We suspect that he held the stocks until the ‘tech wreck’ wiped out his profits and possibly made some of the stock worthless. As we’ve always said, tax concerns should take a back seat when it comes to investment decisions.
Back in 1999, or course, there were no TFSAs. They only came into effect in 2009. If you were at least 18 in 2009 and you’ve never contributed, then you can put up to $63,500 into a TFSA.
Here’s what to do with your TFSA
We believe that you should initially keep some of this money as an ‘emergency fund’. The exact amount to keep will depend upon your situation. For instance, if you and your spouse have secure well-paying careers, then you need not keep as much as those with precarious jobs in what’s known as the ‘gig economy’.
After you’ve built an emergency fund, use the remaining TFSA money to invest. When you spot a company that has great potential, buy it in your TFSA. That way, you can buy or sell based on its merits and your situation without worrying about the tax consequences. TFSAs are suitable when you’re ‘swinging for the fences’.
RRSPs (Registered Retirement Savings Plans) have existed for decades. Self-directed RRSPs, too, let you buy and sell with no tax consequences. Since this is retirement money, however, you should mostly buy high-quality, dividend-paying stocks. You wouldn’t want to enter retirement just as the next stock market setback strikes. At least high-quality dividend-paying stocks almost always recover.
Choosing between TFSAs and RRSPs
Many Canadians lack the cash to maximize both their TFSAs and RRSPs. Which one should you emphasize? That depends mostly upon your current income taxes and your expected taxes in retirement.
If you earn little and pay low taxes, then you should contribute to a TFSA. That’s because withdrawals do not count as income for tax purposes. As a result, even if you withdraw cash from a TFSA, you can avoid a clawback of your OAS (Old Age Security) payments and the GIS (Guaranteed Income Supplement). The tax break from RRSPs would be worth little if you earn little and pay little.
Contribute RRSP tax breaks to your TFSA
If you earn substantial income and pay high income taxes, then contribute to an RRSP. This will give you a meaningful income tax break and will likely give you a larger tax refund. You can then invest this refund into a TFSA.
A 92-year-old friend says: “RRSPs and RRIFs (Registered Retirement Income Funds) are terrible things.” She complains that compulsory withdrawals from her RRIF give her more money than she needs. Worse, the tax department withholds a lot of each withdrawal. But our friend seems to have forgotten about the tax breaks she received when she worked as a real estate agent. What matters is whether our friend’s taxes are higher than they were when she worked outside of her home.
TFSAs are best for low-income and lightly-taxed Canadians. The trouble is, these people often face immediate needs such as child care costs, food costs, utilities, rent payments and so on. If accessibility to this account makes it hard to resist, then there may not be much money left in TFSAs in retirement.
This is an edited version of an article that was originally published for subscribers in the October 18, 2019, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
The Investment Reporter, MPL Communications Inc.
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