When you’re looking to build wealth, holding index funds in a TFSA just makes sense.
TFSAs allow Canadians to invest tax-free, and though there is a contribution limit, there is no limit on the tax-free growth. Holding a long-term asset like index funds in a TFSA allows to safely take advantage of the tax-savings, and simplifies your financial life. Even if it was all you did, you’ll see that this strategy will set you up for retirement.
So let’s explore the tax savings, the best way to use this pairing, and things to watch for.
Tax Savings on Index Fund Growth
Index funds can grow your wealth by increasing in value, or by paying dividends – and in a TFSA both are tax-free.
If you held index funds in a traditional account you would owe taxes on the increase in value and the dividends. Both these forms of income are more favourably taxed (compared to employment income), but wouldn’t you rather pay no tax? Paying no tax allows you to keep the entirety of the dividend, increasing growth, and it means you keep all the growth.
Is there anything better than that?
The Best Way to Use Index Funds in a TFSA
The way to maximize your wealth using index funds in your TFSA is to leave them for as long as possible.
TFSAs have a contribution limit, but they don’t have a growth limit. This means as long as you don’t contribute more than the ~$6,000 contribution limit every year the value can grow infinitely large.
Let’s imagine you contribute $6,000 per year for simplicity’s sake (the contribution limit increases occasionally with inflation) from age 18 to 65 and you purchase index funds. At age 65, you would retire with $2,940,000 (assuming 8% return), and not a dime of that would be taxed. If in a taxable account, you would pay tax on the $2,652,000 of growth, and it would never even grow this big due to the tax you’d pay on dividends. By taking full advantage of the tax savings of the TFSA, you can get as much possible return on your index funds. And all it takes is an annual contribution and purchase of index funds – compounding will take care of the rest.
Holding index funds in a TFSA could literally save you millions in tax. Now all this is predicated on the money being able to compound for as long as possible, but it is entirely feasible. You just need to be willing to invest in your long-term wealth.
Holding index funds in a TFSA long-term is a perfect way to build the wealth you’re looking for.
A Word of Caution
Now this theoretical situation may sounds great, but there are two things to watch out for: Overcontributions and interruptions.
In exchange for the tax savings of TFSAs, there are also contribution limits. It’s important you pay attention to how much you’ve contributed, and what the annual limit is. You also need to remember that if you withdraw any money, the contribution room is not available again until the follow year. Any over contributions will be taxed at 1% a month, which can add up really quick. Make sure you’re keeping track of your contributions.
The second thing to avoid is interrupting the compounding. Compounding only gets better with time, and when you cut it short it has more effect than you’d expect. Imagine in the above example you do your annual contribution for 10 years (until age 28), bringing your balance to ~$100,000. You then withdraw $80,000 for a downpayment. When you reach 65 (37 years later), your balance is $1,563,000, a reduction of almost $400,000 due to a $80,000 withdrawal. Now this may not be a decision you regret, but it’s important you are thoughtful as to the consequences.
Both these items can reduce the wealth you build.
Conclusion
Holding index funds in a TFSA is a great way to build long-term wealth.
The tax savings paired with the compounding effect of time is a recipe for strong growth. Just be sure to not overcontribute, and avoid interrupting the growth by withdrawing. And with index funds you can start investing with whatever capital you have.
So get moving, and take advantage of this strong pairing.