The Tax-Free Savings Account (TFSA) gives Canadians one of the best opportunities anywhere in the world to build wealth tax-free.
The catch is that contribution room is limited. Once you’ve contributed this year’s $7,000 of new TFSA room, that’s it until next year, unless you have unused contribution room carried forward from previous years.
Over the years, I’ve noticed two common mistakes that Canadian investors make with their TFSAs. Ironically, they’re complete opposites.
Source: Getty Images
Mistake No. 1: Treating it like a savings account
Many Canadians use their TFSA to hold cash or Guaranteed Investment Certificates (GICs). There are situations where that makes sense, but for most long-term investors, it is not the best use of limited tax-free contribution room.
Cash and GICs generally earn modest returns that often struggle to stay ahead of inflation over long periods. Even if your account balance never declines, your purchasing power can gradually erode.
An emergency fund is still important. Personally, though, I would rather keep emergency savings in a non-registered high-interest savings account and reserve my TFSA for investments with much greater long-term growth potential.
Mistake No. 2: Swinging for the fences
The opposite mistake is treating the TFSA like a casino. Some investors load it with penny stocks, speculative options trades, or other highly volatile investments hoping to generate enormous tax-free gains.
Unlike a non-registered account, losses inside a TFSA cannot be used to offset capital gains for tax purposes. If a speculative investment collapses in value and you eventually sell it, the contribution room used to make that investment is effectively gone.
That makes valuable TFSA room far too expensive to waste on investments with a high probability of permanent losses. You’re far more likely to blow it up than hit a 10-bagger.
A sensible middle ground
For investors, I think iShares Core Equity ETF Portfolio (TSX: XEQT) is one of the best TFSA investments to own long-term.
XEQT maintains a 100% equity portfolio invested across thousands of companies in Canada, the United States, international developed markets, and emerging markets through several underlying index funds. The portfolio is automatically rebalanced, eliminating the need to constantly decide which countries or sectors deserve more of your money.
It also remains inexpensive, charging a 0.20% management expense ratio (MER). For most investors, the strategy is refreshingly simple. Keep buying more as new TFSA contribution room becomes available. Reinvest the distributions. Stay invested for the long term and let compounding do the heavy lifting.
