There is a potential time bomb lurking in Tax Free Savings Accounts (TFSA) that have investments in them that were purchased using a Deferred Sales Charge (DSC) compensation model.
When I did the math on this, it just reinforced my rationale for encouraging advisors to invest their clients money using no-load investments.
The best way to illustrate this issue is by way of an example.
Mary has a TFSA worth $25,000. She purchased her investments in the TFSA on a DSC basis.
(NOTE: DSC simply means that you as the purchaser are not charged a fee up front to purchase the investments and the advisor who sold the investment to you is paid a commission from the investment company for placing your investments with that company. If you redeem these funds prior the the expiration of the DSC schedule, you as the investor will have to pay all or part of the commission initially paid to the advisor, back.)
Now, a few years later, she needs some money to fund a kitchen renovation. So, she redeems $25,000 from her TFSA because she knows that any withdrawals from the TFSA are considered “Tax-Free”. And, since the TFSA rules allow you to replace your withdrawal from the TFSA in a future year, she feels confident that this is the best place to redeem the cash from.
This feature of being able to re-contribute any withdrawals back into the plan in future years is one of the greatest features of the TFSA, next to its ability to grow the assets on a tax-free basis.
But, when her cheque comes in, it is for $23,750? Why is that?
Well, now we are beginning to see the negative impact of the DSC.
In this example, not only was there a 5% DSC fee that had to be paid before Mary received the funds, but when it comes time to put the money back into the TFSA, she is only able to put back $23,750 as opposed to $25,000 because the DSC fee is considered a charge to the TFSA and is not considered as part of her withdrawal. The rules state that she can re-contribute what was previously withdrawn but she only withdrew $23,750.
What happens to the $1,250 in room that she looses? She looses it forever…
So, when you are purchasing your investments, make sure you are clear on the load structure of the investments. If the load structure is DSC, you want to really understand why this is in your best interest.
