New year, new TFSA room & giant step to Findependence

A belated Happy New Year to all readers and a reminder that every adult Canadian can take a big step this week towards their ultimate financial independence. I refer of course to the fact we can all contribute another $5,500 to our Tax Free Savings Accounts (TFSAs), bringing the total cumulative room to $25,500 (going back to the program’s launch in 2009). For the benefit of any American readers, Canada’s TFSA is the equivalent of the U.S. Roth plans, albeit with different rules.

In other words, if you acted at this time each year, you’d have contributed $5,000 in each of 2009, 2010, 2011 and 2012. Now that it’s 2013, the annual limit has been raised to $5,500, the first time the limit has been adjusted to accommodate inflation.

Of course, assuming you invested wisely in each of those years, your balance should by now be well north of $25,500, and in some cases may have grown past $30,000.

TFSAs a particular boon for young people

I truly believe that maximizing the TFSA is the single biggest step Canadians can take in their quest for financial freedom. As we noted in Julie Cazzin’s “Make Your Child a Millionaire” feature in the current issue of MoneySense, the TFSA is especially a boon to young people because they have such a long investment time horizon ahead of them.

Unlike RRSPs, which require earned income the prior year, an 18 year old can qualify for the full TFSA $5,500 limit this year (they may need parental assistance to come up with the money, but that’s permitted by the rules. Think of it as a tax-effective early inheritance!). Not only that, but they can contribute to TFSAs well into old age, unlike RRSPs, which end after age 71. You better believe that half a century of maximizing TFSAs and investing wisely will mean multi-millions down the road.

Do this right from the get-go and you may not even have to worry about RRSP contributions, although those in higher tax brackets should probably do both.

But how to invest wisely? For the young in particular, but also older people seeking income, I think equities are the only way to go in TFSAs, especially with interest rates being so low as they are now.

I’m all for international investing but if you already have lots of RRSP contribution room, I’d use the RRSP for US dividend-paying stocks, since the tax treaty shelters Canadians from the 15% foreign withholding tax.

Despite the “tax-free” moniker, TFSAs won’t stop you from being dinged by that tax on foreign securities. For this reason, I like TFSAs for Canadian dividend-paying stocks. Yes, I realize the dividend tax credit makes Canadian dividends a good choice for non-registered (taxable) accounts, since the tax is roughly half what it is on interest income. However, Canadian dividends also result in the annoying “gross-up” calculation come tax-time, and such phantom dividend income can ultimately hurt you on the OAS clawback. And to me, zero tax is preferable to even a “low” rate of tax, especially if you plan to reinvest those dividends.

Canadian Dividend ETFs are my choice

For all these reasons, my personal choice for TFSAs this year are Canadian dividend-paying ETFs. A year ago, when it was part of the Claymore family, I publicly stated that the iShares S&P/TSX Canadian Dividend Aristocrats Index Fund (CDZ/TSX) was a tempting choice, at least for those who already have plenty of exposure to the big Canadian banks.  To be included in that index a stock has to be a common stock or income trust listed on the TSE and have increased dividends for at least five consecutive years.

This year, there is a valid new alternative from Vanguard Canada: the Vanguard FTSE Canadian High Dividend Yield Index ETF (VDY/TSX). The management fee on VDY is just 0.30%, half the 0.60% of CDZ. (MER is 0.67%, we don’t yet know what VDY’s MER will be). But keep in mind that VDY amounts to a big bet on the major banks: a whopping 59% of the ETF is in Canadian financials and in fact the top four holdings are all the big banks.  CDZ has much less exposure to financials (just 21%) and minimal exposure to the big six banks in particular.

Half and half is one compromise

One way to go might be to split your contribution between both ETFs: say $2,750 in each. Remember, though, this assumes you have plenty of US and foreign stock exposure in your RRSP. Younger people for whom the TFSA comprises the lion’s share of their wealth should strive for plenty of US and foreign stock exposure through similar types of ETFs. We’ll be looking in depth at these in the next issue of MoneySense, currently in production.

About Jonathan Chevreau

Comments

15 Responses to “New year, new TFSA room & giant step to Findependence”
  1. Robb says:

    I agree with using the TFSA for Canadian dividend paying stocks. While I prefer to buy individual stocks, both of those ETFs are good choices.

    I would only use a non-registered account once my RRSP and TFSA contributions have been maxed out. Most Canadians simply don’t have the means to contribute to all three, so the TFSA is probably the way to go.

    • Agree about maxing TFSA and RRSP first. Actually, I probably own all ten of the top ten holdings in VDY in as individual stocks in non-registered account already but it might not be as cost-effective to add to them separately in a $5500 TFSA contribution. That would be $100 in ten commissions on $500 purchases, plus of course there are all the other holdings beyond the top ten. So if you want to quickly diversify your TFSA when it’s still relatively small, these dividend ETFs are a good way to do it. Of course, you can probably get very similar exposure for 0.09% through Vanguard Canada’s MSCI Canada ETF (VCE/TSX). Top ten is very similar, including most of the big banks.

  2. I like your suggestion, split the contribution, but I struggle with owning VDY, since I believe you might just as well own all big-6 or 6 banks outright and pay no fees. Throw in an ENB or TRP for good measure.

    The 0.30% MER is very attractive.

    Like every edition, I look forward the next issue of MoneySense – keep up the great work on it.

    Mark

    • Thanks. Sure, you can go with the big 6 directly but VDY also gives you the big dividend-paying energy stocks like Encana and Cenovus and all the rest. I’ve only seen the top 10 holdings published thus far but have a pretty good idea of what the rest would be: likely not that much different from XIU or iShares’ other dividend ETF that does hold the big banks.

  3. Spot on with this write-up, I actually believe this website needs much
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