To TFSA or not: Why you should think about paying down debt first

Here’s a new idea: instead of following the crowds pumping unthinking amounts of money into so-called Tax Free Savings Accounts (TFSAs), how about paying down some of your own debt?

In fact, consider completely eliminating all your debt before venturing anywhere near a TFSA. This is especially true of “bad debt” such as credit cards, consumer loans and mortgages on your principal residence. This debt is bad because your interest expense is not accompanied by a tax deduction. Examples of “good debt” include investment loans and mortgages on rental properties where your interest expense is a tax deduction.

Beware that the banks and other financial institutions would like you and your family to have lots of TFSA deposits. At the same time the banks wish you to burden yourself with loans, mortgages and outstanding credit-card debt. In reality you borrow your own money. In effect, the banks profit by renting your own money back to you.

This might not be so bad if it weren’t for the massive spread involved. Your $5,500 TFSA deposit might earn 2.5% for annual interest income of $138 on which you might have paid about $50 in taxes. That’s less than a dollar a week in taxes saved. However, an outstanding credit card balance of $5,500 costs annual interest expense of $1,100 at the 20% charged by most banks. Remember that’s an after-tax figure. To have $1,100 in your pocket to pay the credit card interest expense, you have to go to work and earn about $1,700 before income tax depending on your tax bracket. The before-tax cost of your credit card is actually about 31%. The spread.

Better no TFSA at all if it means having less bad debt. This is true of almost all debt as the spread always favours your lender.

As columnist Jane Macdougall recently rejoiced in the Weekend Post as the nation’s attention turns to financial matters (“Burn Notice: The pleasures of putting your financial feet to the fire” Jan. 3, 2015): “I called up a friend to see what she had to say about where the money goes. She couldn’t come to the phone as she was confined to bed with a severe overdraft.”

In street parlance, many bank customers are being hosed. Perfectly legal.

Elsewhere on the same day in the Financial Post (“Five ways to kick-start tax savings” Jan. 3, 2015) a bank-employed tax expert advised: “After all, there is really no reason anyone should have anything invested in a non-registered account if you haven’t maximized your cumulative TFSA contributions.”

Really really? Surely being debt-free makes for better TFSAs than non-registered investments, doesn’t it?

On the same page as the tax expert, the Family Finance feature at last made the infrequent suggestion to Harry and Priscilla of sacrificing all TFSA monies to partially crush their mortgage. (“Couple worry whether they can keep quality of life in retirement – and own a winter home in the sun” Jan. 3, 2015)

Well done.

As columnist Garry Marr outlined in three recent front page Financial Post articles (“Fat TFSAs in taxman’s crosshairs” Dec. 2, 2014, “TFSA audits raise fears of wider tax grab” Dec. 3, 2014, “Investors locked out of TFSAs under audit” Dec. 4, 2014) there can be real frustration if your TFSA makes so much money that you might not be allowed to keep your money. If you know what you’re doing or you’re really clever or you just get lucky once in a while, then you would think your TFSA is the perfect investment vehicle for you. Perhaps not in the eyes of Canada’s income tax authority.

Maybe the best thing to do (once you’re free of bad debt of course) is to invest your TFSA money in the common shares of your bank.

Spread the joy of the spread!

Christopher Cottier is an advisor at Richardson GMP, Canada’s largest independent investment dealer. The opinions expressed in this article are those of the author and readers should not assume they reflect the opinions of Richardson GMP Limited, Member Canadian Investor Protection Fund.