Young Canadians have a great tool to help them set aside some significant cash for retirement. They just need to use it wisely.
The power of the TFSA
Any Canadian resident who was 18 years old or older in 2009 now has as much as $52,000 in contribution room in his or her Tax-Free Savings Account (TFSA).
The TFSA is designed as an all-purpose savings tool, but the real power of the vehicle lies in the ability it gives investors to buy dividend-paying stocks and channel the full value of the distributions back into new shares.
All income earned inside the TFSA remains tax-free, so investors don’t have to set aside part of the dividends for the taxman, and when the time comes to cash out, all the capital gains go straight into your pocket.
Why reinvest the dividends?
The secret to building a large savings fund lies in the power of compounding. When dividends are reinvested in new shares, the process starts to feed itself, and over time a modest initial investment can turn into a serious pile of money.
Which stocks should you buy?
The best companies have strong track records of dividend growth and operate in industries with large barriers to entry.
Let’s take a look at Canadian National Railway Company (TSX:CNR)(NYSE:CNI) to see why it has proven to be a strong pick.
Wide moat
CN is the only railway in North America with a rail network that offers customers access to three coasts. The company has enjoyed the advantage for years, and the situation is unlikely to change.
Why?
Mergers in the rail industry tend to run into significant regulatory roadblocks, and the odds of new rail lines being build alongside existing routes are pretty slim.
CN has a rail-network advantage, but the company still competes with trucking companies and other railways on some routes. As a result, management works hard to make sure the business is running as efficiently as possible.
In fact, CN is widely viewed as the best-run company in the sector and regularly reports an industry-leading operating ratio.
Dividends
Dividend investors often look at CN’s low yield and skip the stock, but that is a mistake. The growth rate is what really matters.
CN just increased its dividend by 10% and has a compound annual dividend growth rate of about 16.5% over the past decade. The business generates substantial free cash flow, so investors should see the strong trend continue.
Returns
A single $10,000 investment in CN 20 years ago would be worth about $362,000 today with the dividends reinvested.
There is no guarantee any stock will repeat its historical performance, but the technique of buying top dividend-growth stocks and reinvesting dividends has made many passive investors quite rich over the long haul.
