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Noobie at High interest TFSA
March 20, 2009
12:38 pm
truongboi
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Hey all found this site via google and heres my situation:
I recently started saving and acquired $5000 I then approached my bank (TD) and had a talk with a financial person there, I asked him what my best option would be. He told me I should put my 5000 in a high interest TFSA account which I did. But now I'm not sure if I made the right decision?

Heres a little about me: I currently go to school full time (College), and only work like 1day a week.

Thanks

March 20, 2009
10:10 pm
jeremywong
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Because you're a full-time student, you're probably not paying much if any income tax, so your TFSA is of no benefit to you, but it's a potential fee trap. TD Canada Trust allows one free withdraw per month; after that, you pay $5 per withdraw, so it can cost you more in fees than you save in tax. Also, because you've maxed out your contribution limit, you can't deposit again until next year, regardless of how much you withdraw this year. If you're not in a tax bracket, choose a regular (taxable) savings account, because it has no deposit or withdraw restrictions.

Your "financial person" would argue that you should start the habit of saving in your TFSA early. Fine, open a TFSA when you enter the workforce FT. Is that early enough for ya? Don't ask financial reps at banks for advice. Their compensation may partly depend on accounts they open.

March 21, 2009
12:03 pm
Jason
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jeremywong said:

Your "financial person" would argue that you should start the habit of saving in your TFSA early. Fine, open a TFSA when you enter the workforce FT. Is that early enough for ya?


There is still an advantage to using a TFSA if you currently don't pay taxes but will in the future. For example, if you will not pay taxes in 2009 but you will in 2010, we can compare the two options:

1. You save $5,000 outside of a TFSA in 2009 and earn $200 in interest (and pay no tax). In 2010 you contribute $10,000 towards a TFSA and earn tax-free interest on $10,000.

2. You contribute $5,000 to a TFSA in 2009 and earn $250 in interest (again paying no taxes). In 2010 you contribute an additional $5,000 to your TFSA. In 2010 you earn tax-free interst on $10,250 instead of $10,000.

And it doesn't just end there - that $250 will earn compound tax-free interest in subsequent years. This is a key advantage of TFSA's: earnings in one year expand your potential tax-free earnings in future years.

March 21, 2009
6:25 pm
truongboi
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Thanks for the replies everyone.
What would be the best option for me then? I would like to do some more riskier investments (Stocks, mutual funds?) but have no experience in doing any of that. I heard that having a TSFA account when investing is a good idea and I plan on learning this year about everything hopefully. I have about 5000 liquid just in my chequeings right now and would like to put it to use somewhere else since I maxed my TFSA

March 22, 2009
12:37 am
jeremywong
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Jason said:

1. You save $5,000 outside of a TFSA in 2009 and earn $200 in interest (and pay no tax). In 2010 you contribute $10,000 towards a TFSA and earn tax-free interest on $10,000.

2. You contribute $5,000 to a TFSA in 2009 and earn $250 in interest (again paying no taxes). In 2010 you contribute an additional $5,000 to your TFSA. In 2010 you earn tax-free interst on $10,250 instead of $10,000.

And it doesn't just end there - that $250 will earn compound tax-free interest in subsequent years. This is a key advantage of TFSA's: earnings in one year expand your potential tax-free earnings in future years.


If he can earn $250 interest inside TFSA, he can earn the same outside TFSA. So, in your example, he should have $10,250 outside TFSA in 2010 (5000 + 250 + 5000 = 10250), and he would pay no tax on any interest because he's not in a tax bracket. Newsflash: you can earn compound interest outside TFSA. That puts him in the same position as using TFSA.

Actually, because he has no deposit restriction outside TFSA, he can make deposits throughout 2009, and thus deposit more or earlier into a taxable savings account than into a TFSA.

March 22, 2009
1:44 am
jeremywong
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truongboi said:

I would like to do some more riskier investments (Stocks, mutual funds?)...I have about 5000 liquid just in my chequeings right now and would like to put it to use somewhere else since I maxed my TFSA


Leave $2000 in your chequing account, and put the rest into a taxable savings account. You will replenish your chequing account with your taxable savings account as needed. Withdraw from your TFSA (watch out for fees) only if your taxable savings account is drained.

You don't have enough money for real investments, because you need $10,000 of liquidity for comfortable living*. Most investment accounts (like brokerages) require a $5000 minimum balance; that would leave you with only $5000 of liquidity.

*There are families who get by with less, but I wouldn't call their living comfortable.

March 22, 2009
1:55 am
Jason
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jeremywong said:

If he can earn $250 interest inside TFSA, he can earn the same outside TFSA. So, in your example, he should have $10,250 outside TFSA in 2010 (5000 + 250 + 5000 = 10250), and he would pay no tax on any interest because he's not in a tax bracket. Newsflash: you can earn compound interest outside TFSA. That puts him in the same position as using TFSA.

News flash:

There is indeed a difference between the two options. Taking my example, suppose that in 2009 you pay no income tax and in 2010 you have a marginal tax rate of 50%, and each year you earn 5% interest. In both cases you pay no tax in 2009. The difference occurs in 2010 and onwards. In both cases, you earn $10,250*5% = $512.50 interest in 2010. In the first case (no TFSA in 2009) you will pay $250*5%*50% = $6.25 in income tax on the interest earned outside of a TFSA in 2010 (because the $250 interest earned in 2009 is not part of your TFSA in 2010). In the latter case, you will pay no income tax.

This may not sound like a large amount of money, but keep in mind that the benefits of a TFSA are not very apparent in the first year. Interest of $250 at a marginal tax rate of 50% means only $125 in tax savings in the first year.

The benefits of compounding take effect after many years. Say for example that the $250 interest is invested outside of a TFSA for 40 years. At a marginal tax rate of 50%, the effective after-tax interest rate is 2.5%. In this case, this amount earned is $250*1.025^40 - $250 = $421 after 40 years. In the case where this interest is earned inside a TFSA in the first year (and kept inside the TFSA in future years), the effective after-tax interest rate is 5%. In this case, the amount earned would be $250*1.05^40 - $250 = $1,510.

The difference between the two investment options becomes even larger if you delay investing in a TFSA for more than just one year, even if you pay no taxes in those years. Again, this is because interest earned in one year increases the initial principal amount for each of the following years.

Note that I am not claiming that everyone should unconditionally invest in a TFSA no matter what their situation and financial goals are. My claim is that TFSA's have a benefit even in years where no income tax is paid.

March 22, 2009
3:33 am
jeremywong
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Jason said:

The difference between the two investment options becomes even larger if you delay investing in a TFSA for more than just one year, even if you pay no taxes in those years. Again, this is because interest earned in one year increases the initial principal amount for each of the following years.

I know what you're saying, but you're not saying it right. After the first two years, his TFSA balance (and limit) will be more than $10,000 (10K + interest) -- his limit is increased by the interest. Whereas if he opens his TFSA after two years, it cannot exceed $10K (his natural contribution limit). So he's starting life with a boosted TFSA balance (and limit), which lets him save more tax in future years. At 2%, the interest earned in those two years is $302, so his TFSA has a boost in limit of $302.

Jason said:

The benefits of compounding take effect after many years. Say for example that the $250 interest is invested outside of a TFSA for 40 years. At a marginal tax rate of 50%, the effective after-tax interest rate is 2.5%. In this case, this amount earned is $250*1.025^40 - $250 = $421 after 40 years. In the case where this interest is earned inside a TFSA in the first year (and kept inside the TFSA in future years), the effective after-tax interest rate is 5%. In this case, the amount earned would be $250*1.05^40 - $250 = $1,510.

There's no 50% marginal tax rate. Even the highest marginal tax rate is in the 40s. A more realistic marginal tax rate is 30%. If he continues to earn 2% interest with a 30% marginal tax rate for 40 years, the advantage is merely $140.

$302 x (1+.02)^40 - 302 = 365
$302 x (1+.014)^40 - 302 = 225
$365 - $225 = $140

At 4% interest, the advantage is $538. At 5% interest, the advantage is $930. In any case, he has to wait 40 years to reap it.

March 22, 2009
10:57 am
Jason
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jeremywong said:

I know what you're saying, but you're not saying it right.

Read this thread from top to bottom, and hopefully you'll realize who is and isn't "saying it right."

There's no 50% marginal tax rate. Even the highest marginal tax rate is in the 40s. A more realistic marginal tax rate is 30%.

For 2008, the highest marginal tax rate in both Quebec and Nova Scotia is 48.2%. I do apologize, I guess I was way off.

Actually, I was merely trying to illustrate my point with a simple example. The advantage of using a TFSA in years when you pay no income tax remains no matter what interest rate, number of years and marginal tax rate you consider.

I suggest you get rid of the obnoxious attitude, especially when you have no idea what you're talking about.

March 22, 2009
10:29 pm
Peter
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Let's stop the personal attacks. There's some good and helpful information in this thread, and it's good that we're helping truongboi and other visitors.

March 23, 2009
9:03 am
truongboi
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So if one had about 10000 free and only works part time once a week still in school and not much expenses what would the best option be at this point?

March 23, 2009
10:33 am
Jason
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truongboi said:

So if one had about 10000 free and only works part time once a week still in school and not much expenses what would the best option be at this point?

I don't think there's anything wrong with your current TFSA strategy. TD doesn't offer the most generous rates, but this strategy is fine.

But you did mention an interest an interest in stocks or mutual funds. If you go that route, I would recommend a TD e-series mutual fund. They offer low MER's (management expense ratio - the cost of managing the fund). The MER's for these funds are a fraction of a percent compared to 1.5-2.5% in most other mutual funds. The goal of these funds is to track an index (for example, the TSX composite). This is in contrast to most other mutual finds, which try (very often unsuccessfully) to beat an index. It probably wouldn't be too much of a hassle to set this up since you're already a TD customer.

Note that if you hold the equity-based funds in a TFSA, there may be less of a tax advantage. This is become the earnings would be mostly capital gains and dividends, which are taxed at a lower rate than interest income (for example from savings accounts or bonds). This may not be an issue for you yet though, as you only work one day a week and likely claim the tuition amount in your taxes.

The best strategy to choose will probably also depend on other factors such as your financial goals (are you saving for a home in the near future? retirement in the long term?). It may also depend on when you plan to start working full-time.

April 11, 2009
10:48 pm
JB
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For Jason Guest:
Note that if you hold the equity-based funds in a TFSA, there may be less of a tax advantage. This is become the earnings would be mostly capital gains and dividends, which are taxed at a lower rate than interest income ??? What are you talking about???
It doesn't matter what kind of tax your paying outside a TFSA dividend/capital gains or whatever. What you earn inside a TFSA is totally tax free and should be taken advantage of by everyone who is trying to S-A-V-E. This is even better than an RRSP. This is the best tax shelter ever and should be used to the fullest benefit. The idea is to invest it in the highest rate of interest equal to the investors comfort zone.

April 12, 2009
2:53 pm
Jason
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JB said:

For Jason Guest:
What are you talking about???
It doesn't matter what kind of tax your paying outside a TFSA dividend/capital gains or whatever. What you earn inside a TFSA is totally tax free and should be taken advantage of by everyone who is trying to S-A-V-E. This is even better than an RRSP. This is the best tax shelter ever and should be used to the fullest benefit. The idea is to invest it in the highest rate of interest equal to the investors comfort zone.


What I am talking about is the optimal allocation of different kinds of investments in different accounts. Capital gains and dividends are taxed at a lower rate than interest income. Many people own a combination of stocks and cash/bonds/income trusts. So the idea is to ask yourself what kind of allocation of these assets among different accounts will result in the greatest after-tax benefit.


A TFSA is not necessarily better than a RRSP. If you end up not paying any taxes (or very little taxes) after you retire, the RRSP would be the superior choice. In this case, all your gains would be tax-free and on top of that, you'd receive a tax deduction when you contribute. With a TFSA, you would enjoy the tax-free gains, but there would be no deduction.


However, I agree with you that the TFSA is a great investment tool and I think it is superior to a RRSP in most cases. But of course, there's nothing stopping you from using both a TFSA and a RRSP.

Please write your comments in the forum.