The Tax-Free Savings Account (TFSA) is arguably one of the best policies ever enacted by the Canadian government. Think about what it offers. Capital gains earned inside the account are tax-free. Dividends are tax-free. Interest income is tax-free. Even better, withdrawals are completely tax-free and do not increase your taxable income later in retirement.
Over time, that can be an incredibly powerful wealth-building tool. Every dollar earned inside the account gets to compound without the drag of annual taxation, allowing investors to keep more of their returns.
If there is one thing that irritates me about the TFSA, though, it is the name itself. Calling it a “Tax-Free Savings Account” encourages people to treat it like a savings account. As a result, many Canadians simply park cash, Guaranteed Investment Certificates (GICs), or high-interest savings products inside the account and call it a day.
Sure, that money is safe, and you will earn some interest. But it is not risk-free. Inflation steadily pushes prices higher year after year. Groceries get more expensive. Housing gets more expensive. Utilities get more expensive. Even if your account balance never declines, your purchasing power can.
For that reason, if you are using your TFSA exclusively for GICs or cash, you may not be getting the most out of the account. A non-registered account could accomplish something similar. Yes, you would owe some tax on the interest income, but at least you would not be using some of your most valuable contribution room on assets with limited long-term growth potential.
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The real power of compounding
The real value of a TFSA comes from compounding. Historically, stocks have generated higher long-term returns than cash because investors are taking on risk in exchange for potential growth. While markets can be volatile over shorter periods, ownership in productive assets gives investors an opportunity to participate in economic growth, rising corporate profits, and dividend payments.
Cash does not really offer that. In fact, one of the biggest risks associated with holding too much cash is that it often fails to keep pace with inflation over long periods. Even when interest rates are elevated, the real return after inflation can be far lower than many investors expect. That is why so-called risk-free returns are not always truly risk-free.
You may avoid stock market volatility, but you still face purchasing power risk. If your investments fail to outpace inflation, your future standard of living can gradually decline despite never experiencing a visible loss on paper.
A simpler alternative: Just buy XEQT
For investors who want to put their TFSA to work without constantly researching stocks, one option worth considering is iShares Core Equity ETF Portfolio (TSX:XEQT).
XEQT is an all-in-one asset allocation exchange-traded fund (ETF) that provides exposure to thousands of stocks around the world through a single purchase. The portfolio includes U.S. stocks, Canadian stocks, international developed markets, and emerging markets.
The allocations are automatically maintained and periodically rebalanced on your behalf, meaning investors do not need to worry about managing the portfolio themselves. The fund also remains very affordable with a management expense ratio of just 0.20%.
Over the past five years, XEQT has generated annualized returns of 14.18% with dividends reinvested and before taxes (which, in a TFSA, amounts to zero). Buy shares regularly, hold for the long term, and let the underlying portfolio do the heavy lifting.
