Beloved by investors, the tax-free savings account is one of the greatest tools Canadians have for increasing their after-tax wealth.
For those unfamiliar with the TFSA, it’s like the inverse of an RRSP. With an RRSP, you are using pretax dollars, which means you can deduct your contributions from your income for tax purposes. When you withdraw from your RRSP – ideally in retirement – the withdrawals are taxable.
With a TFSA, you use after-tax dollars to contribute.
It’s a choice between paying tax on your income now (with a TFSA) or later (with an RRSP).
Your TFSA money can be invested in a variety of ways, including stocks, bonds, mutual funds and exchange-traded funds. The growth in your TFSA investments is then tax-free, forever.
But that tax-free growth is exactly where some go astray. The allure of massive, tax-free investment returns makes many investors salivate at the potential upside. They buy high-risk investments such as individual growth stocks, dreaming of hitting a tax-free home run.
And they rarely consider that they might strike out. But historically, most individual stocks perform pretty poorly – the growth in global stock markets has been driven by a small handful of companies with exceptional performance over time.
Given how rare it is that a stock produces outsized returns, investors should be careful in taking on too much risk to grow their TFSAs. Besides the obviously painful outcome of earning poor returns, there are two other less obvious issues with swinging and missing.
The first is a result of how your TFSA room is calculated each year. Each year adults over the age of 18 accumulate new TFSA room based on the contribution limits for that year. In 2024, that limit is $7,000, and it is indexed each year to the nearest $500 based on inflation as measured by the Consumer Price Index.
The TFSA was launched in 2009, so Canadians who were at least 18 in 2009 now have a total of $95,000 of available TFSA contribution room.
The second factor that determines your TFSA room is the dollar value of any withdrawals made from the TFSA in previous years. Withdrawals can be recontributed to your TFSA dollar-for-dollar the following calendar year or any time after that.
For example, someone who has maxed out their TFSA each year and, owing to investment growth, now has a TFSA of $110,000 can withdraw the entire $110,000. The following calendar year, their TFSA contribution room would be equal to the withdrawal amount – $110,000 – plus any new room available for that calendar year.
But that works both ways.
The same person who contributes the max to their TFSA and suffers a 70-per-cent loss from which they never recover would now have a TFSA balance of just $28,500. Even if they then switched their investment strategy to something more rational – say, a globally diversified portfolio of low-fee index funds – they’ve done permanent damage to the future value of their TFSA and the amount of tax-free withdrawals they can expect over their lifetime.
The second problem with this type of risk taking is that if you experience a loss in your TFSA – such as our unfortunate investor above – there is no tax relief. Since investment income such as capital gains is completely sheltered from tax in a TFSA, investors can’t generate capital losses for tax purposes in a TFSA either.
Had the $66,500 capital loss instead happened in a non-registered investment account, the investor would have been able to use those losses to offset capital gains today or at any point in the future.
So they’ve not only impaired their lifetime tax-free withdrawals, they’ve gained no tax relief for their losses, either – a double whammy.
Conscientious investors should instead consider a more prudent approach with their TFSAs by avoiding concentrated bets on risky investments. There’s a reason diversification is known as the only free-lunch investing: It significantly reduces the probability of a catastrophic or total loss.
And while it also reduces the chances of hitting a home run, most investors will strike out anyways.
Mark McGrath is a Squamish, B.C.-based certified financial planner and associate portfolio manager with PWL Capital Inc.
