Confusion aside, a TFSA is still the best tax shelter in town

Five years after their introduction, there still appears to be rampant confusion about tax free savings accounts. Not just about the cumbersome rules on replacing withdrawn funds, but about the very nature of the TFSA itself.

TFSA withdrawal rule continues to trip up thousands of Canadians

Some 54,700 taxpayers got warning packages from the Canada Revenue Agency earlier this year about the problem affecting the 2013 taxation year, and were told they face a penalty.

Newcomers often end up in default TFSA plans offered by the nearest financial institution, believing they can hold nothing but interest-bearing vehicles like GICs. Since interest rates have been pitifully low over the five-year history of TFSAs, they reason they just aren’t worth it.

Of course, why these products are even on offer is a mystery in itself.

A bank one-year GIC pays about 1%. TFSA skeptics say this earns a mere $55 in annual interest on a $5,500 contribution, so if you’re in a top tax bracket, the tax savings amount to $25. Chicken feed, they scoff.

If moving out of GIC-TFSAs for the first time, you may be comfortable buying the stock of the bank that sold you that TFSA and handles your mortgage. Royal Bank (RY/TSX) pays a 3.64% dividend: triple the paltry 1% of the GIC. Other big banks are in the same ballpark, but for a single initial lump-sum TFSA contribution I’d plump for an exchange-traded fund (ETF) that holds all the Canadian banks and a few insurance and mutual fund companies to boot: the iShares S&P/TSX Capped Financials Index ETF (XFN/TSX) pays a 2.74% dividend and exposes you to less risk than any one bank stock. If you are really concerned the banks are ripping you off on your TFSA, this is the perfect way to fight back.
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Don’t even think of withdrawing this money any time soon. Put it in, forget it and reinvest all dividends into more ETF units. Wait 30 or 40 years and retire happy. (assuming you add another $5,500 every year).

What about sector and country risk? Good point. If you have a big RRSP, you can put U.S. dividend payers there rather than your TFSA. Put Canadian dividend payers in the TFSA because there’s a bit of tax leakage with foreign dividends there. Young people can put 100% of their TFSA in equities. As the years go by, I’d diversify with two or three low-fee ETFs or index funds if you’re making smaller monthly contributions to your TFSA. Consider Vanguard Canada or the new iShares Core ETFs from BlackRock Canada, but BMO and RBC also offer some interesting ETFs. Talk to your advisor about how to spread investments among TFSAs, RRSPs and taxable accounts, but the classic mix would be 20% in each of a Canadian, U.S. and international equity ETF, and 40% in a fixed-income ETF.

For the crowd just moving up from GICs who want a single “simple as can be” solution, try a version of Vanguard founder Jack Bogle’s suggestion in a recent Motley Fool podcast: the Vanguard Balanced Index Fund. That’s for Americans but Canadians could get comparable exposure through the low-fee Tangerine Balanced Fund (formerly known under the ING Streetwise label.
Put your TFSA money there and rest easy.

For the crowd just moving up from GICs who want a single “simple as can be” solution, I’d suggest the Vanguard U.S. Total Market ETF. The version hedged back to the C$ is ticker VUS on the TSX.

Put your TFSA money there and rest easy.