Note: In the Northwood Perspective newsletter, we usually target our writing to current and prospective family office clients (i.e. those with $10M+ of investable assets). However, we are also aware that many other people read our newsletter on a regular basis. With that in mind, we wanted to include something more applicable to a broader audience this quarter. So whether you’re one of our next gen clients, or simply someone looking for financial advice, we hope that you enjoy the below article.
As the calendar turns from December to January, there are some time-honoured traditions that many of us participate in with the hopes of creating a better version of ourselves in the New Year. After the indulgences of the holiday season, we convince ourselves that a simple thing like a New Year’s resolution will allow us to transform our lives. We begin the new year exercising more, drinking less, and going to bed earlier. And then, by the time February rolls around, most of us have reverted to our natural tendencies. We spend the rest of the year living our lives the way we want to until January rolls around again and we repeat the process. Like I said, a time-honoured tradition.
With that said, there are some positive actions that we can all take right now that will pay dividends long after we have given up on the rest of our New Year’s resolutions. For Canadians, each calendar year brings with it the opportunity to contribute new funds to your Tax-Free Savings Account (TFSA). For 2021, that amount is $6,000, which brings the cumulative amount of contribution room since the TFSA was introduced in 2009 to $75,500.1
As I was doing some personal financial planning over the holidays, I was pleasantly surprised to see that after our 2021 contributions, my wife and I both now have just under $100,000 in our individual TFSA accounts. This is a result of us using up our $75,500 each of cumulative contribution room, and then investing those amounts and allowing the stock market to work its magic.
By saying “work its magic”, I don’t mean to imply there was anything magical about how we got to today. These $100,000 balances did not come from homerun stock picks or perfect financial behaviour. In my case, I contributed to my TFSA in 2009, and then cleared my account out to go travelling in 2010. I then contributed in 2011 and 2012, and cleared it out again to help pay for graduate school (2013-2015). I didn’t fully utilize my existing contribution room until 2018, a full nine years after the TFSA was introduced. And yet still, I have almost $100K in the account as of the beginning of 2021.
The real purpose of this story though is not to marvel at the fact that six figure TFSA balances are becoming normal. Rather, it is to illustrate the potential of having $100K in a tax-free account at a relatively young age, and what that amount can turn into over time with the power of compounding.
The annual contribution limit for the TFSA account is indexed to inflation and rounded to the nearest $500 each year. This is why the contribution limit has increased from $5,000 per year in 2009, to $5,500 per year in 2013, and to $6,000 per year in 2019. If we assume that inflation averages 2% per year over the next 30 years, the annual contribution limit will continue to steadily increase to $11,500 per year in 2052. By that time, I’ll be 65 years old and should be ready to move to Del Boca Vista and run for condo board president.2
If the stock market averages 6% returns over that timeframe,3 and I continue to contribute the maximum amount to my TFSA each year, I will end up with well north of $1M in my TFSA by the time I hit the traditional retirement age. Any skeptics are welcome to go row by row through the below table, but everyone else can just skip to the number at the bottom right: $1,362,300. This sum can then be withdrawn tax-free to pay for whatever it is retired people will be spending their money on in the 2050s. If my wife does the same thing, we’ll have $2.7M in our TFSA accounts alone by the time we’re 65.
When Canadian Finance Minister Jim Flaherty introduced the concept of the TFSA with the 2008 federal budget, some observers scoffed at the initial $5,000 contribution limit. They asked how Canadians could accumulate a reasonable nest egg for retirement if they could only save $5,000 per year in the new tax-free account. What the above table shows us is how wrong headed these observations were. With a long timeframe and consistent saving, regular Canadians can easily become millionaires by utilizing the TFSA account.
The key to making this happen is to use your annual contribution room and then get the money invested. From an investing perspective: for these kind of account balances, a low cost, globally diversified ETF, like Vanguard’s VEQT, will work well for most people. From a savings perspective: $6,000 per year works out to $500 per month or $115 per week. Not everyone has an extra $500 to save at the end of the month, but I’d assume that many of the people reading this article do.
So make it happen! Turn $500 per month into a million dollars and come join me in Del Boca Vista. Once you get here, the first round is on me.
1 The Conservative Party raised the TFSA limit to $10,000 per year but eliminated the indexation for inflation in their 2015 federal budget. When the Liberal Party returned to power later that year, they restored the pre-2015 contribution limit of $5,500 for the 2016 tax year, and reinstated indexation for inflation for future years.
3 This is the conservative assumption we use at Northwood Family Office when running long term client cash flow projections. If you look at the historical records, long term returns in equity markets have averaged closer to 8% per year.