One of the best wealth-building tools available to Canadians is the Tax-Free Savings Account (TFSA). The account allows for dividends and capital gains to compound tax-free for decades. What investors need, however, are the right TFSA habits to make that growth happen.
Here’s a look at three key TFSA habits for investors to adopt during those savings years.
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Habit #1: Reinvesting every dividend automatically
Dividend reinvestment can be one of the easiest ways to compound wealth inside a TFSA. Instead of taking distributions as cash, reinvested dividends can purchase additional shares, which then generate even more dividends.
A great example of this is Enbridge (TSX: ENB). The energy infrastructure behemoth pays an impressive 5.6% yield as of the time of writing. An investor accumulating Enbridge shares over many years could reinvest every dividend and increase the number of shares that are generating income.
That makes plenty of sense while saving. Retirement changes the equation.
Those dividends become a valuable source of cash flow for monthly expenses. Automatically reinvesting every payment while selling other investments to fund expenses doesn’t always make sense.
The best habit here is to assess whether each payment is better suited to buying another share or helping to fund retirement.
Habit #2: Treating maximum growth as the only goal
Investing in growth stocks can be one of the most important objectives when retirement is still decades away.
An ETF investment such as the Vanguard S&P 500 Index ETF (TSX: VFV) provides exposure to hundreds of large U.S. companies. During the accumulation years, investors contribute through market downturns and can potentially benefit when markets eventually recover.
Retirement introduces a different risk.
This is known as sequence-of-returns risk, where withdrawals during a market downturn can have an outsized impact on how long a portfolio lasts.
If markets fall sharply while an investor is withdrawing money, they may need to sell more shares to generate the same level of cash. And selling during a prolonged downturn can leave fewer shares available to participate in that eventual recovery.
In other words, once retirement approaches, growth may no longer be the only objective of the portfolio. Instead, income, diversification, and keeping enough liquidity available may become more important.
Habit #3: Ignoring small tax inefficiencies
While the TFSA is great for Canadians holding Canadian stocks, there are important nuances when it comes to holding U.S. stocks in a TFSA.
That’s because the U.S. doesn’t recognize the TFSA as a retirement account. This means that U.S. stocks held in a TFSA are still subject to U.S. withholding tax on dividends. That tax hit occurs before the dividend hits the TFSA, but it can add up.
For an example of this, let’s consider Procter & Gamble (NYSE: PG). The 15% haircut on the dividend may seem insignificant during the growth years, but once the TFSA becomes a source of retirement income, investors may want to keep as much of that dividend as possible.
Avoiding U.S. stocks entirely isn’t the solution. Instead, investors can opt to hold U.S. dividend-paying stocks in another retirement account, such as an RRSP. Unlike the TFSA, the RRSP generally exempts U.S. dividends from the 15% withholding tax.
Adopt the TFSA habits today for retirement income tomorrow
The TFSA habits outlined above aren’t the only ones that investors should be aware of, but they are key to long-term portfolio growth, much like picking the right investments.
The key is knowing when a habit that helped build the portfolio needs to change once that portfolio starts producing income.
The TFSA is a great long-term wealth-building account. The habits investors build today can have a big impact on how much income that TFSA can provide in retirement.
