The Motley Fool

Avoid Making This Mistake With Your TFSA

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Tax-Free Savings Accounts (TFSA) offer investors a range of advantages, which are aimed at promoting long-term wealth creation and financial independence. Regrettably, many Canadians fail to use TFSAs correctly. A common error, according to many financial advisors, is that Canadians use their TFSAs to hold low-return-generating assets such as cash, GICs, and bonds.

According to a Bank of Montreal report, 80% of TFSAs contain cash and GICs. This means that many Canadians are failing to take full advantage of the accounts tax-sheltered status, where essentially all capital gains, dividends, and interest paid are tax free for the life of the investment. By parking cash in a TFSA, Canadians are wasting a significant once-in-a-lifetime opportunity to build wealth and ultimately achieve financial independence.

Accelerate wealth creation

TFSAs are ideal vehicles for long-term investing and building wealth because of their tax-sheltered status, which accelerates the returns that can be generated over a relatively short amount of time. Another important tool to consider is the power of compounding. Essentially, by reinvesting the dividends received, investors can magnify the returns generated, thereby reducing the amount of time required to meet their goals.

One of the most effective ways of taking full advantage of the benefits provided by a TFSA is to buy quality dividend-paying stocks with strong growth potential, wide economic moats, and that offer a dividend-reinvestment plan (DRIP). By choosing stocks that possess these characteristics, investors can accelerate wealth creation, improve their portfolio’s ability to weather economic downturns as well as bear markets, and cost effectively access the magic of compounding.

You see, a DRIP allows investors to use their dividend payments to acquire additional stock at no extra cost. Over time, this is a powerful tool for building wealth, especially when the company has a long history of regular dividend hikes.

Quality dividend stock

A top dividend-paying stock that offers a DRIP, pays a regularly growing dividend, operates in an industry with oligopolistic characteristics, and benefits from the relative inelastic demand for its products and services is National Bank of Canada (TSX:NA). The bank reported some solid numbers for the third quarter 2019, including a 7% year-over-year increase in net income, an efficiency ratio of 53.5%, a common equity tier one capital ratio of 11.7%, and a gross impaired loans ratio of 0.44%. That underscores the quality of its operations and balance sheet, making it an ideal long-term investment.

National Bank offers investors a DRIP, which allows them to use their dividends to acquire more shares at no additional cost, thereby accessing the power of compounding without extra brokerage costs diminishing returns. The bank has one of the best histories for increasing its dividend among the Big Six, having hiked the payment for the last nine years to yield a juicy 4%. The dividend is clearly sustainable when it is considered that it has a payout ratio of 42% of net income.

Those attributes make National Bank an ideal investment to hold in a TFSA and take advantage of the account’s tax-sheltered nature to accelerate the creation of wealth over the long term.

Foolish takeaway

This becomes apparent when it is considered that $10,000 invested in National Bank 10 years ago would now be worth $34,558 if all dividends have been reinvested, which equates to an average annual return of 13% compared to $29,364 if they weren’t.

While past returns are no guarantee of future performance, if you invested your $6,000 2019 TFSA contribution in National Bank, added $6,000 annually, and reinvested all dividends paid through the DRIP you could amass $100,000 in as little as eight years. Importantly, because the investment is held in a TFSA, there are no taxes payable on the dividends or capital gains earned, removing what can be a significant impediment to building wealth.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Matt Smith has no position in any of the stocks mentioned.

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