One of the things that many people have trouble understanding is that you don’t just need money to make money as an investor. While it’s true that having a decent amount of cash to invest surely helps, and the more you have, the more you are likely to grow your wealth, there are other things you need to focus on as well.
The right investments, asset allocation, investment vehicles, investment strategies, the time you have to grow your wealth, and choosing the right securities are all important considerations.
One of the best tools available for investors in Canada is the Tax-Free Savings Account (TFSA). This is a flexible account that can help people with their short-term and long-term financial and investment goals.
But the problem is that even though the account is now over a decade old, people are still making mistakes with it. About 33% of the Canadians are making a huge TFSA mistake: overcontribution.
Contribution limit and penalties
Understanding the basic contribution limit is simple. If you haven’t contributed to your TFSA yet, you will likely have the full contribution limit available to you, which is $69,500. If you regularly contribute to your TFSA, you have to keep in mind the yearly limit.
For example, if you had a TFSA full to the brim in 2019, the new amount that you can contribute to your TFSA is just $6,000 – this year’s contribution room.
Let’s say you overcontributed and placed $10,000 in your TFSA this year. That’s $4,000 in over-contribution. The penalty is 1% of the excess amount from the contribution month until the excess is removed or absorbed in the next year’s contribution room.
So if you placed $4,000 excess in your TFSA in May, you would have incurred $320 ($40 x 8 months) in penalties by the end of 2020.
At year-end, it will get absorbed in the new limit. If it’s $6,000 again, that means you can only contribute $2,000 for the next year ($4,000 excess carried forward to next year). So the best way is to remove the excess.
One typical reason for over-contribution is that people think that having two different TFSAs gives them two separate contribution limits, but that’s wrong. No matter how many TFSAs you have, your limit for the year won’t change.
Maximize your returns
The good news is that $69,500 is a sizeable enough sum that you can grow to a decent nest egg with the right investments, so it’s better not to overcontribute. If you invest in a decent growth stock like Parkland Fuel, currently trading at a 21% discount, you will have ample chances to grow your wealth to sizeable proportions in due time. Currently, it’s trading at $37.9 per share at writing, with a yield of 3.23%.
And you don’t have to invest the whole sum in one stock. In fact, it’s better if you don’t. For retail investors, diversification can be a hedge against massive portfolio losses. But even if you invest just $20,000 and it keeps growing at a rate of 10.5% per annum (its five-year CAGR), you might be sitting on over $650,000 in 35 years. And that’s apart from the monthly dividends that the company has been steadily growing.
The TFSA is an amazing investment tool, especially if you are leveraging on growth. You can grow your TFSA wealth without fear that the CRA will take a big bite out of your pie.
But it’s imperative that you follow the rules and don’t make costly mistakes with your TFSA, like over contributing or using it to day trade.
Speaking of TFSA mistakes...
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Fool contributor Adam Othman has no position in any of the stocks mentioned.