TFSA Limit Increase and Long-Term Cut
A reader, Garth, suggested a good topic for an article: “I would love to see you do an article on what the Time Value of Money will do to unused and future TFSA contribution room now that it is no longer indexed to inflation.” Most people aren’t good at understanding the long-term effects of inflation. Let’s look at how TFSAs will be affected.
To start with, the reports of how people can use TFSAs to build up million-dollar portfolios are highly misleading. For example, if 25-year old Sandy socks away $10,000 in her TFSA every January for the next 40 years and makes a 7% return, she would end up with $2.1 million that she can withdraw tax-free.
However, if inflation is 3% per year, the value of money will be less than one-third of what it is today. The purchasing power of Sandy’s money will be only about $650,000 in today’s dollars. This will put Sandy in a good financial position, but she won’t be a multimillionaire by today’s standards. Even low levels of inflation build up significantly over time.
In fact, at 3% inflation, it would have taken only 20 years for the TFSA limit to reach $10,000 per year under the old rules. So, in 2 decades or so, this so-called TFSA limit increase will start to look like a TFSA cut. Older Canadians will benefit from a higher TFSA limit now, but younger Canadians will eventually need the $10,000 limit to be raised to counter the effects of inflation.
Turning our attention to unused TFSA contribution room, inflation is a kind of leak in your available room. Any unused room is a fixed dollar amount that doesn’t rise with inflation. This isn’t a consequence of removing the indexing of the TFSA limit; it was true before the change and it’s still true now. When you invest TFSA contributions your returns tend to counter inflation, but unused room declines a little in value every year.
Whenever you think of money over long periods of time, it’s important to account for inflation. If we do this properly, it changes the discussion of the TFSA limit change in important ways.
To start with, the reports of how people can use TFSAs to build up million-dollar portfolios are highly misleading. For example, if 25-year old Sandy socks away $10,000 in her TFSA every January for the next 40 years and makes a 7% return, she would end up with $2.1 million that she can withdraw tax-free.
However, if inflation is 3% per year, the value of money will be less than one-third of what it is today. The purchasing power of Sandy’s money will be only about $650,000 in today’s dollars. This will put Sandy in a good financial position, but she won’t be a multimillionaire by today’s standards. Even low levels of inflation build up significantly over time.
In fact, at 3% inflation, it would have taken only 20 years for the TFSA limit to reach $10,000 per year under the old rules. So, in 2 decades or so, this so-called TFSA limit increase will start to look like a TFSA cut. Older Canadians will benefit from a higher TFSA limit now, but younger Canadians will eventually need the $10,000 limit to be raised to counter the effects of inflation.
Turning our attention to unused TFSA contribution room, inflation is a kind of leak in your available room. Any unused room is a fixed dollar amount that doesn’t rise with inflation. This isn’t a consequence of removing the indexing of the TFSA limit; it was true before the change and it’s still true now. When you invest TFSA contributions your returns tend to counter inflation, but unused room declines a little in value every year.
Whenever you think of money over long periods of time, it’s important to account for inflation. If we do this properly, it changes the discussion of the TFSA limit change in important ways.
Hi Mike;
ReplyDeleteThis is similar to when I converted my Target fund in to an RRSP. The secretary said "well at least you didn't lose any money" as it was basically the same value. I told her I had lost 2% per year because of inflation. She had not bothered to mention that little hiccup.
A 7% yield is only 5% and if it is a non-registered account then your 5% is more like 3.5%. Still better than anythign on th emarket but you need to be realistic on just how much you are putting in your pocket. Over time than 3.5% does add up and is well worth the while.
RICARDO
@Ricardo: You're right that it's returns over inflation that really count.
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