The TFSA is not a Toy

It may be a flaw in the name. The government-intended use of the registered retirement savings plan is clear, retirement, but the tax free savings account is less commonly viewed as a long-term savings vehicle. I often meet investors who are using their TFSA to trade individual securities; the TFSA is their ‘play’ account. They are likely acting under the influence of their own overconfidence bias, imagining the large tax-free profits that they are going to make when their bet on a stock pays off, and not considering the significant negative consequences of taking unrecoverable losses within the TFSA.  An unrecoverable loss occurs when a security loses its value and never recovers, something that can easily happen when trading individual securities.

Something lost, nothing gained

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 capital gains are not taxed in the TFSA, capital losses cannot be claimed. Assuming an investor is taxed at the highest marginal rate in Ontario in 2016, and they have taxable capital gains to offset, a $1,000 capital loss is worth about $268 in tax savings. Losing out on this tax savings makes an unrecoverable loss in a TFSA about 37% more damaging than an unrecoverable loss in a taxable account.

It’s all fun and games until someone loses their TFSA room

Any amount withdrawn from the TFSA generates an equal amount of new room the following calendar year. For example, if a $5,500 TFSA contribution was invested and grew to be $6,500, the full $6,500 could be withdrawn before December 31 and $6,500 of new room would be created on January 1 of the following year. Conversely, in the event of an unrecoverable loss, the amount of the loss will permanently reduce available TFSA room. If a similar $5,500 investment in the TFSA decreases in value to $4,500 and never recovers, there is only $4,500 available to be withdrawn, and the TFSA room has suffered a permanent decrease.

Losing a bit of TFSA room may seem trivial, but consider that $5,500 invested in a well-diversified portfolio* held in a TFSA for 30 years 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 2016. A 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.

*80% globally diversified equity, 20% globally diversified fixed income, 6.11% return comprised of 1.94% interest, 0.49% dividends, 1.84% realized capital gains, 1.84% unrealized capital gains, net of a 1% management fee.

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