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ROB CARRICK

Why you shouldn't be tempted by the higher cap on TFSAs Add to ...

You can put an extra $500 in a tax-free savings account next year, but don’t do it.

TFSAs have had an annual contribution cap of $5,000 since their introduction in 2009, but on Monday the federal Finance Department said the limit will rise to $5,500 next year as a result of increases in the cost of living.

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There are better uses that many people can put that extra money toward. Paying down debt is far and away the best example, but there are others. Parents who aren’t making full use of registered education savings plans should put the money there. A charitable donation is a third option.

I have nothing against TFSAs. They’re a model of practical versatility – useful for saving for a vacation or a home down payment, holding an emergency fund, long-term investing for retirement or even active trading in the stock market.

The flexibility of TFSAs has helped them achieve a very high level of popularity already. A survey by Canadian Imperial Bank of Commerce issued last summer showed that almost one in two people have them. Now, what else might some of these people have on their personal balance sheets?

Mortgages and other borrowings, for one thing. Paying down these debts would be a great use of the $500 that has been added to the annual TFSA contribution limit. Let’s examine the usual objection to paying down debt as opposed to investing, which is that the potential rate of return on investments today easily beats the low cost of borrowing.

This is true in many cases. People who bought a house in the past couple of years most likely have a mortgage rate in the range of 3.5 per cent or less. There are about 90 stocks the S&P/TSX composite index with higher dividend yields than that.

But such logic is wasted on people who spend much of their household income on debt repayment. Debt is considered so acceptable today that people have lost the old sense of discomfort about it. They consider their bloated mortgage payments and line of credit debt payments simply as line items in their household budgets along with groceries, heating and hydro.

People are so used to debt that they’ve forgotten the big reward when it’s paid off. However much you were paying on your debt, that’s how much your monthly cash flow increases. Putting $500 down against your debts might just hasten the day when you find yourself with $500 more a month to play with.

Credit card debt should be paid down first because of astronomical interest rates around 20 per cent. But let’s assume that people who would contemplate a higher TFSA contribution wouldn’t dream of carrying a card balance. A line of credit balance is another matter. The affluent use credit lines to live the life of the even more affluent.

And let’s look a bit more closely at that mortgage debt, which can be massive if you bought recently in one of the higher-priced cities and made either the minimum 5-per-cent down payment or near to it. Making a mortgage prepayment in the early years after you buy gives you the most efficient use of your prepayment dollars in terms of saving on interest.

A mortgage prepayment today would also help recent buyers prepare themselves for renewal in a few years at higher interest rates. The smaller your outstanding mortgage balance, the less impact higher rates will have on the amount of your mortgage payments on renewal.

For parents, taking $500 that would otherwise go into TFSAs and using it in your kids’ RESPs makes good sense. The federal government’s Canada Education Savings Grant gives you a 20-per-cent matching grant for RESP contributions of up to $2,500 per year, which means your $500 becomes $600 in fairly short order. Rates of return like that are hard to come by in the market.

The arguments in favour of making RESP contributions usually focus on the high and fast-rising cost of a post-secondary education. It can cost as much as $20,000 per year to get an undergrad degree out of town. Help your child get a good education and the chances of him or her moving back home decline. There’s another return on money that you put into an RESP, instead of a TFSA.

Finally, how about donating the amount of next year’s extra TFSA room to charity? If you have a TFSA, you’re in a better financial position than all kinds of people here in Canada and elsewhere. The holiday season is an ideal time to share the wealth.

For more personal finance coverage, follow me on Twitter (rcarrick) and Facebook (Rob Carrick).

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