The article “5 reasons why TFSAs aren’t always the best fit for everyone” was originally published in Financial Post June 10, 2024, by Jason Heath
Jason Heath: They could end up costing you if you have debt or RRSP contribution room
Tax-free savings accounts (TFSAs) are a great choice for the right people at the right time in their lives. For others, they may not be the best fit. I am a certified financial planner with a TFSA, so I am in favour of them — sometimes. So, what is the right time for a TFSA? And how do you know when to cash it out?
Do you have debt?
If the answer is yes and you have a TFSA, you need to consider the type of debt you have and the type of TFSA investments you own. If you have high interest rate debt, such as a credit card or an unsecured line of credit, you might want to cash in your TFSA to pay down your debt. Your interest rate is probably double digits and you could be paying 20 per cent or more for credit card debt.
You would need to expect a higher return for your TFSA than the interest rate on your debt to be better off in the long run. The S&P 500 has had a total return of 30 per cent over the past year and 15 per cent annualized over the past 10 years. These returns are way beyond the expected returns for Canadian domestic and foreign developed market equities that are in the 6.5 to seven per cent range based on FP Canada’s guidelines, which are influenced by pension plan estimates. On that basis, a high-rate borrower with a TFSA might consider themselves lucky and reconsider their TFSA strategy.
If you have a secured line of credit, your interest rate is probably in the 7.45 to 7.95 per cent range right now. Despite the strong short- and medium-term historical returns for the S&P 500, most investors have a mix of stocks and bonds — meaning lower expected returns — and pay one to two per cent fees to own their investments. So, an expected seven to eight per cent future return may be tough for some people to achieve.
If you have a mortgage renewing in the next year or two, you probably took out a five-year mortgage in the post-pandemic period when interest rates dropped like a stone. If your mortgage is a fixed rate, you might be paying two per cent or less. Although interest rates are expected to decline over the next year or two, your rate will probably still be much higher at your next renewal.
You could keep your TFSA invested and wait for the renewal, or you could make lump sum payments now. Most mortgages allow you to pay off at least 10 per cent of the original principal each year without penalty, sometimes more. You may also be able to double your payments, depending on your mortgage terms. If you do make extra payments, each subsequent payment will pay down more principal due to less interest owing, meaning you’ll have a lower mortgage balance subject to your higher renewal rate.
In summary, if you have debt, a high tolerance for investment risk, have low investment fees, a long investment horizon and a mortgage with a relatively low interest rate, you’re a good candidate for keeping your TFSA.
Do you have RRSP room?
While TFSAs are great, they have stolen a little too much thunder from registered retirement savings plans (RRSPs). I have also noticed a rise in negative sentiment around the deferred tax that comes with having an RRSP in retirement. That tax deferral is one of the things that makes RRSPs great, and, for the right saver, better than TFSAs.
As your income increases, your next dollar may be subject to a higher marginal tax rate. For example, an employee or retiree in Ontario typically pays 20 per cent tax on their income below $51,000. For income over $112,000, that marginal tax rate can rise to 43 per cent. There are many tax brackets in between, and though tax rates vary from province to province, the concept is similar.
So, if your income is relatively high and your projected retirement income is lower, you can come out ahead by using an RRSP. You can shift highly taxed income to retirement by contributing to an RRSP, claiming a tax deduction today, letting the savings grow, and withdrawing at a lower rate in the future.
You do not need a six-figure income to justify an RRSP, but the higher your current income and the lower your future income, the better the strategy.
If you have TFSA savings and RRSP room, consider moving money from your TFSA into your RRSP and investing the savings for retirement.
Do you have an employer matching plan at work?
If you have a savings plan at work, you should always do your best to maximize the matching employer contributions. This includes defined contribution (DC) pension plans, group RRSPs, and other registered or non-registered savings plans.
If you have room in your TFSA and are not maxing out these plans, you should at least consider increasing your payroll deductions to contribute and tapping your TFSA to top up your cash flow if needed.
Are you a renter?
If you think you might buy a home in the next 15 years, the new first home savings account (FHSA) is a way to supercharge your TFSA.
You can open a FHSA if neither you nor your spouse or partner has owned a home in the past five years. FHSA contributions are tax deductible, and withdrawals are tax free when used for the purchase of an eligible home.
So, if you can take money out of your TFSA, get a tax deduction to put it into your FHSA, and still have the money grow tax free with tax free withdrawals in the future, you’ll save by simply moving your money around.
Do you have children?
If you have children who are minors and will be attending post-secondary school, whether university, college, or trade school, a registered education savings plan (RESP) can provide the same tax-free growth as a TFSA, but with 20 per cent matching contributions from the federal government on your contributions.
Some of your future RESP withdrawals are taxable. The growth beyond your original principal as well as the government grants are reported as income by your child when they withdraw money to pay for tuition. But if their income is relatively low, they will not pay tax on the RESP, making it effectively tax free.
Summary
TFSAs can be great tools to save tax, which is always appealing. But if there are better ways to reduce taxes, maximize government grants and employer matching contributions, or save more interest than the return your investments may generate, you should reconsider your TFSA strategy.
The government gives us these tools to use to our advantage. It is important to use them in the right circumstances based on your personal situation.
Jason Heath is a fee-only, advice-only certified financial planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products. He can be reached at jheath@objectivecfp.com.
