A tax-free savings account or TFSA is arguably one of Canadians’ most beneficial savings and investment accounts. You can use it for holding mutual funds, bonds, stocks, exchange-traded funds, guaranteed investment certificates, and cash savings.
However, if you don’t know when, how, or how much to invest, you can easily lose money in a TFSA. Learning how to manage your account effectively is important if you want to avoid losing money.
So, let’s take a look at how you can lose money in a TFSA and what you can do to prevent it.
Importance of TFSA
The Canadian government introduced the tax-free savings account or TFSA as a savings plan in 2009. But it’s important not to fixate on the “savings” part — a TFSA is much more than a traditional savings account.
Through a TFSA, you can save and grow your money without paying taxes on it, similar to what the 401K is in the US. Even when your account only holds cash, you still earn interest. To make the most out of a TFSA account, however, it is best to invest as it has the potential to earn more and your tax remains zero. So, the amount will always be tax-free whether you earn capital gains, dividends, or interest. These benefits make a TFSA ideal for long-term savings.
Another major benefit of a TFSA is removing your savings whenever you want. So, you won’t have to worry about not having funds for emergencies.
Can You Lose Money In A TFSA, And How?
While a TFSA is a great way to grow your money tax-free, it still involves certain risks. But as long as you do not borrow money for your TFSA, you will never have a loss.
You only lose money in a TFSA when you incur investment losses. Just like any other investment avenue, using your TFSA account as an investment vehicle increases your chances of turning a profit but also exposes you to the risk of losses.
For example, X buys a company’s stocks for $5,000 through his TFSA. After a few days, the price drops 10% from what X bought it at. This means his new TFSA balance is $4,500, and the total return is -10%. However, if you have made other investments, chances are that those stocks prove profitable, and you do not lose money as a whole.
But a bad investment will not sabotage your TFSA; making the mistake of selling underperforming investments will.
In this example, even after the 10% drop, the account still has money, and X does not owe anyone any debt but has lost $500 on paper. And losses can be recovered as there is always a chance that the stock will rise back. But if you panic and sell the investments when they are low, you have turned a temporary loss into a permanent one.
So, if X decides to sell off the remaining $4,500 worth of stock, then he has officially lost $500 from his TFSA account. Now, along with the loss, X has also lost the TFSA room because more TFSA room is not awarded for investment losses. X also cannot deduct these losses on his tax returns like he would have been able to do if it was an unregistered account and not TFSA.
How To Avoid Losing Money
Now that you know how you may lose money in your TFSA, let’s explore some steps you can take to avoid losses.
- If you experience losses, wait and see if the stock recovers or sell the stock and use the money to buy another stock that will grow in value inside your TFSA.
- Making volatile investments or over-contributing are common reasons to lose money from your TFSA account.
- High-risk investments have a high risk of losses. So, to avoid incurring losses, making low-risk investments is a good idea.
- Avoid over-contributing; it can cause your account to be taxed at the rate of 1% for every month that there is over-contribution. Canadians can contribute $6,000 annually to their TFSA account. They can also make up for the past years when they did not add any funds to their TFSA account.
- Diversification will also reduce your chances of incurring a loss. Invest in different stocks like precious metals, commodities, collectibles, and real estate. You can also consult an advisor to go over your current portfolio and discuss diversifying.
Conclusion
Having a TFSA offers a versatile way to invest and save without paying taxes. But when you use it to make investments, you need to know about your risk tolerance, where you’re investing, and whether you’re over-contributing to prevent losses.
To avoid losing money, make diversified and smart investments to grow your money and create a substantial cushion of funds over time.
Sources:
https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/rc4466/tax-free-savings-account-tfsa-guide-individuals.html
https://www.bmo.com/main/personal/investments/learning-centre/understanding-tfsa-the-basics/
https://www.thestar.com/business/personal_finance/2022/03/07/what-happens-to-losses-in-a-tfsa-account-we-make-it-make-sense.htm
https://www.fidelity.ca/en/investor/commontfsamistake/
