What you earn in a TFSA is largely tax free (except there could be withholding taxes on foreign dividends). So, you want to aim to maximize the money you make in your TFSA.
Here are three big mistakes you should avoid in your TFSA to take the best advantage of the wonderful tool that shelters your money from taxes.
Not making full contributions every year
You’re stepping in the right direction if you have contributed to your TFSA. However, many investors aren’t making full contributions. For example, if they’ve only made half of the contributions every year since the inception of the TFSA in 2009, they would have lost about $20,500 of tax-free returns, assuming a modest total return of 10% per year.
This is lots of money that could be used for a luxurious vacation or fast tracking the pay back of your mortgage. Ideally, though, you want to keep that money in your TFSA to compound tax-free for even more returns to secure your financial future.
Earning interest income with low returns
If you want 10% or higher returns, you’ve got to invest in stocks. Investing in bonds or GICs aren’t going to cut it. Historically, bonds have delivered lower returns than stocks in general, while there’s still volatility in bond prices. Needless to say, GICs deliver the lowest returns, as it guarantees the security of your principal amount.
Although stocks are the most volatile (and viewed as the riskiest) of the three, investors can choose to buy quality stocks at discounted prices to greatly boost their returns and reduce their risk.
Sell out of your quality dividend-growth stocks
The biggest gains are made from long-term investments in high-quality businesses. Canadian National Railway (TSX:CNR)(NYSE:CNI) is among the cream of the crop for quality and dividend growth that I regret selling in my earlier, naive days as an investor.
Here’s a long-term stock price chart of CN Rail stock.
CNR data by YCharts.
Specifically, since 2007, before the last recession occurred, CN Rail has delivered total returns of about 14.6% per year, which roughly doubled the market returns!
Additionally, its dividend is five times what it was, increasing from an annual payout of $0.42 to $2.15 per share. The January dividend hike of 18.1% was very impressive for a nearly $90 billion market cap company that has increased its dividend for 23 consecutive years.
As one of the few Class I railroads in North America, CN Rail has a large network that brings in more than $14 billion of annual revenue and enjoys very high operating margins of about 40%. Its recent net margin of 30% was nothing to sneeze about either!
Importantly, CN Rail consistently enjoys very high returns on assets (ROA) and returns on equity (ROE). Its five-year ROA and ROE are roughly 11% and 26%, respectively. These indicators suggest a very solid investment idea.
It would be a shame to sell out of quality dividend-growth stocks like CN Rail for short-term gains. Instead, we think it makes the most sense to buy such stocks when they’re a good value and hold them for the growing dividends and long-term price appreciation.
CN Rail stock currently offers a low dividend yield of 1.7%. However, its growth and dividend-growth potential are solid for the long haul. At about $124 per share as of writing, CN Rail trades at a forward price-to-earnings ratio of about 20. Therefore, the stock is pretty fully valued.
If you’re looking to buy (more) shares, you should wait for a meaningful dip. For example, investors can take the opportunity to buy shares at a cheaper price in a market-wide correction.
If the stock dips to a forward multiple of 18 or roughly $110 per share or less, it would be a good time to start buying the long-term core dividend holding in your TFSA.
If you have a long investment horizon to grow your wealth in your TFSA, it makes good sense to buy great businesses that pay you increasing dividends. That’s the Foolish way anyway.
When you buy heavily cyclical stocks at low prices… and then hold the shares until the cycle reaches its peak… you can make a very healthy profit.
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Fool contributor KayNg has no position in any of the stocks mentioned. David Gardner owns shares of Canadian National Railway. The Motley Fool owns shares of Canadian National Railway. Canadian National Railway is a recommendation of Stock Advisor Canada.