Using a Tax Free Savings Account (TFSA) in Retirement

The Tax Free Savings Account is still a relatively new way to save in Canada. It was introduced by the Conservatives in 2009 as tax-advantaged account unique from the RRSP.

Modeled after the Roth IRA in the U.S.A. and the (much better) ISA in the U.K., a TFSA allows you to contribute after-tax money to an account up to a specified annual limit that increases every few years with inflation. Unused room is carried forward indefinitely.

Once the money is in a TFSA account, you can invest in anything from stocks and ETFs to GICs. Or you can open a simple bank savings account in a TFSA format that earns pitiful interest.

Although the name can be confusing, the TFSA is a flexible account structure, not just a place to park your money at the bank for 0.6% interest. To invest in ETFs and stocks, you should open a self-directed TFSA with a brokerage like Questrade.

All of the investment returns earned within the account are completely exempt from all Canadian taxes, including standard income tax and investment taxes such as dividend taxes and capital gains taxes. Wisely invested, a TFSA should grow into a million dollar account over a lifetime.

As long as you are careful not to double contribute, money can be withdrawn from your TFSA account at any time without penalty. This makes the TFSA an ultimate investment account in terms of flexibility!

Withdrawals from a TFSA are not even reported on your tax return. It is as if you earned nothing at all! The benefits of this should not be understated.

TFSA Statistics

Right now the vast majority of Canadians are wasting the value of this awesome tax advantaged account.

To explain, here are some statistics on TFSAs straight from the CRA.

Canadians with TFSA Accounts:  12,731,020 (about one-half of adult Canadians)
Canadians who Maximized their TFSA:  1,249,900
Average Unused TFSA Room:  $24,191.99
Average Account Value per Holder:  $15,205.96

Even the wealthiest Canadians, those individuals earning over $250,000 per year, are ignoring the power of TFSAs. Of these wealthy Canadians who even bothered to open a TFSA, the average account value lingers around $30,560.

If you were over the age of 18 in 2009 when TFSAs were introduced, there is no reason why you shouldn't have $60,000 or more in your TFSA right now. That is $5,000 contributed every year returning 6% per year. (We have been in a bull market after all...)

Best Use for TFSAs

The TFSA should be used for one thing, and one thing only. Retirement savings! But as I will clarify later, a specific kind of retirement savings.

Any suggestion that TFSAs can be used to save for a new car, buy a house, buy new furniture or a new TV, vacations, or anything else should be dutifully ignored and even scorned.

Anyone who depletes a TFSA while they are young to buy something is a complete idiot! And count me in that category since I did exactly that with my ~$20,000 TFSA in 2011 when I bought a house.

Thanks to aggressive saving after realizing my idiocy and good investment returns, my TFSA and my wife's TFSA are both back in the $70,000 range.

The problem with making early withdrawals from your TFSA is that you lose the investment returns on the withdrawn money.

Plus, if you let the contribution room get away from you, it can become nearly impossible to catch up on your contributions.

If you take just $15,000 out of your TFSA to buy a house when you are 25, you will be $155,000 poorer at 65 years old. That's a wasted potential tax-free investment gain of $140,000.

A TFSA for Retirement

The TFSA account should be used in conjunction with an RRSP (or pension) to save for retirement. When carefully done, you can achieve amazing wealth with extremely low tax liabilities in retirement.

$1,000,000

Source: PortfolioVisualizer.com

If you would have saved just $5,500 a year ($458 per month) for the past 30 years, you would have seen your account grow to $1,000,000.

Returns since 1987 were good, but there's absolutely no reason to believe this won't happen again over the next 30 years. Your TFSA can be worth some real serious money if you invest assertively.

If you get past the constant drama of the naysayers, there is truly no better time financially to be a young saver in Canada! Ignore the mourning of those disappearing crappy workplace pension plans, the TFSA in your own hands is a much better tool.

A TFSA offers fantastic flexibility, affluence, and freedom from taxes. Three things a workplace pension cannot give you.

Effective Use of a TFSA in Retirement

In your retirement savings strategy, your TFSA will form just one component of your total retirement income.

First, there will be the fully taxable income which you cannot control to any significant degree. This includes things like government benefits and workplace pensions.

You may be surprised that this annual income is likely to be $15,000 per person, or more. If you have a larger RRSP or a workplace pension, it can be significantly higher.

By their design, the minimum seniors income after all government benefits is likely to cover the basic costs of living if you have a paid-off residence. A combined annual income of $30,000 should pay for things like utilities, food, a vehicle, and basic entertainment.

Also, after seniors tax deductions, an income of $15,000 per person will be completely tax-free in nearly every province. It may actually qualify you for additional benefits in some provinces.

A TFSA can be perfectly paired on top of this foundation of basic income to keep you completely tax-free in retirement and fully eligible for every government benefit that is accessible to you.

TFSAs should be used as a highly tax efficient way to pay for the extras, especially lump sum expenditures, without jeopardizing your benefits.

TFSAs are a very tax efficient way to pay for things like home renovations, large vacations, new vehicles, or other high cost items.

If you have a larger TFSA, one worth approximately $1,000,000, you can live a truly luxurious tax-free retirement. We know that an account this size can afford annual withdrawals of $40,000 to $50,000 a year.

If both partners in a relationship have large TFSAs, a tax-free investment income of $80,000 to $100,000 a year plus government benefits of $30,000 is a very real and foreseeable scenario for high saving Canadians.

One issue is there already have been discussions about using TFSA values when determining qualification for low income benefits.

It is all but certain sometime in the next decade or two, as TFSA values expand, TFSAs will be considered when applying for benefits. There is a reason why the CRA is tracking this stuff.

Although total net worth and lifetime tax-adjusted net worth may not necessarily be the highest when using a TFSA compared to a RRSP, the TFSA forms a very important part of your retirement savings options.

The flexibility and ease of use of TFSA's are unmatched!

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How Does Dual Momentum Perform with Leverage

Dual Momentum is a great way for a self-directed investor to take advantage of a simple investment method which has provided higher than index historical returns with lower drawdowns.

My Time Averaged Dual Momentum model uses an average of the 6 month past performance and 12 month past performance in the Dual Momentum analysis. The 48 year backtest shows annual returns averaging more than 16% per year with a max drawdown of 22.47%.

I detail my Time Averaged Dual Momentum model analysis on the Portfolios page of this blog. The page also includes a backtest showing simulated historical results going back to 1970 comparing my Time Averaged Dual Momentum to an equal weight buy-and-hold strategy (66% equities with 33% bonds) over the past 48+ years.

Dual Momentum—as popularized by Gary Antonacci—evaluates three main asset classes. The two equity assets are U.S. stocks compared with International stocks in a relative momentum test.

Following this, the best performing equity asset is compared to the risk-free rate of return—represented by Treasury bills—in an absolute momentum test. The best performing asset is the investor's sole holding for the next month.

Pros and Cons of Leverage

Understanding Problems with Leverage

From what I've gathered reading Gary Antonacci's work, he has typically frowned on the idea of adding leverage to the Dual Momentum model.

His response goes something like this: Dual Momentum still has a lot of short-term volatility, leveraged products (like ETFs) have their own issues which make them less efficient than you think, and the consequent drawdowns of added leverage are likely to be too high for many people.

I don't disagree with most of Gary's perspective. Dual Momentum is designed to be a less risky investment strategy that is easy to follow. Low relative drawdowns means more "stick-with-it-ness" for the average investor.

The value of sticking to a good investment strategy should not be underestimated. Both self-directed investors and professional advisors are notorious for their poor long-term performance purely due to strategy changes and fund turnover.

According to Dalbar studies, the average investor is better off investing 100% of their portfolio in intermediate duration Treasury bonds than trying to invest on their own with various equity strategies.

Aggressive strategies will typically fail in the long run for most investors. Not because the strategy itself failed, but rather because the human executing the strategy failed to keep their emotions in check.

Benefits of Leverage

All this said, I am still a big proponent of proper use of leverage in self-directed investor portfolios. For the smaller group of investors out there who are seeking high overall returns, leverage is the only consistent option.

Other promoted high return strategies are often timing period based, temporary, or inconsistent. Winning stock picking strategies come and go, isolated sector bulls come and go. Even factor-based advantages are not always a great choice.

Proper, risk-adjusted use of leverage is a consistent way of gaining an advantage on the broader markets. This includes use of leveraged ETFs when paired appropriately with safer assets like Treasury bonds, or even short-term high-grade corporate bonds.

Adding Leverage to Dual Momentum

There are two main methods an investor can use to employ leverage with their Dual Momentum strategy.

Using margin to buy standard ETFs is often the better choice in non-registered investment accounts. This eliminates tracking error issues and provides access to a broad range of high volume ETFs.

You can generally deduct the interest expenses on your tax return when you borrow money used to purchase an investment in a non-registered account.

Also, your margin loan interest rates in a good non-registered account are likely to be very competitive at brokerages like Interactive Brokers.

Leveraged ETFs are typically the better choice for accessing leverage in registered accounts. When you borrow in a registered account, you are likely going to pay extremely high interest rates to your broker. In addition, you will not be able to deduct those interest costs from your income on your tax return.

On the U.S. stock exchanges, there are several options for leveraged ETFs for each asset class. Thanks to their growing popularity, there are a number of very high volume ETFs with thin trading spreads.

In my evaluations for adding leverage, I did a monthly readjustment on the leverage. This will vary somewhat from real-world results if you use a daily leveraged ETF, or if you leverage up manually with use of margin. However, the results should be fairly close to both of these methods.

I only applied leverage to the portfolio with the TADM signal was in equity holdings. When the signal is in the bond allocation it rarely makes sense to use leverage as the return differential is not as large.

Adding 1.25x Leverage

I performed three separate leverage tests. This first test was leveraged 1.25x, or adding 25% exposure to the base allocation.

I chose this leverage factor as it is available in the market in ETF format thanks to the Portfolio+ ETFs which are listed on the U.S. exchange. Trading volume is still light in these products, but should be satisfactory for a smaller self-directed investor.

The Portfolio+ products have a current expense ratio of approximately 0.4%. I adjusted the returns down on a monthly basis for each month the portfolio was in equities to reflect the increased cost of this leveraged product compared to standard ETFs.

Source: TheRichMoose.com

TADM with 25% Added Equity Leverage Statistics

Compounded Annual Return:  +19.19% (48 years)
Largest Annual Gain:  +91.66% (1986)
Largest Annual Drawdown:  -12.31% (1973)
Peak to Trough Drawdown:  -29.97% (1973-1975)

Adding 1.5x Leverage

The next leverage test I performed was increasing the equity exposure by 50% on a monthly adjusted basis.

This level of leverage exposure on equities is not currently available in ETF format. If you want to follow a 150% exposure model in a registered account, I would recommend using 2x leveraged ETFs with 75% of your account and leave the remaining account in cash or short-term bonds.

The cost of a 2x leveraged ETF is approximately 0.9%, an increase of about 0.8% over standard ETF products. I adjusted the returns down on a monthly basis for each month the portfolio was in equities to reflect the increased cost of using leverage.

Source: TheRichMoose.com

TADM with 50% Added Equity Leverage Statistics

Compounded Annual Return:  +22.01% (48 years)
Largest Annual Gain:  +115.00% (1986)
Largest Annual Drawdown:  -16.13% (1973)
Peak to Trough Drawdown:  -37.09% (1973-1975)

Adding 2x Leverage

The next leverage test I performed was increasing the equity exposure by 100% on a monthly adjusted basis, effectively doubling the exposure for each signal change.

There are a number of ETFs on the market with 2x leverage on a daily adjusted basis. Even the Canadian exchanges have 2x leveraged products provided by Horizons ETF.

It is also easy to double your exposure with margin loans in a non-registered account. Most margin loans will require 33% equity on the loan. This means a 2x exposure is about as high as you want to go with adequate safety to prevent margin calls.

The cost of a 2x leveraged ETF is approximately 0.9%, an increase of about 0.8% over standard ETF products. I adjusted the returns down on a monthly basis for each month the portfolio was in equities to reflect the increased cost of using leverage.

Source: TheRichMoose.com

TADM with 100% Added Equity Leverage Statistics

Compounded Annual Return:  +28.45% (48 years)
Largest Annual Gain:  +170.41% (1986)
Largest Annual Drawdown:  -23.36% (1973)
Peak to Trough Drawdown:  -49.17% (1973-1975)

Summary

My Time Averaged Dual Momentum model would have performed extremely well when adding leverage to increase the holdings when the signal is in U.S. or International stocks.

The results are simply outstanding, increasing up to a compounded annual return of nearly 30% per year for 48 years at a 2x leveraged equity level. That is a better result than Warren Buffett, John Templeton, and Peter Lynch achieved.

To put that result into some perspective, if you have $100,000 today and you invest in the 2x leveraged model for the next 30 years without any deviation, your portfolio would grow to approximately $183,000,000. (Provided, of course, that future returns are similar to past returns and the costs of leverage stay similar to what they are today.)

However, with increased leverage, Dual Momentum ceases to be a fantastic investment approach for risk-averse individuals. Once you take on a strategy with expected 50% drawdowns, would you be able to stick with the strategy when those drawdowns go to say 60% or higher?

Remember, when you have a model that is historically backtested over an adequate time period, you still need to expect your extreme results to be 25% worse in the future.

Personally I like the 1.25x model for an investor who is looking to add a bit of an edge to their Dual Momentum portfolio. With just 25% leverage, the daily re-balanced ETFs still track very well to the index over long holding periods.

Adding 25% with a margin loan is also very feasible, low risk, and low cost. There is almost no chance of a margin call, plus this leverage amount is easy to maintain on a monthly basis. The leverage is unlikely to run away from you from the time you enter a new position to the time the signal changes to a new position.

Of course a 19+% return compounded over 30 years should not be minimized. That would grow a $100,000 portfolio today into more than $19.3 million dollars. Alternatively, investing $500 a month for 30 years would grow to $9.57 million.

The volatility at 25% leverage is still amazing at less than 20%! Historical drawdowns are under 30%, annual losses of less than 15%, and annual gains up to 91%!

Although a somewhat imperfect measure as the extreme results are tilted to the upside in Dual Momentum, a 25% leveraged TADM model has an impressive Sharpe Ratio of 0.863.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.