If you put $5,000 into an investment that earns three per cent, that $5,000 TFSA will earn you $150 bucks a year. The income tax you save would be minimal.
Last issue I said I’d discuss the Tax-Free Savings Account (TFSA) that’s starting January 2009. This account will let any Canadian over 18 deposit up to $5,000 per year and invest that money in a number of ways and any money you make will be tax free. So this is a totally reversible decision savings account, which really is one of several good things about it.
You will be able to take money out of that account tax free, put it back, and add to it the next year. It looks to be a very flexible chequing/ investment account. Here are a few things I’m thinking about for our family.
First, I will try to set it up with our discount broker so we can trade stocks in that account for a low commission, which is around $10 now in all of our accounts. I will ask to have that account allow me to work with options. To do that, you have to apply to the broker for permission. Only one catch: you need to have some knowledge and background on options to get that permission.
Second, with my TFSA, I will buy stocks that I can sell covered calls on. But I will be a little picky on which stocks I might put in there. Readers and I are looking for what we call comfort stocks that should do OK in a market that might not be very perky. By comfort stocks, I mean ones that we could more or less count on for a number of years.
By selling covered calls on these stocks, it looks like we can make one to three per cent per month and keep the dividends. As this bear market ends, I really don’t think most stocks are going to run up to their old highs in any big hurry. Oh they might have a quick up day or two, but I doubt that they will just keep on running up and up. The world is going to be a different place in the years to come, at least that’s how I see it. So I don’t know if we can expect stocks to rebound and climb. I hope I’m wrong. Stocks in Japan have not gone up much over the past 15 years. Their index, the Nikkei, is below the value of 1982. We should keep our expectations low.
There will be many new rules and regulations and a lot less credit for many going forward, so I don’t expect any new “bubbles” to form in the stock market in the next few years. Therefore this business of selling covered calls could fit in very well in the months and years ahead. I’m very blessed that I was able to learn this strategy and I teach it in my newsletter StocksTalk. You can read it free for a month if you send me an email.
By the way, selling covered calls on stocks is like renting out your farm. We just rent out our stocks and collect cash “rent” pretty well every month and we keep the dividends the stocks pay. Even during this bear market we were taking in around $10,000 a month. Many readers of StocksTalk have smaller accounts so they make $500 to $1,000 a month quite easily. This strategy works for big or small investors. And starting In January, we can do it in the TFSA.
Of course I’m not saying go out and buy stocks on January 2. If you don’t know stocks, put the money into treasury bills, government bonds or GICs and the money they earn will still be tax free. Then learn how to manage stocks and the market will still be there when you’re ready to buy. In fact, you might even miss a good part of the bear market by the time you’re ready to go.
RRSP or TFSA?
Should you put your money into a registered retirement savings plan (RRSP) or a TFSA? So the federal government set up the TFSA to serve two purposes. One is to encourage people to save some money and the other is to encourage people to put less money into an RRSP so the government pays out smaller tax refunds. In many homes, it will be one or the other and of course in some homes it won’t be either one.
This means Canadians have two savings plans that are cumulative, so if you don’t use them in any one year, you can use them later in life. Also the money earned year by year is tax free, except in an RRSP some day the money coming out will be taxable income. The real difference is that we can use the TFSA more or less as a chequing/ investment account. When we have spare money, we can let it earn income tax free and if we need some we can take it out and then put it back with no tax problems.
I don’t pretend know if you should put money into the TFSA or not, but I will give you an opinion. The TFSA is a very flexible savings plan. If we look ahead after a few years the TFSA account could have a lot of money in it that you could take out and replace or just take out and use. It’s very reversible, but you’re working with after tax dollars to start.
When you put money into an RRSP, you pay less income tax. The amount you save from taxes varies a lot from province to province, but let’s say that each $1,000 you put into an RRSP saves you $350. So you put in $3,000 you save $1,050 in taxes. Then all the money that RRSP earns also will be tax free perhaps for 20, 30 or 40 years depending on your age.
If you plan to put that $5,000 into an investment that earns three per cent, on $5,000 you will earn $150 bucks a year. You’d pay no income tax on that $150 growth, but the amount saved is minimal. Compare that to amount of tax you defer by putting that same amount into an RRSP. You could keep putting money into an RRSP and the refund will be many year’s worth of the income that $5,000 will earn in the TFSA.
Seems to me that unless you know how to make more than the bank rate of three per cent per year on that $5,000, maybe for now put the money into an RRSP. The money allowed into the TFSA is cumulative. So if you don’t use it in 2009 you carry it forward. In the meantime, you saved maybe $350 or so of income tax for each $1,000 you put into your RRSP.
TFSA fits 4 situat ions
Look ahead five or six years and these accounts could have $30,000 to $50,000 earning tax free money. That would be nice. But if you put that money into an RRSP, you could still have that much plus $5,000 or $6,000 worth of tax refunds. But the TFSA is very flexible, so you could take out money for a monthly payment on a car for example or to just pay for the car or whatever.
So, seems to me the TFSA fits four types of situations: 1) where you have already paid as much as you can per year into an RRSP and still have money; 2) where you already have lots of money in an RRSP and don’t want any more in there; 3) if you don’t pay income tax in any one year, so you wouldn’t have a tax refund anyway; and 4) when you want an investment account that lets you use money from time to time and any money the account earns is tax free.
Here’s what I would do
If you already have lots of money in an RRSP and you have cash and you know how to make money with money, then the TFSA could well be a decent investment strategy. If I do it, here’s what I will do. I will buy 100 shares of a stock such as CNR or maybe a Canadian bank or 200 shares of a company like Fortis (FTS). I would then sell covered calls on those stocks month by month.
As things stand now, 100 shares of CNR, 100 shares of Bank of Nova Scotia (for example) or 200 shares of FTS would pay us around $100 a month plus we’d keep the dividends. I’d buy the options back each month if I had to and just sell a call for another month so we’d be collecting what is called time value month after month of about two per cent per month. That could be say $1 a month per share, which often is more than the dividend for a year.
You can do the math. When a $5,000 account grows by $1,200 to $1,500 a year tax free, it would be well worth learning how to do this strategy. Look ahead three years and the money adds up.
I sell covered calls in our RRSPs, but taking money out or putting it in can affect our income tax. The TFSA does not.
Andy publishes a newsletter called StocksTalk where he discusses how to make money in up, down and flat markets with stocks that are household words. For a free one month subscription send an e-mail to [email protected].