Why You Shouldn’t Borrow To Invest In Your TFSA & RRSP

*Note: I’ve updated some of the wording in this post since it went live to replace the places where I said “borrowing on a margin” to say “borrowing to invest”. I was using the terms interchangeably when they’re not for these types of accounts: “Government regulations prevent you from trading with margin in registered accounts like RRSPs, TFSAs and LIRAs.” (because it’s dumb, as you will see in the post below). Sorry for the confusion! I had also typed ‘ever’ as ‘every’ so this definitely needed a proofread ;)

You can and should open brokerage accounts within both your TFSA and RRSP. I suggest the TFSA first, because if you’re a new grad just starting out, it’s unlikely your income is high enough to justify aggressively contributing to an RRSP — particularly if you paid for your education yourself and have tuition credits you can claim. For an understanding of how an RRSP and TFSA differ, here’s a quick cheat sheet:

The TFSA vs. RRSP

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 The main difference between a TFSA and RRSP is how the funds in each account are taxed, particularly in a brokerage account. In a TFSA brokerage account, all dividends, interest and capital gains you earn on your investments is tax free. This is a huge advantage in this account because if you continue to reinvest dividends and interest, the compounding income will also be tax-free. In your RRSP, you’ll also benefit from compounding, however you will be taxed on all these gains when you withdraw the funds with the exception of borrowing under the first-time Home Buyer’s Plan or the Lifelong Learning Plan. To learn more about withdrawing from your RRSP, check out this post: Ways To Use Your RRSP For Things Other Than Retirement.

A seasoned investor might understand that using leverage like cash borrowed on a margin for trading is a quick way to grow you money. After all, if your investments increase in value, the more you’ve put in, the more you’ll get out. However, if your investments lose money,  twice because you still have to pay back what you borrowed. Taking this risk on accounts that have contribution limits is idiotic. If you lose even part of your investment, you never get that contribution room in your TFSA or RRSP back. Which is why I suggest…

Don’t borrow to invest in your registered accounts!

Borrowing to invest can turn very expensive, very fast. Depending on where you get the funds to invest, the total borrowing cost could vary from 3% on a line of credit to 18%+ if your funding it with a credit card (I don’t even want to go into how stupid that is).

This means that when you borrow to invest, you need the stock to earn at least 3% to 18% just to break even, and even more if you want to make a profit!

I don’t think it’s unreasonable to earn 3%+ on a stock, but shooting for 18%+ is a little more challenging.

and what if you lose?

This is where it gets nasty. For example, someone borrows $5,000 to invest in a hot stock in their TFSA. They borrow this at 6% so in a year’s time they will have to pay back $5,300. They dump all $5,000 plus an additional $5,000 of their own money for a total of $10,000 into one stock and watch it for 12 months. It falls, and then falls agin, finally plummeting down 20% to $8,000 by year end. Finally ready to call it quits, the investor withdraws their money and pays off the $5,300 they owe the brokerage, leaving only $2,700 for themselves. This means of the $5,000 of their own money they initially invested, they lost nearly 50%. Ouch!

They also lost the contribution room in their TFSA.

That’s $2,300 that could be safely earning interest in a savings account. If you’re thinking buying stocks in your TFSA at all is risky because a loss will always translate into a loss of contribution room, you’re right. And that’s why investing in stocks is riskier than keeping your money in a simple savings account. But what’s most important to note is this:

borrowing to invest unnecessarily magnifies risk. 

If the person had invested only $5,000 of their own money, they would have suffered a loss of only $1,000 instead of $2,300. If they had saved up the extra $5,000 they needed and gone all in for $10,000 just like in the example, they’d only be down $2,000 instead of $2,300. It’d still be a loss, but at least they’d have an extra few hundred dollars. They’d only realize a loss of 20% instead of 46%. That’s a HUGE difference!

The scenario plays out the same way in your RRSP. If you borrow and lose, the RRSP contribution room is gone forever. If you’re serious about building wealth, you know that investing in stocks in a registered account is risky enough and you don’t want to magnify that risk with borrowed money.

Is it ever ok to trade on a margin in your TFSA and RRSP?

Honestly, it’s up to you! I’m too risk-averse to gamble with fire in my registered accounts but some investors might really feel confident borrowing to invest in their TFSA or RRSP. As a seasoned investor with maxed out registered accounts that have already returned some extra money for you, you might feel comfortable taking the plunge and buying on a margin. Ultimately, it comes down to what kind of investor you are. But if you’re like me and still managing small investments (less than $50,000) and still learning the ropes of the stock market, buying on a margin is simply too much risk for too little reward.

What are your thoughts? Is borrowing on a margin in your registered accounts a great way to build up your long term savings or too scary to play with contribution room you can’t recover?

Tackling My TFSA

One of my goals for January was to figure out how much contribution room I have in my Tax-Free Savings Account. This shouldn’t be difficult, but despite my love of all things personal finance, I’m not quite as organized with my TFSA as I should be.

First of all, I have two of them: one is a simple savings account with ING, the other is a brokerage account with Questrade. This immediately creates two piles of paperwork I needed to go through. Secondly, I don’t contribute regularly or with any rhyme or reason. I transfer some money from every paycheque to my brokerage TFSA since I opened it in the summer, but my ING savings account one is kind of all over the place. I put money in it some months, and some months I don’t. Lastly, I’ve made withdrawals in the past. Because my emergency fund is my ING TFSA, I’ve pulled cash out to cover my butt when paycheques came up short.

My ING TFSA has been earning interest and my Questrade TFSA collects dividends and profits from stock sales, so their balances don’t reflect my actual contributions (in a good way!). So my only plan of attack was to sit down with the monthly statements from each account and go through every contribution and withdrawal.

Well, it actually wasn’t too bad. The stock account is fairly new and the ING one is a bit inactive so I figured everything out within an hour. I’m happy to report I have less contribution room than I expected — this means I’ve actually contributed more to my TFSA than I previously thought. Win! But I’m still not close to maxing it out.

Since it is now 2012, Canadians have $20,000 worth of contribution room in their Tax Free Savings Account — $5,000 for each year since 2009. For those of you new to TFSAs, they’re registered accounts in which any earnings are NOT taxed. This means any profit you make on money within a TFSA can’t be gouged as income. (For more information about the Tax Free Savings Account visit the Government of Canada TFSA website here). Maxing out my TFSA is a personal goal of mine, though I know I won’t be able to meet it for a couple of years, because not only do I have to catch up on old contribution room, every year you can contribute another $5,000.

But this year I am going to get $5,000 in there. I will! And I’ll worry about the extra contribution room later.

My plan is first to put $250/mo into my brokerage TFSA for a total of $3,000. Starting in March, I’m going to contribute $100 to my ING TFSA for a total of $1,000. This kills two birds with one stone: extra money into the TFSA and getting my emergency fund to 3 months worth of savings ($3,000). I’m not sure where the remaining $1,000 will come from. Probably a combination of things (ie. I add $50 every time I complete a goal on my Day Zero list). Sadly I have earmarked some of the money in my TFSA for a trip to Africa in July (hopefully), but I figure as long as the balance grows more than it decreases in 2012, I’m doing ok.

 Canadians, have you maxed out your TFSA? What is your strategy? Also, US & international readers, does your country have a similar type of account where earnings are not taxed? How does it work?

I love ING because I love money

I’ve been banking with ING for nearly 3 years now. It’s a romance that I think has the strength to last a lifetime. Why? Because it has all the strengths of any successful relationship:

mutual love & respect, great communication, room to grow, and no qualms about money.

I signed up to be an Orange Ambassador on ING’s Facebook page a few months ago. The week I got back from my work trip, I found a pleasant surprise in my mailbox: free swag! Not only am I an Orange Ambassador, but I’m one with a nifty orange travel mug and a lunch bag. I love these things because like any smart saver, I know that bringing in your own mug to Starbucks gets you a discount on your beverage and packing your lunch for work is way better for your wallet than buying from the food court every day.

Now I think I even have a bag of coffee in the mail, thanks to a kind exchange with @SuperStarSaver.

But truthfully I sung the praises of ING long before they started giving me free stuff. This is because long before ING sent me tools for my lunch kit, they gave me something I like even more: free money.

When I first opened a savings account with ING, the interest rate was 4% (I miss those days!). Even now that the markets have taken a beating and my interest rate is only 1.5%, it’s still way higher than what traditional banks offer. After saving up $1000 in it, I took my first baby steps into investing and bought some StreetSaver mutual funds and have been contributing monthly ever since. Not long after opening these accounts, the Tax-Free Savings Account was introduced in Canada, so I also opened one of those with ING. As faithful readers know, this is where I keep my Emergency Fund (which even sporadic readers know is the savings I insist upon the most), my DayZero Fund. It’s also where I save for vacations and put a few dollars in towards the future purchase of a car or a downpayment on a home. Last year, I even started an RRSP with ING. My future is in this banks hands! (because I trust them with it). A few GICs along the way, and I’ve basically taken advantage of every service ING offers except a mortgage — and frankly, that’s just a matter of time!

How much has ING paid me in interest and dividends on my investments? Over $300. I’ve also earned $100 for referring others. Which, by the way brings me to an important point: if you would like to bank with ING, use my referral code when you open an account with at least $100, and we’ll both get $25…

How much has my other bank paid me? Maybe fifteen cents.

When ING introduced the THRiVE checking account, I naturally signed up for that as well. And who wouldn’t? With no fees, interest earned on your balance, online bill pay, and your first set of cheques free, I’m surprised anyone with grade school math abilities can say no. Furthermore, an agreement with HSBC means I can withdraw and deposit money from my ING accounts at local HSBC branches and lucky me, there’s one very close to my house!

ING, I love you — and I never expected to say that about a bank.

The TFSA

Since my first entry was devoted to saving, it’s only fitting I tell you where to put that cash away. The Tax-Free Savings Account is the best place for students to save their money. DO NOT put money in RRSPs or any unregistered accounts until you have maxed out your TFSA contributions. Why? Even if you don’t need the tax-break on interest & earnings that the TFSA offers, it will give you the most bang for your buck long-term. Here’s why:

1) Like RRSPs, you can put your TFSA money in a number of different investment vehicles including mutual funds & GICs. Don’t feel restricted to a simple bank account!

2) You never lose the contribution room in your TFSA. Even if you make a withdrawal, you can simply return that amount in addition to your regular contribution in the next year. With the exception of the Home Buyer’s Plan (which really isn’t that great of an idea, to be discussed in a later post), when you withdraw money from an RRSP, you can never put it back if you’ve maxed out your contributions.

3) TFSA earnings are tax-free, RRSP earnings are not. This means your money is better invested long-term in a TFSA, because the more time it has to grow, the more money it earns, all of which you get to keep. This is unlike an RRSP, where you will be taxed on your withdrawals in your old age, which means taxed on all that interest your money earned for you. If your earning a small income now, it doesn’t make sense to take the RRSP tax break at this time in your life, only to suffer a greater tax when you withdraw it in your old age at a higher tax bracket.

While the TFSA is excellent, there are some limits, namely the $5000 per year contribution cap. As a student, this may not affect you since $5000 is a huge sum given your restricted earning potential (only working part-time!) and significant financial obligations (tuition!). To reach the $5000 limit each year, you effectively need to save $416.67 per month. That’s a lot, but if parents are helping you or you have some magic way to make such impressive strides in saving, make sure to watch your limit so you don’t go over and suffer the financial penalties.

Lastly, if you can or have maxed out your TFSA, don’t stop there! $5000 per year is probably not enough to meet all your goals and wants, so if you have cash left over, go ahead and start saving and investing in unregistered accounts and RRSPs. In short, you should be saving as much as your comfortably can — the TFSA is merely the best place to start.

Below is a nice TFSA vs. RRSP compairison chart from TD Canada Trust that reiterates a few of the points I made, plus provides some additional information.