The TFSA (Tax-Free Savings Account) is an amazing tool Canadians can use to build wealth. Inside the account, you don’t need to pay any income tax on your investment income (capital gains, dividends, and interest). Likewise, when you withdraw from the account, you don’t need to pay any tax.
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Avoid pitfalls to see your capital portfolio prosper
Over a lifetime, the saved tax can be worth thousands of dollars. It can actually be even more valuable if that saved income is reinvested and compounded over years and decades.
While the TFSA is the most straightforward registered investment account, there are some pitfalls. Here are some common TFSA mistakes and how to avoid them.
Open a TFSA for immediate savings
The first investor mistake is simply not opening or using your TFSA contribution limit. If you were 18 years or older and a Canadian resident in 2009, you can invest a grand total of $102,000 in the account today.
$102,000 compounded at a market rate of return (8%) for 20 years ahead could be worth as much as $475,414. That would be a $373,414 capital gain. Inside the TFSA, all those gains are yours. However, outside the TFSA, you could be on the hook for a $74,682.80 tax bill (even with only half the capital gain being taxed).
You don’t want to risk giving up that kind of capital to the government when it could be yours. Opening a TFSA is free and easy to do at any bank. If you plan to invest, it should be one of the first things that you do.
Don’t waste your TFSA on “high interest” accounts
The second mistake is to only use your TFSA as a “high-interest savings account.” Many banks sell high-interest savings accounts for TFSAs. They might provide a promotional elevated interest rate of 2.5% to 3.5% to open the account. Often in the fine print, this interest rate only lasts for a few months. It then reverts to a lower rate, like 1% to 2%.
There are several issues here. Firstly, a 1-2% annual return doesn’t even exceed the cost of inflation (which is between 2% and 3% right now). If you keep your money in an account like this long-term, the value of your capital is declining by 1-2% per year, depending on the rate of inflation.
Secondly, a $102,0000 TFSA investment at 1.5% for 20 years would only be worth $137,379. Sure, it’s a completely safe investment. However, you would only gain $35,379 over that time. Average that over 20 years, and you are only earning about $1,769 per annum.
Invest in a mix of high-quality stocks for optimal capital appreciation
The smartest way to invest in a TFSA is to own a mix of quality ETFs or stocks. I like to find stocks that can compound at elevated rates of return for years. You want stocks that have the best chance of delivering large capital returns over long periods.
Why? You simply don’t want to pay any tax on those big gains. A stock like Constellation Software (TSX:CSU) has compounded returns by a 30% compounded annual growth rate since it was publicly listed in 2006. Now, its rate of return has recently slowed to the 20% rate. Even if those annual returns decline to 15%, shareholders could do very well in the future.
$102,000 invested at a 15% compounded rate for only 10 years would be worth $412,646. Over 20 years, it would be worth as much as $1.67 million!
Some other stocks that have successfully compounded at high rates (10-25% per annum) include TerraVest Industries, WSP Global, Colliers International, and Descartes Systems. Some up-and-coming small-cap stocks that could deliver great forward growth include VitalHub, Firan Technologies, and Zedcor. Each could be a great addition to a long-term TFSA portfolio.
