TFSAs can permanently protect your portfolio from taxes. This is an opportunity you shouldn’t pass up.
But TFSAs aren’t foolproof. If you’re not careful, the Canada Revenue Agency could even start taxing your account.
The biggest mistake that Canadians make is one of this simplest: they invest in the wrong securities. With unlimited tax protections, TFSAs are better suited for some investments over others.
Don’t commit this sin
Do you think 1% matters? Over long periods of time, a simple percentage can change your life.
Here’s a powerful example. The TFSA contribution maximum for 2020 is set at $6,000. Let’s say you opt to hit this maximum for 30 years. That’s quite a feat! What would all that saving amount to?
If you earned 7% annual returns, your nest egg would grow to $606,000. Not bad, but what if you only earned 6% annual returns? Surely the gap couldn’t be very big, right? Not so. Earning 6% per year would grow your capital to just $503,000. A 1% difference lost you more than $100,000!
The magic of compound interest is hard to overstate. When invested for decades, or even just a handful of years, every bit counts.
That brings us to the worst mistake that TFSA holders make: investing in cash. Millions of Canadians at this very moment hold cash in their TFSAs. This is an outright travesty. Most cash balances accrue interest at just 1% or 2% per year. Some accounts pay nothing at all.
With a long enough time frame, your best bet is nearly always to own a diversified portfolio that includes higher-returning securities like stocks, but even risk-averse investors should ditch cash.
Your low-risk options are endless. iShares Core Canadian Short Term Bond Index ETF, for example, has delivered annual returns of 3.9% since inception with almost no volatility. Meanwhile, Vanguard Canadian Short-Term Corporate Bond Index ETF yields 2.7% in annual interest. These rates of return aren’t breaking the bank, but they beat owning cash.
Your best bet
If a 1% difference can make a dramatic different for your portfolio, what about 5%? In the previous example, we invested the TFSA annual contribution maximum of $6,000 for 30 years. At a 7% interest rate, you’d wind up with $606,000.
What if you invested in cash? Earning 2% annual returns would shrink your eventual capital to just $248,000. Even if you earned 3% annual returns with a bond ETF, you’d only wind up with $294,000. That’s a difference of more than $300,000.
As mentioned, when it comes to compound interest, every bit matters. That’s because as interest builds year after year, gains start to be exponential.
If you have an investing time horizon of at least a few years, it pay offs to take on more risk. If you’re investing for a decade or longer, there’s zero reason to own any cash in your TFSA. Get as much as you can invested in long-term stocks that can compound your capital at attractive rates.
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Fool contributor Ryan Vanzo has no position in any stocks mentioned.
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