Late last year Canada Revenue Agency (CRA) announced that the Tax-Free Savings Account (TFSA) contribution limit for 2020 would be $6,000 — unchanged from 2019 — although the cumulative contribution room has increased to $69,500 since their inception in 2009.
While the awareness of TFSAs and their tax-sheltered status is growing, many account holders continue to make serious mistakes that impact their ability to maximize the benefits offered and achieve their financial goals.
Here are two common mistakes that can destroy wealth and prevent you from achieving your financial goals.
A key error that continues to occur is that many account holders treat a TFSA as a transactional account, making considerable volumes of deposits and withdrawals. In many cases, they fail to keep track of their contributions and withdrawals, seeing many over contribute and making them liable to pay penalty tax on the excess amount.
For 2020, the maximum contribution is $6,000. Any amount over the limit will be subject to penalty tax. The CRA levies a tax of 1% per month on the excess amount until it is withdrawn from the TFSA and the balance is reduced to within the allowable limit.
This can be an expensive mistake that defeats the purpose of holding a TFSA, which is to generate tax-free investment returns. It also highlights one of the key risks associated with using TFSAs as transactional accounts to hold cash.
Only holding cash
According to a poll from Royal Bank of Canada, over 40% of TFSA accounts are holding a significant amount of cash, meaning that many account holders are failing to take full advantage of their TFSAs tax-sheltered status. Generally, all dividends, interest and capital gains earned in a TFSA are not taxable for the life of the investment.
That means there is a tremendous opportunity cost associated with using a TFSA to hold cash rather than growth assets like stocks, as over the long term, the stock market has delivered superior returns to cash.
By investing in quality dividend-paying stocks and then reinvesting those payments to acquire additional shares, you can unleash the power of compounding, accelerating the pace at which you can create wealth. The longer you can generate compounding investment returns, the more wealth you can create.
Nonetheless, it’s important to select quality stocks with a long history of earnings growth, dividend payments and solid balance sheets while avoiding volatile speculative investments.
Unlock the power of compounding
One top Canadian stock that stands out as a worthy addition to any TFSA is Brookfield Renewable Partners (TSX:BEP.UN)(NYSE:BEP), which has gained a whopping 22% since the start of 2020 despite the latest market correction.
The partnership possesses the same defensive characteristics as a traditional electric utility along with the added benefit of the move to cleaner sources of energy across the world to battle climate change, which will serve as a powerful long-term tailwind for earnings growth.
The certainty of Brookfield Renewable’s earnings coupled with growing demand for electricity generated from renewable sources means that its market value tends to remain relatively stable compared to other stocks.
As a result, it has a beta of 0.70 indicating that it’s significantly less volatile than the market, making it an ideal candidate to hold in a TFSA and grow wealth.
That appeal is further enhanced by Brookfield Renewable’s solid growth prospects, with its focus on expanding its operations via developing new power generating facilities and acquisitions.
The latest initiative is Brookfield Renewable’s plans to acquire all the outstanding stock of TerraForm Power that it doesn’t already own.
Brookfield Renewable also has a distribution reinvestment plan (DRIP) that allows unitholders to reinvest distributions to acquire further units at no additional cost. This accelerates wealth creation by unlocking the power of compounding and ensuring that transaction costs don’t erode returns.
While past returns are no guarantee of future performance, over the past decade, Brookfield Renewable has delivered a whopping 484% if distributions were reinvested. That equates to a compound annual growth rate (CAGR) of 19% compared to 16% if the distributions were taken as cash.
Despite Brookfield Renewable being an attractive investment for any TFSA, it should be noted that holding a diversified portfolio of stocks across a range of industries is an important tool for managing risk.
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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.