With November being financial literacy month here in Canada, I was asked to post my best financial tip. After hours and hours of combing through the archives of The Loonie Bin, I have decided that learning to maximize your TFSA is probably one of the smartest decision a person could ever make.
We’ve all heard about them yet year after year, Canadians still haven’t figured out how the TFSA actually works. The problem I see is in the name. Calling it a “savings” accounts gives people the impression that it’s to be used like a normal savings account. In fact, I remember the original government website said that a TFSA is perfect for saving for a trip, home renos or for that new car. While it’s important to save for those kinds of expenses, a regular savings account would work just fine for short term financial goals. To truly get the most from your TFSA, you have to think more long term.
Tax Free Income
I opened a TFSA in 2009 and the interest rate the bank promised me was 1.5% on my $5000 contribution. I was paid $75 in interest and did not have to pay any taxes on that amount. $75 is not a whole lot of money, in fact, the 1.5% interest rate didn’t even cover the inflation rate which averages 2-4% every year.
Frustrated, I decided to invest my money in stocks rather then rely on pitiful interest rates from the bank. I opened a self directed TFSA trading account and transferred my $5075 into it. In 2010 I contributed another $5000 and purchased 200 shares of Enbridge stock. That year I was paid $340 in dividends AND the stocks also increased in value by $1142. Sure the stock could have gone down in value, but the dividends still paid me a return of 3.4% regardless of the stock value.
Each year I kept contributing $5000 into my self directed TFSA trading account and invested it in common shares of dividend paying stocks. I would also re-invest the dividends to buy even more dividend paying stocks. The more dividend stocks I purchase, the more dividend income is deposited into my account each year. As of 2012 I have contributed the full allowable amount of $20,000. The total value of my TFSA account is now over $27,000 and it makes me over $1000 a year in dividends. If I would have kept the low interest bank account, the value of my TFSA would be $20,700.
As I mentioned before my yield on cost of my initial investment was 3.4% when I first opened my TFSA trading account. The stocks that I invested in over the last few years have also increased the dividends they pay out. My current yield on cost is 5% thanks to dividend increases. As I add more stocks that keep increasing their dividends, then my yield on cost or return will keep increasing.
What About Risk?
Investing in stocks may seem like a risky venture but it doesn’t have to be. I like to invest in blue chip stocks like Canadian banks. Some have been around longer then Canada has been a country which means they are not going anywhere anytime soon. They also increase user fees all the time so their profits will almost always be up. No matter if the stock price increases or decreases, as long as the dividends keep coming into my account I’ll still be making more money then the low interest bank accounts.
With my current strategy of investing in common share dividend paying stocks, I can withdraw the dividends without paying any taxes at any time. If I ever need some emergency money I can just withdraw the dividends without having to sell any of the stocks. I would rather re-invest the dividends, but it’s nice to have the option for emergencies if it’s needed.
My ultimate goal is to use my TFSA to generate a TAX FREE income that I can use when I retire. The money I withdraw from my TFSA does not count towards any other income I may make nor does it effect the amount of old age security I could receive when I’m 67.