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.
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But as wonderful as TFSAs are for growing your savings, they can also magnify the negative impact of bad investment decisions.
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.
“I felt guilty saying, ‘Oh, you’ve had bad investments.'”
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.
“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.
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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.
But what exactly constitutes a speculative bet?
In Felix’s book, the definition goes well beyond things like cannabis stocks or tech startups.
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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.
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“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.”
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.
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.
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.
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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.
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.
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.