How Risky Should You Get With Your TFSA?
I read an interesting article titled, “Do Risky Assets Belong in a TFSA?” (Canadian MoneySaver – March/April 2014). The author compares purchasing a GIC paying a guaranteed 2% a year with a risky ETF tracking the TSX with an expected average return of 6%, but which could result in returns ranging from a gain of 20% to a loss of 15% in any given year.
Contrast this with, “The Great TFSA Race”, a contest in MoneySense magazine searching for the highest balance in a TFSA.
Related: Why TFSAs are still misunderstood
The winner, with a balance of around $300,000, took an investment risk with highly volatile penny stocks and, in fact, currently is 100% invested in only one stock!
I say, good for him, but I think he was also very lucky. This could have turned out very differently.
Should you take big risks to reap huge rewards?
The risky investment
One advantage of a TFSA is that investment returns are tax free – i.e. no capital gains tax. Would this influence the type of investments a person would purchase?
Here are some of the risks:
No capital gains tax also means no offsetting capital losses. Would someone be tempted to hold on to a losing investment longer than is prudent, hoping for a rebound? Many investors find it difficult to sell a loser anyway, even when it’s found to be unsuitable. No tax break could make it worse.
You may lose future contribution room. If you do sell a losing investment and have to withdraw the funds from your TFSA you’ll lose some re-contribution room.
e.g. Franklin uses his 2014 contribution of $5,500 to purchase XYZ Widget Company. His shares drop in value to $3,380. He needs the money so he withdraws this amount. Next year he can only re-contribute $3,380, not the original $5,500, so has essentially lost the re-contribution room of $2,120.
Investor behavior is the greatest risk of all. Markets have rebounded nicely since 2009, which might give investors the confidence to take on additional risk. Many investors are optimistic enough to believe they can’t lose, especially in bull market conditions. Who wouldn’t want a cool $300,000 tax-free like the Money Sense winner above?
Related: 5 lessons learned about investing
Final thoughts
Too many investors treat their accounts as separate, individual entities, especially when they are held at various different financial institutions. The question should not be whether to own risky investments in your TFSA. All holdings should be part of an overall, properly allocated and diversified portfolio based on your financial situation and needs.
When a TFSA is part of a retirement savings or income plan, it needs to be integrated with any RRSP/RRIF or company pension plan. Someone who is using a TFSA for short term to medium terms funds will choose much different types of holdings.
Related: Using tax free savings accounts in retirement
Any risks taken should be based on your own comfort zone, time horizon, and other guaranteed money. Don’t treat your TFSA like a casino hoping for huge wins. You may end up striking out.
TFSA’s are best used for long term compounding of interest and growth from investments.
If you shop around today, you can find 3.00% GIC’s unless you go short term 1 to 2 years.
Longer term provincial strip bonds are yielding about 4.00% a year.
Maybe someone that does not mind more risk but wants safety too can invest in 3.00% GIC’s, 4.00% provincial strip bonds and dividend paying ETF equities and equity ETF’s.
Assuming all split equally by 33.33% and their equity portion earns 8.00% a year long term, a 5.00% average annual return might be what they could be comfortable with.
They could do this with their RRSP’s, RESP’s and non-registered money as well. The only dilemma that they might have is they may need to save more per month or quarter to have a comfortable financial position in 20, 30, 40 years.
I forgot to add in my post above that the earlier one gets rid of debt and continues to stay out of debt would reduce risk and help save more.
This maybe enough for most people achieving a 5.00% annual rate of return over decades to be financially stable and strong when they precisely need it.
The tFSA is so flexible numerous strategies can be used. My goal is to safely grow the amount with dividend growth stocks. Sure my portfolio will not double every year but I hope to grow my capital than most fixed income solutions. The key is growing that TFSA ceiling to one day become a huge tax shelter.
I tend agree with Asset Grinder,
Wouldn’t it be nice to grow your TFSA to 100K over the next 10 years, and have it spit out a clean 4% in dividends to supplement your CPP later, while your security picks continue to grow in value?
“Wouldn’t it be nice to grow your TFSA to 100K over the next 10 years, and have it spit out a clean 4% in dividends to supplement your CPP later…”
That’s my plan and I hope it won’t take 10 more years to get there.
This account is a gift for everyone.
I agree with Mark (above). The TFSA really is a gift and shouldn’t be taken for granted. I don’t think any unnecessary risks should be taken with a TFSA because even though the capital gains are not taxable, the capital losses aren’t deductible.
My current plan is funding my TFSA with my RRSP refund. Dividend stocks are my choice…hopefully generating a stream of tax free income down the road. I am praying that the gov’t raises the TFSA contribution amount.
I agree. I see so many people taking risks and losing out but getting mad as they couldn’t claim the capital loss. If I’m going to “gamble” with my investments, I’d be using the non-registered investments.
I believe there will come a point when the government caps the TFSA limit so why take the chance to “lose” the contribution room if you lose all your investments. That’s just my opinion.
That Money Sense the Great TFSA Race final winner is a BC government employee with ‘a good defined benefit pension’ plan, maxes out his and his wife’s ( a conservative investor )RRSP contributions every year. He was using his extra cash, money that he can afford to lose to play the risky ‘investment’game in his TFSA account. More power to him. I would probably do the same if I had the spare change in my wallet.