The Tax-Free Savings Account (TFSA) is an exceptional tool for savers. The account acts as a tax shield that protects your dividend income and long-term capital gains up to a certain amount each year, shaving thousands of dollars off your tax burden over time.
As such, maxing out your annual TFSA contributions and investing wisely is the key to a satisfying retirement in this country. But the rules and regulations that govern this special account could work against you if you’re not careful.
Here’s a closer look at a common mistake that could actually dent the value of your TFSA permanently.
The magic of room expansion
The amount of money you can invest in a TFSA actually expands with capital appreciation. So, if you’ve invested $50,000 into your account over time and the investments are now worth $100,000 (congratulations!), you can sell your investments and withdraw the entire $100,000 tax-free.
If you do so, your contribution limit for the next financial year would be $100,000. In other words, your capital appreciation has temporarily expanded the room you have for tax-free capital deployments.
However, what if you lose money instead? If your $50,000 TFSA turned into $30,000 over time due to bad investments, liquidating your holdings will shrink your TFSA room when you withdraw cash.
Permanent capital losses in your TFSA could deliver a two-punch blow to your personal finances. Not only have you lost money on bad investments, but you’ve also adopted the opportunity costs of lower tax-free investment contributions. I would argue that over time, the opportunity costs of less contribution room matters more than present-day losses.
While there’s no way to predict the outcome of your investment decisions with precision, there’s one simple way to avoid a severe hit on your TFSA contribution room: avoid speculative bets.
The TFSA could be used to buy steady dividend income stocks that deliver passive income or reasonably priced growth stocks that have a track record of expansion and the financial strength to fuel growth over time.
The key is to focus on seemingly boring companies with a track record of stable returns on equity and a conservative approach to cash management. It might also be better to focus on recession-proof, defensive industries like healthcare or waste management.
You should probably avoid penny stocks, risky biotechnology firms, unprofitable cannabis stocks, crypto mining companies or volatile startups on the Toronto Venture Exchange for your TFSA.
Create a systematic investment plan that balances risk as well as reward over time. You can keep speculative and risky bets for your regular investment account. Losses in a traditional account can actually be claimed as a “capital loss” to reduce your tax burden.
TFSA investors tend to focus on maximizing their capital gains and passive income, while overlooking the risks of losing money in a tax-free account. Bad investments in a TFSA could permanently lower the room you have for contributions and the capital loss cannot be claimed as a write-off.
Instead, focus on stable income or reasonable growth stocks and keep speculative buys for your regular trading account. With clever tactics and a long-term strategy that balances risks and rewards, you can accumulate wealth efficiently and bring yourself one step closer to an early retirement.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.
Fool contributor Vishesh Raisinghani has no position in any of the stocks mentioned.