The Tax-Free Savings Account (TFSA), in my opinion, is one of the best policies that any Canadian government has enacted. Fresh off the impact of the 2008 financial crisis, the Canadian government introduced this tax-sheltered account type to encourage better savings practices among Canadians.
The account incentivizes Canadians to save more through tax-free capital gains, interest income, and dividend income. Withdrawals from the account also do not incur any taxes or come with early withdrawal charges. Making withdrawals from a TFSA doesn’t contribute to your taxable income, eliminating the fear of moving to a higher tax bracket.
While the name suggests that it is a savings account, I think the TFSA is better suited as a tax-free investment vehicle for long-term wealth growth. Each dollar you earn inside a TFSA can compound without taxes dragging down the total, letting investors keep more of the returns they generate on their hard-earned money.
Unfortunately, many Canadians simply use the account to park cash, fixed-income assets, or high-interest savings products and call it a day. While that investment is safe and will grow without incurring taxes, it is a wasted opportunity.
Fixed-income assets and interest income do not match the returns you can get from investing in the stock market and holding shares in a TFSA.
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The power of compounding in a TFSA
The real value of a TFSA comes through the ability it gives you to compound growth. Historically, the stock market has generated far greater long-term returns than cash or fixed-income assets due to the higher degree of risk that it carries. While markets can be extremely volatile and lead to short-term downturns, owning these assets over a longer period has historically resulted in significant growth.
The biggest risk with holding cash is that it will just sit there and grow based on the going interest rate. While it might not be at risk of going down due to market downturns, cash often fails to keep pace with inflation. This means that the real returns from cash and fixed-income assets after inflation might be lower than investors expect.
If you’re new to stock market investing, building a portfolio of high-quality stocks might seem overwhelming. Thankfully, you don’t need to be an expert to get started. Through assets like Exchange-Traded Funds (ETFs), you can invest in the market and enjoy the returns it offers without constantly researching stocks.
A one-ticket investment
There’s no shortage of high-quality ETFs that Canadians can own. There are funds available for a wide range of investing goals. For newer investors who want to unlock the power of compounding in their TFSAs, I would consider BMO Canadian Dividend ETF (TSX:ZDV) a good investment.
ZDV is a fund that seeks to provide a balance of income and potential for long-term capital appreciation. The fund invests in a mixture of stocks and fixed-income securities worldwide to deliver returns to its investors. It holds the kind of companies many investors already know and trust to deliver reliable returns.
The appeal of investing in ZDV is simple: It is a one-ticket investment that pays monthly distributions and lets investors gain exposure to a basket of stocks in a single trade. As of this writing, ZDV ETF trades for $32.35 per share and pays $0.08 per month, translating to an annualized dividend yield of around 2.7%.
Foolish takeaway
Annualized 2.7% returns are not the kind of yields that make you wealthy overnight. The real key is to take advantage of the tax-sheltered status of the TFSA and use it to compound your investments for faster overall wealth growth. Reinvesting the dividends you earn and consistently contributing to your TFSA can help you reach your financial freedom goals. To this end, ZDV ETF can be a great starting point to consider.
