Tuesday, October 26, 2010

I tell my own children to use a TFSA (Tax Free Saving Account)

I tell my own children to use a TFSA and once they make enough money (30 - 60K per year) then combine it with a RRSP. Basically, the idea is that when your tax-bracket is high enough, you could contribute say $4000 per year to your RRSP and put the tax refund (say $1000) in your TFSA.

If you do not maket enough money to pay a lot of tax right now, put your money in a TFSA. With a disciplined investment approach and improving salary, over the years the account will build up to a sizeable portfolio (deposit every year the max of $5000 and in 5 years you have $25,000 plus profits).

The disadvantage of both account types (RRSP and TFSA) is that you cannot deduct capital losses from your taxes. So a loss is a loss. A lot of people put only fixed-income investments in them which are less volatile than stocks and you have often to pay the full taxes on them (e.g. GICs or anything that earns interest). I am not entirely in favour of that because over time, inflation will eat into your investments and the overall ROI is not sufficient to accumulate more money. When you withdraw money from an RRSP you have to pay taxes on the withdrawal and the typical end result is that you only take out what you originally put in plus inflation. So RRSPs are more a 'capital preservation' than a wealth building tool in my opinion.

TFSAs are similar but since you put in 'after-tax' money you do not pay taxes when you take money (including profits) out afterwards. But don't use it as a ‘chequeing account’ - taking money in and out during one year because then it becomes taxable - tricky. If you have a long time horizon - i.e. intend to keep investments 5 to 10 years, or better longer then a diversified stock portfolio is good as well. This is because the 'risks' in stocks disappear the longer you hold them. The key is 'diversified' though, since individual companies can, and from time to time do, go bad or broke. Thus, buy a lot of different stocks.

Best in my eyes are ETFs like i-shares that comprise the 60 largest Canadian companies trading on the TSX. The stock symbol for that ETF is ‘XIU’. You put them in your account and reinvest the dividends that are paid every 3 months or so. (B.T.W. use a discount brokerage account - a full service brokerage is too expensive for a small investor).

Holding individual stocks of excellent companies purchased at a good price is not bad. But in a small portfolio the combination of stock volatility, commissions on small transactions and individual company risk makes this approach not ideal. Besides many of such stocks are part of the XIUs anyway.

Another thing a small investor should consider is becoming a member of the Canadian Share Owner Association. They offer education on-line through webinars, have a monthly investment magazine, they have an excellent stock database and they allow you to invest for very low commissions in small investment accounts. My son has an account of $1700 and dividends are automatically re-invested. Since it is a 'practice account' he does own individual stocks.

The Canadian Shareowners Association, kind of like REIN, teaches how to invest in stocks - they use fundamentals like earnings per share, revenue, dividends, profit margins and several other criteria to determine whether a particular stock is a good investment. They are 'value investors' and they are good at it. Their website is a mess and geeky but with some patience you will figure it out. Annual membership fees are $90 (last time I checked). http://www.shareowner.com/index.html

Of course read as many books as you can about investing - both on real estate and on paper securities. In my opinion it is best to start building your nest egg in stocks and bonds, then when you have a sufficient down payment buy your first residence and pay it off ASAP. If you want landlord experience rent out the basement suite. Once you have the basics under control, you have a solid financial base and a decent down payment (30%) move into real estate investing. But be careful, nothing is as bad as being overleveraged and with vacancies. (I speak from hard experience).

No comments:

Post a Comment