Chess or checkers for your TFSA

When developing an investment strategy for your TFSA, it is prudent to start with the end in mind. This article will focus on an individual whose goal is to provide tax-free income in retirement as part of a total retirement plan.

When Tax-Free Savings Accounts (TFSA) were first introduced, many an article was written that poo-pooed the $5,000 limit. These articles focused on the annual amount that could be tax sheltered and implied that what was the point of saving tax on $5,000. Unfortunately, the authors were (metaphorically) playing checkers and not focusing on the long-term accumulation of money exempt from taxation. The Conservative government raised the limit to $10,000 then the new Liberal government felt Canadians should not have money exempt from their taxing powers so they restricted the annual contribution to $5,500 per year. January 1, 2019, the annual limit will be $6,000 and the cumulative amount an individual can have tax free is $63,500. This is a significant number and if married, a couple can have up to $127,000 of principle invested growing tax-free inside a TFSA.

Now if you are thinking long-term and a few moves ahead, like chess, then there is an interesting strategy you can consider for your TFSA.

The scope of this article is not to compare TFSA’s to an RRSP but rather to focus on the benefits of a TFSA. In fact, many of our clients maximize their registered savings and TFSA’s are in addition to, rather than, instead of registered savings.

The strategies discussed are general in nature and should not be construed as a solicitation of or recommendation for an individual stock or investment fund (got to love the disclosures) Please consult your licensed tax or investment professional (I happen to know one).

The strategy to consider is a dividend paying and reinvestment strategy. Now, when you buy an individual stock or a stock investment fund, as the shareholder, you are entitled to the proportional share of the company profits (the Dividends) and your only risk is the amount of capital invested in the stock or investment fund.

Let’s take a couple, both 50 who have maximized their contributions to their TFSA’s. On Dec. 31, 2018, they will have had the opportunity to put $115,000 into a TFSA (57,500 each)., For this article lets assume this is their starting balance on Jan 1, 2019. They decide to implement a dividend reinvestment strategy in their TFSA’s and will contribute monthly their maximum each year until age 65. They have 15 years to retirement, their investment will grow at 5% and the Dividends will be reinvested (DRIP). The current dividend yield is 3.5% and this will grow at 7% a year (for illustration purposes people and certain to not occur).

No taxes are taken from any portion of this calculation, because, IT’S TAX-FREE.

Now at 65, the capital in the combined TFSA’s has grown to $753,048.31, but the really interesting number is the annual income that can be received TAX-FREE. This income at 65 is $29,183.33 of dividend income. Guess what the income is the next year at age 66?... $33,066.09 or a 13.7% increase.

Why such a large annual increase between 65 and 66 if the dividend yield is currently 3.5%? Two reasons, the first is the yield was 3.5% when you purchased but it has been growing at 7% per year for 15 years. The second is the dividends received are being reinvested and are buying more shares and because they are tax-free dividends you get to buy more stock or investment fund units. This is the power of compounding growth on display!!

The beauty of a TFSA is this income received is TAX-FREE and does not get included for means testing of government benefits.

Want to see something that is counter-intuitive? If we keep all these assumptions the same except for the growth of the company stock and we lower that to 1% growth rather than 5% for 15 years. The annual dividends are $36,734.24 at 65 or 25.8% more than the first calculations. 

I would love to here from you in the comment section as to why the dividend income is higher in the second illustration, even though the stock appreciated at a lower rate.

This is why investors care about the Free Cashflow of a business and growing dividend payouts, Speculators focus on an increasing share price. Neither is right or wrong, they are just different.

If you want to talk STRATEGY and not product as it relates to tax minimization and investing then we should probably have a conversation. It could be the most valuable 15 minutes of your financial life as we tend to save our clients 12-15% in lifetime taxes with chess-like moves described above.

There are four ways to start a conversation with us, connect with me on LinkedIn, call our office, send an email or we would be happy to skype with you!

Live well

Lance Howard CLU, CFP

444 York St.

London Ontario

519-850-6565

[email protected]