‘Oh, you’ve had bad investments’ — when the magic of the TFSA works against you

Click to play video: 'Money123: Should your savings go into an RRSP or a TFSA?'
Money123: Should your savings go into an RRSP or a TFSA?
RRSPs aren’t for everyone – here’s an in-depth look at which registered account might suit you better – Feb 13, 2018

Many people understand how the magic of tax-free savings accounts (TFSAs) works. Your savings grow tax-free, which, compounded over time, can make a huge difference after several years. You also don’t pay tax on withdrawals.

There is also another important perk: your TFSA contribution room grows along with your investments. For example, let’s say you’ve been diligently maxing out your TFSA ever since it was introduced in 2009, for a grand total of $63,500 worth of deposits into your account. Let’s also say, you’ve invested the money, which has now grown to $90,000. If you were to empty your account today, your contribution room in 2020 would be $90,000 — not $63,500 — plus the additional $6,000 annual increase.

READ MORE: What’s the best way to generate cash from your investments in retirement?

But as wonderful as TFSAs are for growing your savings, they can also magnify the negative impact of bad investment decisions.

Story continues below advertisement
Click to play video: 'Money123: A look at how taxes affect your savings outside an RRSP or TFSA'
Money123: A look at how taxes affect your savings outside an RRSP or TFSA

Financial planner Jason Heath sees this from time to time with new clients. The tell-tale is often a TFSA balance that is strangely lower than the allowed maximum.

But when Heath would inquire about unused contribution room, he heard instead about how clients had made some investment mistakes.

While TFSA room expands when the value of your portfolio grows, it also shrinks if you lose money. Heath’s clients had seen their investments decline and never recover, which permanently erased some of their contribution room.

Those are painful conversations, Heath said.

Three ways the TFSA magic can turn against you

Using the TFSA for risky investments

The potential to reap large tax-free returns can be a temptation to use the TFSA for speculative bets, Heath said.

Story continues below advertisement

“You get some people that make silly investments in their TFSA that they wouldn’t otherwise make.”

But if you must scratch the itch of making a speculative bet, the TFSA is not a good place to do so, said Benjamin Felix, portfolio manager at PWL Capital.

The TFSA amplifies the risk of permanent investment losses in two ways. Not only do you lose your contribution room, but you also won’t be able to claim your capital losses to reduce your income tax.

Get the latest Money 123 news. Sent to your email, every week.

READ MORE: Here’s what fees can do to your retirement if you don’t pay attention

If you sell, say, a stock at a loss inside a taxable account, you can claim the capital loss and use it to offset the tax you’d pay if you were to sell, say, another stock at a profit in the future. That tax break on future capital gains effectively reduces the financial impact of your bad investment.

However, since you don’t pay taxes inside a TFSA, you also don’t get to claim a capital loss.

Click to play video: 'Why trying to beat the stock market doesn’t work'
Why trying to beat the stock market doesn’t work

But what exactly constitutes a speculative bet?

Story continues below advertisement

In Felix’s book, the definition goes well beyond things like cannabis stocks or tech startups.

READ MORE: Nest-egg inequality explains why women need to save more than men

The more diversified your investments are, the greater your chance of earning positive returns over the long term. At the low end of the risk spectrum, Felix puts investments like broad exchange-traded funds that track global markets, what he calls “betting on everything.”

The chance of everything declining in value permanently over the long term is pretty low — hinging on capitalism continuing to function.”

At the opposite end of the spectrum — a.k.a. maximum risk — is having no diversification, like when you put everything you have into a single stock.

The risk of incurring permanent losses when betting on one company is higher than most people think, Felix argues. He cites a 2014 study from JP Morgan showing that, of the 13,000 stocks that were included in the Russell 3000 Index (a broad index of U.S. stocks) between 1980 and 2014, 40 per cent tumbled by 70 per cent or more from their peak value and never staged a meaningful recovery.

WATCH: What you might not know about your TFSA

Click to play video: 'What you might not know about your TFSA'
What you might not know about your TFSA

READ MORE: How much do you really need for retirement? We did the math

“Realistically, even if you own 20 stocks as a whole, you’re pretty unlikely to lose money over the long term,” Felix said. “But still, it’s a non-zero possibility. And the more diversified you get, the less likely that becomes.”

Story continues below advertisement

That said, losing your TFSA contribution room shouldn’t be the primary concern when deciding whether you should be selling an investment. Heath has seen clients who don’t want to sell underperforming investments until they’ve recouped the money they originally put in.

“If you should be selling an investment, you should consider selling it [based on its] merits first and foremost — not just … because it’s in a TFSA and you don’t want to lose that room.” 
Click to play video: 'Money 123: why deferring withdrawing from your RRSP may be a bad idea'
Money 123: why deferring withdrawing from your RRSP may be a bad idea

Panicking in a downturn

Bad investments aren’t the only way to sabotage your TFSA. Another mistake is to press the “sell” button when your investments are down.

Story continues below advertisement

Even though global markets are volatile in the short term, over many years they have reliably trended upward. With a broadly diversified portfolio, your investments will do the same — if you let them.

READ MORE: The ‘wealth formula’ — Bay St. insider has two simple rules for making money

The name of the game is being able to ride out the downturns, knowing that the market will eventually bounce back. But if you panic and sell your investments at the wrong time, “you’ve turned a temporary loss into a permanent one,” Heath said.

Since some investments, like stocks, are more prone to wild ups and downs than others, like bonds, the key is to choose a mix that results in a degree of volatility you’re going to be able to live with.

Click to play video: 'Money 123: Spending less from your RRSP could leave your loved ones with less'
Money 123: Spending less from your RRSP could leave your loved ones with less

Withdrawing at the wrong time because you have to

But panic isn’t the only reason why you may end up compromising your TFSA by selling your investments at the wrong time, Felix said. Sometimes people can’t wait out a market downturn because they need the money.

Story continues below advertisement

In this scenario the real mistake is not having an emergency fund you can tap instead, he added.

Bottom line: “Invest in a diversified, balanced portfolio and make prudent investment decisions regardless of other potential,” Heath said.

Sponsored content