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The TFSA (Tax-Free Savings Account) is a great tool that Canadians can use to build wealth. You do not have to pay income tax on your investment income (capital gains, dividends and interest) in the account. Likewise, you don’t have to pay taxes when you withdraw money from the account.
Avoid pitfalls to see your capital portfolio prosper
Over a lifetime, the taxes saved can be worth thousands of dollars. It can be even more valuable if that saved income is reinvested and accumulated over years and decades.
Although the TFSA is the simplest registered investment account, there are some pitfalls. Here are some common TFSA mistakes and how to avoid them.
The first investor wrong is simply not accessing or using your TFSA contribution limit. If you were 18 years or older and a resident of Canada in 2009, you can invest a total of $102,000 in the account today.
$102,000 compounded at a market rate of return (8%) over the next twenty years could be worth as much as $475,414. That would be a capital gain of $373,414. Within the TFSA, all these profits are yours. Outside of the TFSA, however, you could face a tax bill of $74,682.80 (even if only half of the capital gains are taxed).
You don’t want to risk handing over that kind of capital to the government when it could be yours. Opening a TFSA is free and easy at any bank. If you plan to invest, this should be one of the first things you do.
Don’t waste your TFSA on “high interest” accounts.
The second mistake is to use your TFSA only as a “high-interest savings account.” Many banks sell high-interest savings accounts for TFSAs. They may offer a promotional increased interest rate of 2.5% to 3.5% to open the account. The small print often states that this interest rate is only valid for a few months. It then returns to a lower rate, such as 1% to 2%.
There are several problems here. First, an annual return of 1-2% is not even higher than the cost of inflation (which is currently between 2% and 3%). If you keep your money in such an account for a long time, the value of your capital will decrease by 1-2% per year, depending on inflation.
Second, a $102,000 TFSA investment at 1.5% interest over twenty years would only be worth $137,379. Of course, it’s a completely safe investment. However, you would only win $35,379 in that time. Average over 20 years, and you’ll only earn about $1,769 per year.
Invest in a mix of high-quality shares for optimal capital growth
The smartest way to invest in a TFSA is to own a mix of high-quality ETFs or stocks. I like to find stocks that can continue to perform at high returns for years to come. You want stocks that have the best chance of generating large capital returns over long periods of time.
Why? You simply don’t want to pay tax on those large profits. A share like Constellation software (TSX:CSU) has increased annualized returns by 30% since listing in 2006. Now the return has recently dropped to 20%. Even if that annual return drops to 15%, shareholders could do very well in the future.
$102,000 invested at 15% compound interest for just 10 years would be worth $412,646. In twenty years it would be worth a whopping $1.67 million!
Some other stocks that have successfully risen at high rates (10-25% per year) include TerraVest Industries, WSP worldwide, Colliers InternationalAnd Descartes Systems. Some emerging small-cap stocks that could deliver great future growth include: VitalHub, Firan TechnologiesAnd Zedcor. Any of them could be a great addition to a long-term TFSA portfolio.
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