TFSA or pay down debts
The Tax Free Savings Account (TFSA) is big news in the personal finance world. These new tax free accounts have brought about lots of discussions not only about the TFSA basics but also some new and interesting debates. Not too long ago, I discussed the new debate between TFSA or RRSP and came to a conclusion that both have merits. Just these past couple of weeks, I have run into three situations where people are debating between TFSAs and paying down debt. Although I’m a big fan of the TFSA, I came to the conclusion that it may make more sense to pay off debts than keep money in the TFSA.
Credit card debt vs TFSA in savings
Joanne is in her early 30’s working for a software company. Although she has a $6500 credit card balance because of a vacation she took this year, she makes enough income to manage the payments and plans to have the balance paid off before the end of the year. Joanne also has $5000 in her TFSA making less than 1%. The math is really clear that every day she is paying 18% on her credit cards and making less than 1% in her TFSA, she is making the bank a lot of money. When I suggested that she should cash out the TFSA and put it directly against the credit card balance, she was worried that she would not have any emergency money left. As much as I can appreciate the importance of having an emergency fund, the math suggests that she will have the credit card paid off within 2 months and then she can aggressively build up her TFSA again.
Mortgage vs TFSA savings
Amanda and Gary are in their early 40’s with 2 children and quite involved in their financial affairs. They currently have a mortgage of $200,000 at a 4% interest rate and plan to have the mortgage paid off in 15 years. Gary contributes about 14% of his pay to RRSPs through payroll deduction and employer contributions. They each have $11,000 in their TFSAs and hope to put another $5000 lump sum each into the TFSA. Just like Joanne (above), they like the idea of having the TFSA as an emergency fund and as a result, the interest they are making is about 1%.
Although the math is not as extreme when comparing the TFSA return to credit card debt, the math still works in favour of paying down the mortgage. If you have an account earning you 1% while having debt that costs you 4%, you are going backwards. Putting the TFSA money towards the debt is the equivalent of earning 4% on the money instead of 1%.
Amanda and Gary have a $25,000 unsecured line of credit in Amanda’s name from early in their marriage. They have used this line of credit only once and had is paid off within a few months. Given their discipline and aversion to debt, they are prime candidates to use the Line of credit as their emergency fund. For those that lack discipline, a line of credit can be problematic.
What should you do with extra cashflow?
Melinda and Santos are about 5 years to retirement. Although they are mortgage free, they do have a $50,000 line of credit they want to have paid off by the time they retire. They are paying $1000 per month directly to the line of credit. They are also putting $500 per month to the TFSA into low interest savings to also supplement their retirement spending. Would that $500 per month be used more effectively if it went directly to the line of credit instead of the TFSA?
By putting the $500 per month towards the line of credit, they are earning the equivalent of 5% due to the interest savings. They are not earning anywhere near that in their TFSA. By putting the entire $1500 per month directly to the debt, they would have it paid off in 3 years and then could aggressively build up the TFSA then. I’ve refered to this in the past as the principles of cashflow.
Some final thoughts . . .
I run into so many people that are not investing their TFSAs. If you are going to keep TFSA money in low interest savings, you may be better off using the money towards debt than keeping it in the TFSA.
If you have credit card debt at high interest costs, then no matter what you invest in, you should consider the merits of paying down credit card debt instead of investing in TFSAs.
Although these three examples are based on real life people and real life situations, they merely serve as examples. The best way to tackle any financial debate like the TFSA vs RRSP or the TFSA vs paying down debt, remember that everyone has unique circumstances and individual planning is always recommended.
Instead of telling people they should be ditching their emergency fund for a higher return alternative, you can help them by analyzing their choice of keeping cash.
A line of credit is not the same thing as an emergency fund, and everyone has different comfort levels with regards to debt and cash-in-hand.
You’re technically correct that that cash would have better returns elsewhere over the long run, but everyone needs some amount of safety. You should not be telling people to give that up. You can at best educate them on what that choice is costing them, and they can make an informed decision.
Part of the point is that TFSAs are so new, many people are not really using them properly. Many people are buying them ‘just because’ they are getting a lot of hype. It’s important for people to think and make sure they are using their money effectively.
This may be a controversial statement but I do not think everyone needs an emergency fund. The irony is that good savers probably need emergency funds less. Disciplined people can access emergency money differently. I’m also not sure that everyone needs the ‘traditional’ example of an emergency fund.
That being said, you are right. Some people are better off keeping their emergency fund instead of paying down the debts despite the math but as I said, all planning is personal.
Another way to address this is to invest the emergency fund better or differently.
I totally agree with you Slacker. And the “Mortgage vs TFSA savings” portion of this article is more interesting.
I totally agree with Jim. Joanne is not “ditching her emergency fund” she is better utilizing her resources and claiming what would otherwise be bank profits for herself. She still has an “emergency fund” in the freed up credit card limit.
@jim – You are absolutely correct. Some people do need an emergency fund. My sister is one of them. She is an over spender to the max. As soon as her check comes it, it goes out. Myself on the other-hand, I have built up some savings and choose to live frugally and pay down debt. I never want to fall into a situation when I don’t have the cash I need.
So if she is the overspender, is she better off having an emergency fund or paying down some of the debt that comes from being an overspender?
I really think she needs money management classes. It seems that for the most part she will only pay off debt when it goes to collections. For this reason an emergency fund would be necessary for her.
I would have no problem advising anyone to pay off credit card debt rather than have money sitting in a TFSA. Credit card debt is just plain BAD, unless it is paid off fully at every statement. It makes NO sense to have cash sitting in a TFSA as an emergency fund if you owe thousands on a credit card at 18%. It’s a no brainer.
I would further advise that if a person has to pay 18% interest on funds used for a vacation, they should not have taken the vacation. JUST SAY NO!
Well said and tough to argue against common sense.
I’d have to disagree with you there. Even though credit cards do have higher interest rates, having cash on hand gives you the biggest benefit: time. In an upside-down situation, with no money in your pocket, you cannot pay down your debts regardless of how big your debt is. You can “buy” time by paying your credit card with minimum payments and higher interests. Then, use that time to think of ways to cut back on spending or generate income to further reduce the debt.
Gotta agree with Jim and Flo who seems to have a good grasp of financial concepts.
JS, I find it hard to imagine how paying 18% interest for a longer time gives you the “biggest benefit”.
TFSA vs debt, very good information.
If a person has no debt, is retired with a Defined pension, but in a low income bracket, should that person buy TFSA’s or RRSP’s, if that person has money to invest?
The RRSP is superior to the TFSA only if there is a lower tax bracket in your future. If your tax bracket will remain constant, or is expected to increase, or you don’t know, go with the TFSA.
Jim, I agree with you completely that paying down debt makes more sense than the TFSA….. Now let me lead you a little further.
As you are probably aware, most financial advisors contend that the RRSP and the TFSA are equal as long as your tax bracket does not go down at withdrawal time. Surely you agree?
Approximately 65% of Canadian taxpayers are currently in the lowest tax bracket (under $45,000). For ALL of these people, the RRSP is equal to the TFSA as there is no hope of a lower bracket.
You have correctly demonstrated that paying debt is better than the TFSA. If the RRSP is equal to the TFSA then surely paying debt is also better than the RRSP for most Canadians (at least the 65% under $45,000).
For years I have been trying to convince people that paying debt is priority one, and TFSA is next best for most people and RRSP is next best. You may recall that we have had this discussion previously. Are you coming to my way of thinking?
Paul Rastas, CPA, CA, CFP