I love tax free savings accounts (TFSA). All Canadians should love TFSAs. The federal government, and the CRA, on the other hand have probably already figured out that, for them, they were a very bad idea. Let’s hope it is many, many years before they decide to eliminate them.
At very least, the CRA has figured out that limitations needed to be set. This happened when a few TFSAs began to approach $1 million in value. You’re probably thinking the same thing that I did, “how in the hell did that happen”? It happened very simply. A small number of skilled investors knew how to make large sums of money by frequently trading rapid growth stocks. The CRA determined that these people were not adhering to the basic tenets of the program and were in fact operating businesses within their TFSAs. The CRA shut them down and made them pay corporate taxes on their profits.
The lesson learned is, if you are going to trade equities in your TFSA, do it in a manner that prevents your actions from being interpreted as those of an active day trader. It is now illegal to run a business within your tax-free savings account, so you don’t want to do anything that makes them think that is what you are up to.
The Basics
The basic tenants of the TFSA program are very simple and straightforward. You put money in, you buy investments, when the investments make a profit, you get to keep that profit tax free. In the CRA’s own words:
“It is a way for individuals who are 18 years of age or older and who have a valid social insurance number (SIN) to set money aside tax free throughout their lifetime.”
How much money you can put in every year is determined by the CRA. The following are the contribution amounts as stated on the CRA site, broken down by year.
“You will accumulate TFSA contribution room for each year even if you do not file an Income Tax and Benefit Return or open a TFSA.
The annual TFSA dollar limit for the years 2009 to 2012 was $5,000.
The annual TFSA dollar limit for the years 2013 and 2014 was $5,500.
The annual TFSA dollar limit for the year 2015 was $10,000.
The annual TFSA dollar limit for the year 2016 and 2018 was $5,500.
The annual TFSA dollar limit for the year 2019 is $6,000.
The TFSA annual room limit will be indexed to inflation and rounded to the nearest $500.”*Note: 2020 is also $6000.
The other absolutely delightful feature of the program is that these amounts all accumulate over the years. If you are just going to open a TFSA in the year 2020 you might be thinking that you can only contribute $6000. That is not the case. You can contribute the full amount allowed since the program began in 2009. That means each Canadian citizen, who currently does not have a TFSA, can contribute $69,500 to a brand-new account this year … add it up. It also means that a couple, who are each entitled to open an account, would be allowed to contribute $139,000 combined. Awesome!
Now, you’re probably thinking there’s no way I or we can contribute that amount. Not to worry. You can initially contribute any amount between $1.00 I suppose, and the maximum that you are currently allowed. I say that without any actual knowledge if you would be allowed to open at TFSA with just one dollar. 🙂 The bottom line is you can start small and work your way up.
There are two types of TFSAs that you can set up. One is a basic TFSA that you would set up at your local bank. These are somewhat limited in the types of investments that you can hold in them i.e. fixed income investments like GICs and a limited number of mutual funds. These are not the best investment use of your money, unless you are ultra-cautious. What you really want is a self-directed TFSA.
“Self-directed TFSA – a vehicle that allows you to build and manage your own investment portfolio by buying and selling various types of investments.”
Your local bank cannot set up a self-directed TFSA for you, but they will point you in the right direction if you ask. That would probably be to their brokerage arm or direct investing service.
A self-directed TFSA allows you to invest in a myriad of different financial options – individual stocks, ETFs, mutual funds, GICs, bonds, etc., etc. It might all sound quite intimidating, but it isn’t really once you develop a basic understanding.
If you are interested in reading further about the TFSA program just follow this link to the CRA’s TFSA website.All of the quotes that I have cited so far are from this page. That said, you might find it easier to wade through this SunLife article which covers most of the basic TFSA information you’ll probably need.
How We Do It
You might think that because I am writing this article we were early adopters of the TFSA program, and that we are following some highly-sophisticated economist-developed investment strategy. Not so. We did not start using a self-directed TFSA until 2013, and the investment strategy is an extremely simple one that I came up with on my own.
Here it is. When the Love-goddess and I started talking about what we wanted to do with our two accounts we landed on a small number of guiding principles. Number one, we wanted to be able to generate income that we could easily pull out without having to sell or cash-in any of our investments. Secondly, we wanted the portfolio to grow at a rate in keeping with stock market performance. And thirdly, we wanted to hold investments that would remain relatively stable, and generally safe, over the long haul.
The strategy that we landed on was to build a portfolio of high quality blue-chip Canadian dividend paying stocks. Additionally, we were looking for equities that regularly increased their dividend payouts. Most companies pay out dividends in equal portions every three months, or quarterly. Some stocks, like many REITs, do it monthly.
Every year in January, we make our allowed contribution; with that money we either buy new stocks, or buy more shares of ones that we already hold. Alternatively, we have transferred stocks into our accounts, that we already owned outside of our TFSA as an “in-kind” contribution.
Let me share with you the individual equities we actually own as I write this. I am certainly not recommending that you consider buying these stocks. However, if you go searching for Canadian blue-chip dividend stocks most of these are the ones you will see popping up all the time.
Banks: BMO, BNS, CIBC, TD, RBC
Life Insurance: Great-West, Manulife, SunLife
Telecoms: BCE, Rogers, Telus
Utilities: Algonquin, Canadian Utilities, Emera, Fortis
Energy: Enbridge, TC Energy
REITs: Brookfield Property, Choice Properties, CT Real Estate, RioCan
Infrastructure: Brookfield Infrastructure Partners
Crunching the Numbers
When we are giving thought to any particular stock purchase we always factor in that we are trying to maintain a mean (average) of 4% on our dividend yield or return. Dividend yields will often change daily, so the only time that we were really bearing in mind the 4% goal is on the days we buy. Naturally, we want to see an appreciation in the share prices as well, but the primary motivator is the income being generated through the dividends we are receiving. And, we want a combined 4% return on our money at a minimum.
So, how do I crunch the numbers? Oddly, that’s how I crunch the numbers. 🙂 When I check to see how we’re doing I look at the numbers in a way perhaps nobody else does. Here we go. I will be using our actual numbers here. Over the 12 years since the inception of the TFSA program we have contributed the full amount allowable to both of our TFSAs. That means we have each contributed $69,500, or $139,000 combined. For the contribution year 2020 we will receive a combined total of $10,045 in dividend payments. If we divide the total dividends received ($10,045) by the total amount we have invested ($139,000), that is 7.2% return.
OK, I broke out the calculator, and you are right, your current return is 7.2%. I don’t get it. You said you were attempting to maintain a mean of 4%, how did you get all the way up to 7.2%?
We got up to 7.2% very simply. All of the equities we own have steadily increased the amount they pay out in dividends. (e.g. BCE paid $2.33 per share when purchased, now pays $3.33) This now amounts to the annual figure of $10,045. If none of them had increased their dividends, we would still only be receiving around $5560 at this point (i.e. 4%). We consider 7.2% a very nice return in the current low interest conditions. The best part being that it is all tax free.
The other number I worry about is the total amount of cash the dividends churn out. Every year this amount increases for two simple reasons. One, we are contributing more money, which we use to buy more stocks, which in turn payout new dividends. Secondly, as stated, most of the equities we own will increase their dividend at some point in the year. As you have seen, the tax-free dividends we will collect this year amount to a nice little chunk of change. Especially during retirement. These payments continue to remind us that this style of investing thing is a good thing, for us anyway.
It should be noted that although we received $10,045 in dividends combined, that amount is not split evenly between our two accounts. We have different equities in our accounts and the dividends vary, so we don’t each get exactly $5022.50. Our two separate amounts add up to the $10,045.
We Recontribute What We Take Out Every Year
One of the amazing features of the TFSA program is that you can draw money out of your account during the year. AND, you get to re-contribute that same amount the following year along with your allotted annual contribution. For us this means that over the course of the year 2020 we will fully draw out the $10,045 that we have accumulated in dividends. We will then be permitted to re-contribute that amount in 2021. You’re not allowed to re-contribute it in the same year that you take it out, so be careful. This is one of those features that should have the CRA thinking, “well this was a bad idea”.
In plain terms, this means that we will jointly be able to contribute $12,000 ($6000 each), plus each of our portions of the $10,045. This allows us to contribute $22,045 in total. If we don’t have the funds to contribute the whole amount in 2021 we can add in what we fail to contribute in any subsequent year. Sweet!
How Our Approach Stood Up in the COVID Crash
So, you’re probably all wondering, how has our approach been standing up to the COVID crash in March? I would have to say, “not bad at all, thanks for asking”. Because our primary motivator for our TFSA investments is the dividend income stream, damage to it is our primary concern. The good news is, so far none of the companies we hold have decreased or suspended their dividend payments. I don’t think any of them will increase them before the end of the year, but we can live with that. So, we are still on track to receive the full $10,045
One thing we don’t do is second-guess our investment strategy or decisions. As long as the dividends keep flowing, we’ll happily continue to own everything in our portfolio – minor tweaking along the way not-withstanding.
Have the stocks we own decreased in value during the recent collapse? Of course, they have. Do we worry about that a lot? No, not at all. In general, dividend stocks have rebounded at a slower rate than the whole TSX index, but we’re only worried about what the stock price will be in five years, not in the next six months to a year.
It’s also important to remember that “paper” gains or losses aren’t real until you actually sell a stock. And, since we are planning on holding the stocks for years we haven’t incurred any real losses.
Are we worried about the future direction of the economy and the stock market? Nope, we are of the “this too shall pass” mentality. I definitely saw the big drop in March as a buying opportunity, not as a harbinger of future disaster. As the market was bottoming-out we actually bought two new stocks outside of our TSFAs, Manulife and SunLife. The prices for both of these were at historically low values, and their combined dividend yield was between 6% and 7%. As I write this, their combined price gain is 20.94% since the day we bought them. But as you now know, this is not an actual real gain because I haven’t sold them. Paper gains are fun to have, but the cold hard cash of a dividend payment is real and tangible. 🙂
I suppose the best way to wrap up this piece is to remind everyone that what we do may or may not work for you, and that you should always consult with your financial advisor when considering making changes to your financial portfolio.
Oh! If you don’t yet have a TFSA, it is probably time. Everybody loves extra tax-free money, even if you are playing it really safe and it’s only a once a year GIC pay-out.
