Tax-Free Savings Accounts (TFSAs) are growing in popularity, with Statistics Canada estimating that nearly half of all households have one. While they can be a powerful vehicle for building wealth, many Canadians don’t understand how a TFSA works, nor how to maximize the considerable advantages associated with an account. Failing to use TFSAs correctly can be a costly exercise, as many accountholders are discovering.
Let’s take a closer look at two common mistakes and how to avoid them.
Overcontributing
A common error is for accountholders to treat their TFSA as a transactional account, making multiple withdrawals and deposits while failing to keep track of their contributions and respective limits. The contribution limit for 2020 is the same as 2019, $6,000, and resets at the start of the next calendar year.
Any unused contribution room can be carried forward. This means anyone who was eligible to use a TFSA since they were introduced in 2009 and hasn’t contributed can add a maximum of $69,500, including the 2020 contribution into an account.
Many accountholders overcontribute because they fail to keep track of their withdrawals and deposits, seeing them exceed the cap, thereby exposing them to penalty tax of 1% per month on the excess amount. It is important to note that while withdrawals create additional contribution room, it doesn’t become available until January 1 of the next year.
Yet many Canadians believe that they can use that additional room and make contributions immediately, again exposing themselves to tax penalties. Incurring penalty tax on contributions defeats the rationale for using a TFSA, which is to accelerate wealth creation by removing the corrosive impact of taxes on investment returns.
Holding cash
According to a poll from Royal Bank of Canada, 42% of Canadians have a significant amount of cash sitting in their TFSAs, creating a considerable opportunity cost because they aren’t taking full advantage of the account’s tax-sheltered status.
You see, all interest payments, capital returns, and dividends received in a TFSA are tax-free for the life of the investment. Growth assets such as stocks deliver far greater returns over the long term than cash or other lower-risk assets such as bonds, meaning that by holding cash, investors are failing maximize their tax-free returns.
This becomes clear when it is considered that a GIC only earns up to around 3% annually, which is marginally greater than the Canadian average annual inflation rate of around 2%, meaning that the real rate of return is around 1%. Whereas, a Canadian Dividend Aristocrat like Brookfield Infrastructure (TSX:BIP.UN)(NYSE:BIP), which pays a sustainable regularly growing distribution of 3.8%, is delivering better returns.
Over the last 10 years, it has returned a stunning 621%, which is a compound annual growth rate (CAGR) of almost 22%, if the distributions were taken as cash. That highlights how a dividend-growth stock such as Brookfield Infrastructure can accelerate wealth creation when using a tax-sheltered investment vehicle like a TFSA.
Another downfall to holding cash is that you are not making the most of tax-free compounding. By utilizing Brookfield Infrastructure’s distribution-reinvestment plan (DRIP), where unitholders use distributions to acquire additional units at no extra cost, you can access the power of compounding and maximize long-term returns, thereby creating wealth faster.
This becomes clear when it is considered that over the last 10 years, Brookfield Infrastructure has delivered 820%, which is a CAGR of almost 25% — or 3% greater than if distributions were taken as cash.
While past performance is no guarantee of future returns, there are signs that Brookfield Infrastructure’s assets, earnings, and ultimately market value will keep growing.
The partnership is in the process of completing two needle-moving deals: the US$2.6 billion purchase of Cincinnati Bell and US$8.4 billion acquisition of railroad operator Genesee & Wyoming. Those — along with acquisitions completed during the second half of 2019 — will boost earnings and cash flow supporting additional distribution hikes and boost Brookfield Infrastructure’s stock.
Foolish takeaway
If you avoid the two mistakes discussed, you can maximize the benefits provided by a TFSA and accelerate wealth creation to achieve financial independence sooner. TFSAs remove the corrosive impact of taxes on investment returns while maximizing the power of tax-free compounding when using dividend-growth stocks like Brookfield Infrastructure that offer a DRIP and steadily growing distribution.
