The Tax-Free Savings Account can be one of the most powerful tools that a Canadian can have right now. When most people turn 18 they would rather take a quick jump, skip and a hop to Quebec to have their first legal beer. While this does sound pretty good, there is one thing you should do before you go indulge yourself in liquid courage. The day you turn 18 you should open your TFSA, the spot you want to begin your investing journey. Even if you open it and just fund it with a little seed money to get your feet wet, you’ll be thankful in the long run.
You can also set up automatic deposits that you can transfer the money right into your TFSA off your paychecks so you never even see it. This allows you to remove the temptation of spending all of your money immediately when it comes in. Trust me, you will thank yourself in the future if you do this. If you have enough discipline to do it yourself, all the power to you! There is a limit that you will have on the amount that you will be able to contribute to your TFSA. If you turn 18 in 2020, your contribution limit as soon as you open it will be $6,000. Now most people won’t be able to fill that up right away but that’s okay, just begin funding it. Once you build it into your system you’ll be good to go. As every year goes by, you will collect more contribution room
Now that you put some money in there, you are probably wondering that’s great, now what? First thing I would recommend is to do a little research and don’t take the advice of the bank advisors that help you open your TFSA. Why? I have helped numerous people open their TFSA over the years and at multiple different institutions, the first they do is try to sell you their in house actively managed mutual funds. The reason they do this is twofold:
- They already have your money so why not keep it in house and let them actively try to manage it and get you the returns they are promising. The funny thing with that is that normally those funds are heavily loaded with management fees that will chew into your returns very quickly. Why are the fees higher on them? Baked into the price you have to cover the costs of their buildings, staffing, overhead and a lot of other smaller things. Unless they give you a ridiculously low fee, there’s probably a better option for you. So just politely decline and do some of your own research.
- Not only will the fees eat into your returns, but do the fund manager’s actually care about you? Regardless if the fund goes up 5% or down 5%, they are guaranteed to get their cut of the pie regardless, just for managing your money. I’m not saying that all mutual funds are bad, I think some of them are great, but you need to do a little research and determine what your own investor’s policy is and what fits into your plan long term.
There are a couple different avenues you can go into from her:
- You can buy an index fund and get a collection of multiple stocks inside of a basket that will generate a dividend, which in turn, can result in a dividend reinvestment plan.
- You can buy a single stock that you believe is a solid company, maybe one you use on a nearly daily basis, such as your internet provider, utility companies or cell phone providers. Collect their dividends and let that pay for part of the bills you pay to them..
- You can invest in a company that you feel strongly about that has some growth potential, maybe one that you feel is undervalued.
Single Stock Investment
You have plenty of options here at your disposal. $6,000 worth of contribution room in your first year gives you more options than you think over time. Let’s say you invest this in your internet provider because you want to chip away at your internet bill a bit. If you leave that money invested with that company, you can get your share count to grow if your dividend payment is large enough to Drip you one extra share per dividend distribution. This can definitely add up to some good payments down the road.
Let’s say you use your initial investment to invest into your internet provider, at a price of $60 per share. Investing the entire contribution amount ($6,000) will give you 100 shares in the company. Now imagine this company produces a 5% dividend yield. That’s $75 per quarter ($300 per year) you can collect for just holding your internet service provider. You can pull that $75 per quarter out every time and use that to pay down your bills.
Not bad if you ask me. Also, whatever amount you withdraw can then be recontributed the following year! So, if you withdraw that $300 the first year and the contribution limit is consistent, you can contribute $6,300 the following year! While it’s not going to take care of your entire bill for the year, it can go a long way towards contributing towards your future growth
Now what if you left your shares in there? If you let the shares keep reinvesting for 30 years with a 7% growth of the stock including the dividend reinvestment you are looking at turning your original $6,000 into $180,000 that produces you $8,000 in annual income (more than your original contribution amount) with the dividend increasing to stay consistent with 5% yield. That’s just one stock that you hold for 30 years; now imagine every year with your new contribution room you buy another, followed by another one the year after that and so on and so forth. Here’s the real beauty of it all; it is tax free when you withdraw it in the future. All you did was turn $6,000 into 30x the money in 30 years! That is absolutely mind boggling! The downside with this is that you are possibly leaving yourself exposed to the volatility of having all of your shares in one basket.
Index Fund Investment
Maybe you don’t want to only invest in one individual stock because it’s too volatile and you don’t have quite the same risk tolerance, so instead you invest in an index fund that covers the entire Canadian market. (For this example we will use VCN, the Vanguard All Cap Index ETF VCN). This index matches the market value of the top 188 companies in Canada. The dividend yield on this is lower, however, with it being lower you have lower risk of volatility because you have a large basket of companies. Borrowing some information from the example above, let’s say we contribute the full $6,000 initial contribution into VCN which returns with a dividend yield of 2.8% (at the time of writing). You will start 181 shares, producing about $42 per quarter or $168 per year if you don’t reinvest it. This isn’t as fantastic as owning the individual stock but you have significantly reduced your chances at a large swing in volatility because you own 188 instead of 1.
Now, what if you were investing all of your dividend payments back into the index every quarter as you went along. Again, we will use the same metric as before, using 7% return per year over a 30-year time period. This turns your original $6,000 into $99,000, which multiplied your money sixteen-fold. Now the numbers definitely aren’t as explosive as the single stock investment that was given above but there’s major takeaways from this. You didn’t have to do a whole lot of research to determine which stock to invest in, as you invested in the market as a whole. As it grows you are buying more and more of the entire market, not just a single investment. You still did very well considering you turned your original investment into almost $100,000 for saving a little money and investing it for the long term.
If you were to start this the day you turned 18 and invested your $6,000 you would have that money by the time you are 48. If you would like to have fun, go play around with your numbers a bit and see what type of crazy returns you can get if you were to start early and let time do the heavy lifting for you. That should be your main takeaway here. For the TFSA, if you start early and let time work its magic, you should be able to produce large sums of money that will come out tax free when you withdraw it. Sounds like a pretty easy system to implement to give yourself a nice little chunk of change in the future.