The tax free savings account, or TFSA for short, is a gift that has been given to Canadians by the government to assist them in saving for their financial goals. Taxes can shave off a significant portion of your investment returns each year, which can compound to have an enormous impact on your ability build long-term wealth. The TFSA allows you to bypass those taxes, allowing your investments to grow more quickly. If you have been a Canadian resident over the age of 18 since 2009, you would have accumulated $52,000 of TFSA room by 2017. That is not a small number for most people.
I have had many people tell me that they treat the funds in their TFSA less seriously than they treat their other assets. They might use their TFSA to buy things like the latest hot tech stock, in hopes that their massive gains will be sheltered by their wonderful TFSA.
It is true that if your tech stock increases 10x, you will avoid paying taxes, but the probability of that increase happening is very low. What happens if the price of that stock falls, or even goes to 0? What investors fail to think about is the impact that taking unrecoverable losses in their TFSA can have over the long-term.
In this episode of Common Sense Investing, I’m going to tell you why you should get serious about your TFSA.
An unrecoverable loss occurs when a security loses its value and never recovers, something that is unlikely to happen when you own well-diversified index funds, but can easily happen if you are trading individual securities. Taking unrecoverable losses in a TFSA has a much greater impact on your financial health than taking those losses in a taxable account.
If a stock picker loses on a bet in a taxable investment account, they are able to claim a capital loss which can be used to offset a future capital gain, dampening the blow of the loss. When losses are taken within the TFSA, this is not the case. Just as you are able to bypass capital gains tax in the TFSA, capital losses also go unclaimed. If an investor who is taxed at the highest marginal rate in Ontario in 2017 takes a $1,000 capital loss in a taxable account, the loss is worth about $268 in tax savings. This reduces their total loss on the investment by nearly 27%.
Much more damaging is the potential for losing your TFSA room.
Every Canadian resident over the age of 18 receives new TFSA room each year. Currently, that new annual room is $5,500. If you make a $5,500 contribution to your TFSA, you have used up your room. If you make a $5,500 withdrawal, you get that room back the following year. Your TFSA room each year equals your unused room plus your new room plus withdrawals from last year.
This is all fine and good until you make a contribution that you can never withdraw. Take an investor who contributes $5,500 to their TFSA, and takes the advice of their stock broker to purchase a stock with the potential for large gains. If that stock’s value drops to $0, they have nothing left in their account to withdraw. Their TFSA room has suffered a permanent decrease. Sure, they will get some new room next year, but they have permanently impaired their total TFSA room.
Losing a bit of TFSA room may seem trivial, but consider that if a $5,500 investment in a well-diversified portfolio was held in a TFSA for 30 years, it would be expected to grow to about $34,000, while the same investment in a taxable account would be expected to grow to about $15,000 assuming the highest marginal tax rate in Ontario in 2017. That seemingly meaningless loss of TFSA room today has meaningful long-term repercussions.
Between the significant future value of properly used TFSA room, and the lack of recourse for losses in the TFSA, it is an especially risky account to gamble with. As with any account, the most sensible thing to do is to own low-cost index funds in your TFSA. That way you are diversifying away the risk of any one company having a catastrophic effect on your investments. If you want to speculate, a taxable account is likely a better choice. That way you can claim a capital loss if needed, and you are not at risk of permanently destroying your TFSA room.
The TFSA is an invaluable tool for building long-term wealth. It is not a toy.
