Young people today have it tough. From huge student loans to double-digit unemployment rates, parents have to wonder if their children’s generation will ever catch a financial break. Luckily, they have: the Tax-Free Savings Account (TFSA) introduced four years ago by the federal government for people who want to build wealth. TFSAs let you save and invest your money without paying any tax on the growth—that is, no tax on Canadian dividends, capital gains or interest earned in the plan. Not now, and not when you withdraw the money.
Since 2009, all Canadians aged 18 or older can contribute up to $5,000 a year to a TFSA. That’s good news for savers. But what young adults and their parents may not have considered is the golden opportunity TFSAs present for young people who want to become millionaires. How? By helping young adults start a TFSA as early as possible and having the whole family adopt a focused saving and investment strategy from the day the account is opened. “The basic rules for TFSAs are the same but the strategies you can adopt for investing in them is what’s overlooked,” says Gordon Pape, author of the forthcoming Tax-Free Savings Accounts: How TFSAs Can Make You Rich. “Using the right strategy makes all the difference in the world to building wealth in your TFSA.”
How can you make TFSAs work wonders for your children? Simple—by making sure they open a TFSA early, and by helping them choose the right investments. “The real benefit of putting money into a TFSA at a young age is the power of compounding,” says Marc Lamontagne, a fee-only adviser with Ryan Lamontagne in Ottawa. “It’s exponential. If you have 25 years or more, your returns will be substantial.”
Even if your kids have little earned income at age 18, it makes sense to gift money to adult kids or grandchildren so they can contribute the maximum $5,000 a year to their TFSAs. Left on their own, a child’s contribution room may pile up unused year after year if they have little money of their own. By making TFSAs a family wealth-building tool with contributions made earlier rather than later, the power of compounding is extended over longer time horizons. This can add up to millions of dollars for the child in the long term.
“The key is for kids to understand the payoff at the end of the savings,” says Diane Dekanic, a Certified Financial Planner with Financial Health Management in Calgary. “Sure, having kids pay down consumer debt and their mortgage are important goals, but if you can help your child see how crucial TFSA savings can be between the ages of 18 to 35, they’ll be very motivated to stick with the plan.”
MoneySense thought your family would be interested in finding out how you, too, can build wealth through your child’s TFSA. We’ve come up with four investment strategies with expected returns and figures showing how $5,000 a year invested from early adulthood can grow over a lifetime. And we’ve profiled four young adults who shared strategies ranging from conservative to supercharged growth.
Start by getting your kids involved and help them put together a small saving and investing plan. It can be as easy as showing them how a small portion of their annual earnings—even just 5% or 10%—adds up quickly as earnings increase over time. But be careful. Pape emphasizes the importance of avoiding the common mistake of opening a simple savings account TFSA and parking the $5,000 contribution with no regard to how it’s invested. “Your child is not optimizing their account if they’re simply earning 1% or 2% interest in a savings account.”
Pape’s right. Most young people who have TFSAs open ones that work like savings accounts. They like the idea of putting aside money for future emergencies but while this provides peace of mind, it won’t make your child a millionaire. It’s easy to see why. Say from the time your son (we’ll call him Shawn) turns 20, he (along with gifts of money from parents and grandparents) puts $5,000 annually into a TFSA. It’s invested conservatively in ultra-safe investments that average 2% a year. Would Shawn be a millionaire by age 65? Absolutely not. He’d have about $367,000—barely a third of the way there. Would he be a millionaire by 90? Again, no. Shawn would have about $765,000 in his TFSA—and after 70 years of inflation, that won’t be worth anything close to what it is today.
“Opting for this very safe strategy will probably make your child a good saver, but it won’t make him a millionaire,” says Dekanic. “He needs to adopt a more aggressive strategy and get his money working for him to boost his returns.”
The TFSA name is a bit of a misnomer and might better have been named a TFIA or Tax Free Investment Account. That’s how Dekanic believes it should be viewed. Parents who want to help their kids grow wealth must give them guidance. Start by doing what I did: take your child to the bank and open a self-directed TFSA. For most kids, opening investment accounts is intimidating, so having mom or dad there makes it smoother.
A self-directed TFSA gives your child the flexibility to hold stocks, bonds and exchange-traded funds. Low-fee mutual funds, including index funds, also work well for beginning investors because they minimize trading commissions. Focus on equities to power their money’s growth over time. “In their early 20s, kids with a long-term perspective can ignore fixed-income investments,” says Nancy Woods, associate portfolio manager with RBC Dominion Securities in Toronto. “They get better returns with solid growth stocks or blue-chip stocks that pay healthy dividends.”
The key to success is motivating your child to invest for the long term. Show them how quickly money accumulates with regular $5,000 annual contributions. (See the profiles on the previous pages about the power of compounding for our four young investors.) “Kids are like me—they get excited over getting rich,” says Bridget Casey, 26, a University of Alberta recruiter who started contributing to a TFSA four years ago. “Right now, I’m excited about my TFSA. I’ve learned if I save from an early age and stay out of debt, I’ll be really happy and wealthy in life. If I can do it, anyone can.”
Show your child the importance of establishing the habit of contributing regular set amounts—preferably monthly. The truth is young people don’t have much money but that shouldn’t hold you back. A structured savings program started at an early age guarantees success.
Take my daughter Laura, 21. She’s a full-time forensic accounting student at Seneca College and works part-time as a cashier at a local pharmacy. When I helped her open a TFSA three years ago, saving money was the last thing on her mind. To entice her, I promised to match every dollar she contributed, up to $2,500 a year. Believe me, it didn’t take long for Laura to realize a matching amount of free money for her TFSA is a wonderful thing.
But there’s no point maxing out TFSAs if you have consumer debt. Pay that off first, then look into TFSAs. “TFSAs work best when you’re debt-free,” says Jason Heath, a fee-only adviser with Objective Financial Partners in Toronto. “Young people living at home with no debt and few expenses who are also working part-time or full-time are at the perfect time in their lives to make their contributions count.”
It’s also important to encourage kids to learn about investing. “My son Tyler started contributing to his self-directed TFSA in 2010 when he was 18,” says Woods, the RBC portfolio manager. “I helped him open the account, and although he has a small part-time job and hasn’t been able to contribute the maximum of $5,000 a year, he’s contributed $1,400 to date and is anxious to open his statement every month.”
What’s important is he’s learning to invest his savings wisely to build wealth. “It’s very motivating for him. Today, his TFSA is worth $2,030. The small amounts of money shouldn’t hold kids back,” says Woods. “You can always buy one share of a stock to get started.”
How large can you expect a TFSA to grow if you begin as a teenager and stay invested 50 years or more? That depends on two key things: how much is contributed and how it’s invested. In the four examples we look at, we’ll assume a child—perhaps aided by gifts from parents or grandparents—contributes $5,000 a year beginning early in adulthood, ideally by 18. (The government says annual contribution limits will eventually rise with inflation in increments of $500, but so far it hasn’t increased since TFSAs were introduced in 2009.)
The asset mix is also important. Aggressive investment strategies with 60% equities should grow faster than conservative approaches with 40% equities. “Equities have done best historically and if you and your child can live with the volatility, relax about your holdings and not worry, holding an equity portfolio for the long term probably works best,” says Rick Coyle, an adviser with Financial Bistro near Halifax. “It can be like a snowball. As kids watch their money grow they get motivated to keep saving and it grows even more. The better the growth, the more determined they’ll be to stick with it.”
All that’s left is to pick a suitable plan and start contributing. The lesson? Your kids don’t have to be well-off to build wealth in TFSAs. Let them contribute what they can and top it up when you or grandparents want to give them money. Starting early puts them on the steady road to wealth building.
“Putting money in my TFSA really lets me see that I’m paying myself first,” says Casey. “And even though my parents never helped me out with any contributions because of their modest incomes, they’ve been really encouraging throughout the whole process. I know I’ll be wealthy at some point later on in my life. For me, that’s all the motivation I need to keep saving and investing in my TFSA.”
Millionaires in the Making
*Assumes $5,000 contribution at end of the year starting at age 20.
The conservative approach
Building a TFSA portfolio of 60% equities to 40% fixed income can lead to solid returns over the long term. Using ETFs works well if you want to keep costs low, prefer a hands-off approach and want to minimize volatility compared with buying individual stocks. My daughter Laura Cazzin and I chose this approach after she admitted she had little interest in stock picking but liked the idea of seeing long-term growth. “I’m busy with work and school and like the idea that the decision about where the money will be invested is made once, then every month it’s automatically directed there,” says Laura. “I’m really conservative by nature so I know I couldn’t stomach long periods of time with big losses.”
With that in mind, I helped Laura choose ETFs following MoneySense’s Global Couch Potato portfolio. (See canadiancouchpotato.com to learn how you can do it too.) That means 60% of Laura’s TFSA is in equities and 40% in bonds. She contributes $250 a month via an automatic monthly savings plan so saving becomes routine. I match her contributions until she reaches her contribution limit. (Note, if you gift your child money, make sure they put it in their own savings account first, then make their TFSA contribution from there. This satisfies CRA attribution rules and proves the money belongs to your child.) “I used to think becoming a millionaire was for a few lucky people,” says Laura. “Now I know it can be for me too if I do a few things right with my money.”
How much will Laura’s TFSA grow using this strategy? Since a balanced portfolio can be expected to average 5% annually, she’ll be a millionaire by age 68 when her TFSA rings in at $1,016,634. That’s enough for a comfortable retirement, even if she never contributes a cent to an RRSP.
Aggressive balanced growth
For two years now, Tyler Woods, 21, has contributed to his TFSA. He has a part-time job so doesn’t earn much, but has still managed to save over $1,400. He owns some equity ETFs, a bank stock and shares of a tech company. “Tyler has never bought 100 shares of any of these stocks,” says his mother, Nancy Woods. “He buys five or 10 shares at a time, then watches them carefully. Remember, a lot of these kids make minimum wage, so seeing their shares go up by even $1 is a big deal for them.”
Tyler’s aim is to make sure that as he adds money, his equity portfolio is well diversified, with several sectors represented. “Tyler can take a more aggressive approach because he’s young and has the time to watch it grow,” says Woods. “His returns have been great so far—close to 30%. The only thing to keep in mind with this type of portfolio is that if Tyler picks something that goes down in price and he sells, a TFSA won’t get the preferential tax treatment for capital losses. But having said that, his portfolio should outperform over the years.”
What returns should Tyler get over several decades? An average annual return of about 9% for the long term, which means Tyler will be a millionaire in just 34 years at age 52. If he continues contributing $5,000 a year until age 65 and averages 9% annual returns, he’ll have $2.6 million in his TFSA. At age 90? A whopping $23 million—all tax-free. (For more, look at the online Government of Canada TFSA calculator at http://www.tfsa.gc.ca/tfsacalculator-eng.html. This tool helps you calculate how quickly your child’s money can grow, and helps you see how much less you would accumulate if the money were instead held in a non-registered account.)
Blue chip, dividend- paying stocks
For Bridget Casey, a 26-year-old recruiter in Calgary, the last three years have been a good time to top up her TFSA. “I love investing and not having the gains taxed. Investing is a hobby for me.” Bridget opened her TFSA in 2009 while working full-time at University of Alberta. Initially she invested $50 a month while paying down debt. Then, 18 months ago, she upped her contributions to $700 a month (25% of her salary) to catch up to the $20,000 contribution limit. “I view my TFSA as a wealth-building tool so I don’t plan to use the money for years,” she says. “I aim to use it to supplement my retirement. I’ll save RRSP contributions for later, when I earn more.”
Bridget invests in stocks, mutual funds and GICs, but her portfolio is now 80% equities. “I have a good job, no family, and my expenses are low so I’ve been able to add a few thousand dollars more to my TFSA this year without feeling the pinch. I now have $10,000 in the account.”
Bridget picks her own stocks—dividend-paying blue chips she understands, like Johnson & Johnson or Procter & Gamble—and reinvests all the dividends. “U.S. dividends don’t get the beneficial tax treatment Canadian dividends do, so I hold U.S. dividend-payers in my TFSA—although they’re still subject to a 15% withholding tax,” she says. “I’ll put Canadian dividend payers outside my TFSA when I start a non-registered account. Later I’ll expand to international stocks.”
Her early returns were 4% annually but she’s enjoyed a 15% return so far this year. “Increasing stocks has paid off,” she says. Bridget knows her portfolio will fluctuate, but a portfolio of 80% equities might be expected to average 7% annually. If she can achieve returns like that, her TFSA could make her a millionaire by 60.
Supercharged growth strategy
Over the last four years Helen Chevreau, 21, a fourth-year student at the University of Guelph, has worked several part-time jobs, including organizing cross-Canada tours during her summer holidays and working as a cashier at Shoppers Drug Mart. That, coupled with generous gifts over the years from her family, has enabled her to contribute the maximum to her TFSA in each of the last four years. It doesn’t hurt that her father is MoneySense editor Jonathan Chevreau. “My dad explained how TFSAs work and walked me over to the bank at 18 to open my first account,” says Helen. “My grandparents have also given me gifts for the account. It’s encouraged me to save and invest more.”
Over the years Helen has done a little stock picking, adopting a variant of Peter Lynch’s strategy of investing in businesses she encounters in day-to-day life. “I own Cineplex, BMO and BCE,” she says. “What’s powered my TFSA is my Apple shares. My $20,000 has grown to $24,000. I love technology stocks.” Her portfolio also includes ETFs selected by her father, targeting growth sectors like technology, emerging markets and precious metals. Helen has learned a lot about investing through her TFSA, which helped her pass on the Facebook IPO. “I was anxious to buy but with all the excitement I decided to wait. I’m glad I did. That showed me how stocks can fall out of favour. You have to be ready for that if you hold growth stocks in a TFSA.”
With a lot of luck, Helen can expect mouth-watering returns, albeit with much volatility. Investors who start TFSAs at 18, contribute $5,000 annually and focus on growth may achieve spectacular annual returns near 12%. They could become millionaires by 46, and since compounding starts snowballing after that age, could have $12 million by 68.
Leave More For Your Heirs
To maximize the after-tax value of your estate, you probably know you and your spouse should move as much money as possible from non-registered accounts into TFSAs. “Proper estate planning requires understanding the tax consequences of different investments,” says Jason Heath, a fee-only adviser with Objective Financial Partners. “Topping up TFSAs prudently can reap big rewards.”
But with TFSAs, the devil is in the details. When you complete an application to open your TFSA, there’s a section where you can fill in the name of your “successor holder.” Only your spouse or common-law partner can be your successor. Like the “successor annuitant” on a Registered Retirement Income Fund (RRIF), the successor holder replaces the TFSA holder upon death and the plan continues with all rights passing to the successor. That means your TFSA continues growing tax-free until your successor dies.
“If you aren’t sure you checked the successor holder designation on the application form when you opened the account, catch up with it at your local institution and do it now,” says Gordon Pape, author of Tax-free Savings Accounts: A Guide to TFSAs and How They Can Make You Rich. “It could save you and your family thousands of dollars in taxes.”
If you’re helping set up a TFSA for a young adult who doesn’t have a spouse or common-law partner, complete the beneficiary section of the application. That means you’ll name the person who will own the TFSA proceeds after death. At that point, the account ceases to be a TFSA and any income earned from the date of your death is subject to taxes in the hands of the beneficiary. Your child should go back and name a successor annuitant if he or she gets married. For more, go to the Canadian Revenue Agency website at http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/tfsa-celi/dth/menu-eng.html.
