This year investors have $5,500 of TFSA contribution room in addition to any contribution room they have left from previous years. A TFSA is a great place to invest and save in because what’s earned inside is tax free.
This means you get to compound your investments without the dampening effects of taxes. Further, you can withdraw from a TFSA anytime without any penalties (unlike an RRSP). What’s more? You don’t pay any taxes on TFSA withdrawals. And the withdrawals don’t affect your federal income-tested benefits and credits.
If you contributed the maximum-allowed amounts to a TFSA since 2009, you would have contributed a total of $41,000 by 2015. Assuming you made your contributions at the start of each year and earned a 6% rate of return, the $41,000 would have turned into $45,795.
You may think that earning $4,795 is not much for seven years. However, remember that much of the money was added along the way. The $10,000 contribution you might have made for 2015 wouldn’t have started working for you until you invested it in 2015.
Compounding becomes more and more powerful over time as your investments get bigger. If you continue investing $5,500 in a TFSA at the start of every year for the next 10 years, you will invest $55,000. If you earn a 6% rate of return, at the end of the decade your investments will turn into $76,844.
Your total investment of $96,000 from your hard-earned money will transform to $158,856 in a 17-year period. Dividend stocks such as National Bank of Canada (TSX:NA) and Inter Pipeline Ltd. (TSX:IPL) pay yields of 5.7% and 7.2%, respectively. So, if you’re willing to look, it’s not difficult to target a minimum rate of return of 6%. Most of that return can come from dividends, which are more predictable than stock prices.
Withdraw anytime tax free with no effects on benefits
What you withdraw from a TFSA is not counted towards your income, so you don’t pay any taxes when you withdraw from a TFSA. Further, these withdrawals don’t affect your federal income-tested benefits and credits such as old age security benefits, the guaranteed income supplement, and employment insurance benefits.
There are many types of investments allowed in a TFSA including cash, GICs, mutual funds, stocks, and bonds. However, mutual funds and stocks are likely the types of investment that would give you the 6% rate of return over the long term.
Don’t wait. Contribute regularly to a TFSA, so you can get your money to compound tax free and start working for you.
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Fool contributor Kay Ng owns shares of INTER PIPELINE LTD.