*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
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?
I manage my portfolio of about $180,000 and I refuse to trade on margin. I only trade on cash and tried to get Questrade to remove the Margin option but they wouldn’t.
I don’t like investing money I don’t already have.
I use margin to buy reits and the banks that loaned me the money. It’s free income on the bank’s money. Dividends pay the interest and then some.
And you can’t borrow in registered accounts… Tax code doesn’t permit it. Thus brokerages don’t allow it. You can “accidentally” cause it to happen (through a few complicated steps) but you get phone calls from your brokerage demanding you clear it.
It can make sense to temporarily borrow enough money to “gross-up” your RRSP contribution and then use your tax refund to pay back the loan. For example, say you’re in a 40% tax bracket and you had $3000 to contribute to your RRSP. If you borrow $2000 and make a $5000 contribution you’ll get $2000 back to repay your loan, likely without incurring any interest.
The difficult question is what to invest in once the money is in your RRSP.
I thought TFSAs weren’t covered under Cda-U.S. treaty, and the full 30% applied to U.S. dividend income…unless this has changed recently?