Investment strategy for TFSAs

[Dingo]

I believe the markets are very low at the current time espically more so by 2009 Jan 1st when TFSA is open. Has this effected anyones look at how they will currently use the TFSA?

I was thinking today of picking up some battered stocks here and see what happens over the next 5 to 10 years. Anyone else think of this?

[like_to_retire]

Wouldn't a better use be sheltering interest income that is highly taxed?

ltr

[banker]

Wouldn't a better use be sheltering interest income that is highly taxed?

ltr

I think so. I wont be using ALL of my RSP room and all of my TFSA account each year and really couldnt decide what the most efficient use would be.

I decided the TFSA will be used for cash/emergency savings/general savings as well as any fixed income (bond fund). The RSP will be 100% equity.

I know some people say the equity should actually be in the TFSA and FI in the RSP but heres my thinking.

What goes in the RSP is truly meant to stay there until retirement day, so I dont really care about it going up, down, sideways, zigzaging, I just add and forget. Whereas savings are likely to be built up quite a few times and then utilized again and again.

[Norbert Schlenker]

Please, Mr. Moderator, do not amalgamate this with http://www.financialwebring.org/forum/v ... p?t=108377

I think this may have been discussed when TSFAs were first announced but I'll be darned if I can find the thread now. It's been touched on very briefly (by BRIAN5000) in the above linked thread but I think this needs some careful thought.

What is the proper investment strategy for a TSFA?

The default attitude appears to be, "Well, it's just another account in which no income or gains are taxable, so I may as well just park a bunch of my fully taxed pre-existing investments over there and avoid the tax." The result is that the median TFSA ends up invested in a savings account or perhaps a GIC, making a few (otherwise fully taxable) percent per year. Except ...

There's a feature of the TFSA that I think isn't being taken into account here, namely that any growth in the account is a de facto permanent increase in cumulative contribution room (assuming no adverse tax law changes). It's a free option to escape taxability in perpetuity on a larger sum.

So is the low risk low return path actually optimal investment strategy? Might it better to take a long shot, i.e. take a low percentage bet that will turn $5k into $50k (or $500k) because the payoff is larger than it first seems, i.e. ~15x instead of ~10x?

[couponstrip]

This is exacly what we plan to do, but I have been shy to post about it since it is not the consensus around here. I have some casino stocks in mind that have a better than average chance of going to zero, but if they hit, could hit big. The risk is we lose the 10K plus lose the contribution room. The upside is large, and would help the TFSA to contibute in a more significant way to our financial plan. If we're really lucky, maybe we will be able to eliminate the need for preferreds in the late stages of our careers and retirement....until of course the gov't caps it . Our plan is two different casino stocks for two years (four spins at the roulette table in total). After that, slowly build fixed income investments in the TFSA in the traditional fashion.

[brucecohen]

I recently wrote about this for a client. ISTM the first question should be:

What is the TFSA's role in your planning?

If it's a short-term role as a savings bucket for a big ticket purchase, the low-yield savings vehicle is your best bet.

Is it the home for your emergency fund? Some may want $5,000 or so secure and liquid. Especially the self-employed. So the optimal approach might well be to have two or more TFSAs, one with liquid/secure money and other with more high return stuff.

Is the role long-term, probably as a supplement to your RRSP? Then it certainly makes sense to fill it with equities that will hopefully outperform over time.

[BRIAN5000]

Is it a short term thing or long term ? Can you use some short term gamble which may allow more FI to be hidden in the TFSA in a year or two.

How about Teck or Sherrit ? May be a few years but from about $5 to $20 would be ok, or even $5 to $10.

Hmmm I need to post faster sorry.

[Shakespeare]

For this year, my TFSA will hold a $5K emergency fund. Next year I will probably open a new TFSA at RBCDI and put a [s]gamble[/s] stock pick in it.

[like_to_retire]

I still don't see the TFSA for anything but fixed income.

What would make me any more successful in picking a flyer (if the equities were in a TFSA), than I am now?

The result for myself would be that the equities I chose to put in the TFSA would be flat, and then I would be stuck paying the full taxes on the income that the fixed income enjoyed outside the TFSA.

Situation 1: Fixed income inside TFSA, Equities outside TFSA.
The fixed incomes usual 100% taxability is now 0%, and the taxes on the equities are 0% now and deferred until I sell at a 50% taxability.

Situation 2: Equities inside TFSA, Fixed income outside TFSA.
The fixed income is taxable at a 100% rate, and the taxes on the equities are 0%.

It's a low risk, sure thing, that I will have income each and every year on the fixed income. Now I don't have to pay tax on it.
If by some miracle I actual made some gains on equities (because I never do) they're only taxed when I sell at a 50% taxable rate if I leave them outside the TFSA.

I'd have to be a dunce to put equities in a TFSA...

ltr

[deaddog]

I still don't see the TFSA for anything but fixed income.

It's a low risk, sure thing, that I will have income each and every year on the fixed income. Now I don't have to pay tax on it.
If by some miracle I actual made some gains on equities (because I never do) they're only taxed when I sell at a 50% taxable rate if I leave them outside the TFSA.

I'd have to be a dunce to put equities in a TFSA...

ltr

See the TFSA as an excellent trading vehicle. All the arguments about trading short term trading being inefficient because of tax consequences go out the window.

If you are going to trade short term and hopefully have a better return than fixed income why not in a TFSA.

[Chuck]

I think this may have been discussed when TSFAs were first announced but I'll be darned if I can find the thread now.

This one I think: http://www.financialwebring.org/forum/viewtopic.php?t=107095

[kiwidog]

I think Brucecohen has it right.

It would work differently for different people.

A few examples which come to mind ( just a few)

1 Young person saving for a house within say 5 years fixed income, don't lose the capital. Can always use it for more aggressive investing later in life, because the room is cumulative.

2 Young person given a gift that they want to keep for a long time. Granddad gives $5000 to grand daughter. Invest in say a bank stock and keep it for ever. Could also mix other money in the account like (1) above for house purchase example.

3 Middle aged well capitalized person. Buy the flyer or the beaten up great company that has got potential to double triple or more. Plenty of choice in that area without buying moose pasture.

4 Older couple well established with enough wealth and income to see them through to age 90 or more.(Two TFSA's ) Set aside investments producing income or cap gains they don't need or plan to use. The procceds of the TFSA go to their beneficairies.

5 RSP withdarwals in years that you have low enough income not to pay much tax, and you don't need the cash. Roll cash into TFSA and invest to suit when you need the funds back. If it's never, buy shares in good quality companies or the odd ETF.again lots of choice.

6 Trading vehicle for someone without a RIF that the doesn't need the money to support their lifestyle expenses. RIF is good trading if you can afford it. i.e.The government shares in more of you lose if you are in a high enough tax bracket

I have opened maybe 100 TFSA's. So far I haven't put any in 3 to 5 year GIC/Bond, some still cash watching for good stock and entry point, must be soon, I would think.
Haven't opened one for myself yet as the room is cumulative, and I have little taxable investment income, because I use it all to pay interest on borrowed capital for investment purposes. This by choice, I have done it for 20 years plus. I may stop soon as retirement is not that far a way.
The RSP is still the best place for me to put my first saved dollars beacuse of the deduction.

Different stroke for different folks, plus I think some people will have no idea of the impact (TFSA) on their personal situation until a few years from now.

Thanks jb

[BRIAN5000]

How about one of these? Maybe two, some have some income and maybe a possible chance to double?

[ghariton]

So is the low risk low return path actually optimal investment strategy? Might it better to take a long shot

I think that makes sense if you were going to take the long shot anyway, or if you were close to taking the long shot, and this is just enough to tip you into doing it. Then, if you get the $500k, switch to a fixed income instrument. You will be able to shelter a significant amount of interest.

By contrast, putting $5,000 in bonds at this time might get you $90 annually in avoided taxes. Big deal. Note also that this lost gax shelter is what you sacrifice if your gamble doesn't work out. (You would have lost the principal inside or outside the TFSA.)

But any long shot, inside or outside a TFSA, comes with a lot of risk. If you are comfortable with that risk, go for it inside the TFSA. If not, don't let the tax tail wag this particular dog.

George

[adrian2]

One strategy to use in a TFSA in order to avoid the loss of foreign tax credit / Canadian dividend tax credit is to intentionally skip the dividends: sell on the last day cum-dividend and buy back on the ex-dividend date. Of course, any commissions and trading costs have to be factored in, but for people using no-load mutual funds it's especially worth considering.

[Assetologist]

Might it better to take a long shot, i.e. take a low percentage bet that will turn $5k into $50k (or $500k) because the payoff is larger than it first seems, i.e. ~15x instead of ~10x?

This is exactly the plan for my Tax Free Savings Plan - use it as a field within which to try and hit a few 'Home Runs'. The downstream benefits are huge if this occurs and the account holds several hundred grand. The ability to withdraw large sums without compromising the tax efficiency of other income is of great value during retirement.

This may only be prudent if personal debt is controlled, a real emergency fund/plan is already in place, registered accounts are maximized and one's intestines are full of fortitude.

[Shakespeare]

The downstream benefits are huge if this occurs and the account holds several hundred grand

Many of us think the TSFA will eventually be limited or capped in some way. I expect contributions to be capped eventually, but if too many home runs are hit, I would not be surprised if assets are capped.

IOW, don't count on it.

[bender]

So is the low risk low return path actually optimal investment strategy? Might it better to take a long shot

I hadn't considered a long shot, but I was leaning towards moderate risk by holding emerging markets in the TFSA for 5-10 years. I'm not a stock picker, so if someone has a better idea...

[queerasmoi]

Heck, let's just persuade the government to let us hold lottery tickets outright in the TFSA

[Icarus]

There's a feature of the TFSA that I think isn't being taken into account here, namely that any growth in the account is a de facto permanent increase in cumulative contribution room (assuming no adverse tax law changes). It's a free option to escape taxability in perpetuity on a larger sum.

So is the low risk low return path actually optimal investment strategy? Might it better to take a long shot, i.e. take a low percentage bet that will turn $5k into $50k (or $500k) because the payoff is larger than it first seems, i.e. ~15x instead of ~10x?

Why does the same reasoning not apply to an RRSP? Consider two investments: a GIC returns 3% per annum and is taxed at 50% and a stock returns 50% per annum and is taxed at 25%. Start with $1000.

If you put the GIC into the RRSP then after one year, you'll have 1030 in the RRSP and 1125 in the open account for a total of 2155. If you put the equity in the RRSP you'll have 1500 in the RRSP and 1015 in the open account for a total of 2515. So you end up ahead with the stock in the RRSP even though the capital gain is taxed more favourably. You've also "expanded" your RRSP room and can do a swap for a bond or cash if you like, similar to the strategy contemplated with the TFSA; ie. you've creatd the same de facto permanent increase in contribution room in your RRSP*.

Now I know what you're going to say: you have to pay tax on the RRSP withdrawal, which is true. But you had to pay tax on the TFSA contribution, so to make an apples-to-apples comparison you have to compare the after-tax contribution in a TFSA. (eg. if you're in a 40% tax bracket, a $1000 RRSP contribution is the same as a $600 TFSA contribution.) As long as your tax rate on contribution equals your tax rate on withdrawal, the RRSP and TFSA will come out the same. If your tax rate on withdrawal is lower, the RRSP becomes even more favourable.

If one asset realizes an adequately high return compared to another asset, you can always find a pair of tax rates where the more highly taxed asset will neverthless be more favourably held in (any) tax-sheltered account.

Norbert, I know that you know this, so I feel like I may be missing something. So why do you suggest this for a TFSA but not an RRSP?


*I had a similar issue arise in reverse. I changed my asset allocation to hold more fixed income, but unfortunately did so after the market started to go down (but fortunately before the big crash). I created a permanent loss in RRSP contribution room. This is the flipside risk to the swinging for the fences approach: you can lose contribution room in you tax-sheltered accout, too.

[mpav]

I've kept it simple by using ING to hold short term cash/GIC's. I keep some cash on hand for those rainy days, and like the idea of holding it there and getting the interest sheltered.

Until I get it up to 25-50M, then I may start to moving it around, but I always kept a good chunk of cash.....and now I got a really good spot to put it.

[Gus]

By contrast, putting $5,000 in bonds at this time might get you $90 annually in avoided taxes. Big deal. Note also that this lost gax shelter is what you sacrifice if your gamble doesn't work out. (You would have lost the principal inside or outside the TFSA.)

Not only do you lose the future value of the TFSA tax shelter but you also lose the value of being able to claim a capital loss, should the bet not pay off. I would think that on an expected value basis (ie, factoring in the values of untaxed capital gains and and non-deductible losses corrected for the probabilities of their outcomes) would produce little advantage for the TFSA risky-equity investment. Unless, of course, the risk is disproportionally small relative to the reward.

[Norbert Schlenker]

Now I know what you're going to say: you have to pay tax on the RRSP withdrawal, which is true. But you had to pay tax on the TFSA contribution, so to make an apples-to-apples comparison you have to compare the after-tax contribution in a TFSA. (eg. if you're in a 40% tax bracket, a $1000 RRSP contribution is the same as a $600 TFSA contribution.) As long as your tax rate on contribution equals your tax rate on withdrawal, the RRSP and TFSA will come out the same. If your tax rate on withdrawal is lower, the RRSP becomes even more favourable.

If one asset realizes an adequately high return compared to another asset, you can always find a pair of tax rates where the more highly taxed asset will neverthless be more favourably held in (any) tax-sheltered account.

Norbert, I know that you know this, so I feel like I may be missing something. So why do you suggest this for a TFSA but not an RRSP?

A difference remains. Let me try to make this as much apples to apples as I can. Suppose my tax rate is now and will forever remain 40%. Suppose I have $3k of spare cash and contribution room for either a TFSA or an RRSP. Suppose I have the same investment opportunity and, if it works, it returns 10x my investment.

My choice is to put $3k into a TFSA or $5k into an RRSP. (I can put more into the RRSP because of the tax deduction.) The investment works out. Now I have either $30k in a TFSA or $50k in an RRSP. You're right that any withdrawal from either account will net just $30k. Everything looks even so far.

But there is a difference if I withdraw and put $30k in my pocket. If I pull from the RRSP, I cannot put the money back in. I don't get new contribution room so I lose the possibility of future tax shelter. If I pull from the TFSA, I get a contribution room reload for the whole $30k, i.e. I have an option with the TFSA that I do not have with the RRSP (assuming the law remains as is).

That's a free option and it's worth real money.

Not only do you lose the future value of the TFSA tax shelter but you also lose the value of being able to claim a capital loss, should the bet not pay off. I would think that on an expected value basis (ie, factoring in the values of untaxed capital gains and and non-deductible losses corrected for the probabilities of their outcomes) would produce little advantage for the TFSA risky-equity investment. Unless, of course, the risk is disproportionally small relative to the reward.

Assuming a fair game, e.g. a 1/10 chance of a ten-bagger coupled with a 9/10 chance of a dead loss, and roughing this out back of the envelope, I fear you're right. The killer doesn't seem to be the inability to claim a capital loss but the permanent loss of the tax shelter.

More thinking appears to be required. Helpful hints gratefully received.

[izzy]

Now I know what you're going to say: you have to pay tax on the RRSP withdrawal, which is true. But you had to pay tax on the TFSA contribution, so to make an apples-to-apples comparison you have to compare the after-tax contribution in a TFSA. (eg. if you're in a 40% tax bracket, a $1000 RRSP contribution is the same as a $600 TFSA contribution.) As long as your tax rate on contribution equals your tax rate on withdrawal, the RRSP and TFSA will come out the same. If your tax rate on withdrawal is lower, the RRSP becomes even more favourable.

If one asset realizes an adequately high return compared to another asset, you can always find a pair of tax rates where the more highly taxed asset will neverthless be more favourably held in (any) tax-sheltered account.

Norbert, I know that you know this, so I feel like I may be missing something. So why do you suggest this for a TFSA but not an RRSP?

A difference remains. Let me try to make this as much apples to apples as I can. Suppose my tax rate is now and will forever remain 40%. Suppose I have $3k of spare cash and contribution room for either a TFSA or an RRSP. Suppose I have the same investment opportunity and, if it works, it returns 10x my investment.

My choice is to put $3k into a TFSA or $5k into an RRSP. (I can put more into the RRSP because of the tax deduction.) The investment works out. Now I have either $30k in a TFSA or $50k in an RRSP. You're right that any withdrawal from either account will net just $30k. Everything looks even so far.

But there is a difference if I withdraw and put $30k in my pocket. If I pull from the RRSP, I cannot put the money back in. I don't get new contribution room so I lose the possibility of future tax shelter. If I pull from the TFSA, I get a contribution room reload for the whole $30k, i.e. I have an option with the TFSA that I do not have with the RRSP (assuming the law remains as is).

That's a free option and it's worth real money.

Not only do you lose the future value of the TFSA tax shelter but you also lose the value of being able to claim a capital loss, should the bet not pay off. I would think that on an expected value basis (ie, factoring in the values of untaxed capital gains and and non-deductible losses corrected for the probabilities of their outcomes) would produce little advantage for the TFSA risky-equity investment. Unless, of course, the risk is disproportionally small relative to the reward.

Assuming a fair game, e.g. a 1/10 chance of a ten-bagger coupled with a 9/10 chance of a dead loss, and roughing this out back of the envelope, I fear you're right. The killer doesn't seem to be the inability to claim a capital loss but the permanent loss of the tax shelter.

More thinking appears to be required. Helpful hints gratefully received.

Pardon me for butting in but for the vast majority of people it is never true with an RRSP that the tax rate at the time of contribution is the same as that at the time of cashing in.
The tax saving at contribution is at your marginal rate-
assuming you don't cash in until retirement however the tax you will then pay is your average rate at that time,if graduated rates still apply this will be far lower as only your top dollar is subject to your marginal rate.

[Taggart]

My wife and I will be keeping our TFSA's in high yield bank accounts, for emergency money only. A few years down the road we may expand on that.

Here's what Rob Carrick of the G&M had to say:

Make the most of TFSA's sheltering power

Friday, January 16, 2009