Should you invest in a registered retirement savings plan (RRSP) or a tax-free savings account (TFSA)?
It’s a question that many Canadian investors ask themselves, and the answer is rarely cut and dry.
The advantages of each account are well known:
- The TFSA lets you deposit, compound, and withdraw your funds tax-free.
- The RRSP gives you a tax deduction for contributing, and lets you compound your investments tax-free until retirement age (maximum age 71).
The disadvantages of each account are also pretty well known:
- The TFSA does not give you a tax deduction.
- The RRSP becomes taxable on withdrawal.
The most common advice is that the RRSP makes the most sense for long-term retirement saving, while the TFSA makes more sense for investments that you may want to cash out for spending in a few years. This takeaway is pretty sensible, as the RRSP’s withdrawal tax hits the hardest when you are working (retirees have lower tax rates on average). However, there are other subtle differences between the RRSP and the TFSA that most investors don’t know about. In this article, I will explore one rare situation where trading in an RRSP is less risky than trading in a TFSA.
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Active trading
If you trade actively in an RRSP (for example, day trading), you are far less likely to be taxed for it than in a TFSA. The reason is that the RRSP is specifically designated as 100% tax exempt in paragraph 146 of the Income Tax Act. So, even if you’re day trading so frequently and aggressively within an RRSP that it looks like you’re carrying out a business, it doesn’t matter: you’re still tax-free. If you day trade and reap enormous profits in a TFSA, on the other hand, you might wind up getting taxed as a business. Risk factors for this include:
- Trading options.
- Advertising yourself as a professional trader.
- Having worked in the financial services industry prior to starting full-time trading.
- Using pricey research services.
- Having expensive software (e.g., a Bloomberg terminal) that only financial businesses use.
- Running up massive account balances
If you day trade in your TFSA and all the characteristics above describe you, there is a good chance you’re getting taxed. Yet doing the same in an RRSP, you’re likely safe.
An example of how you could get taxed in a TFSA
Let’s say that you’re trading a high volatility stock like Shopify (TSX:SHOP) with options, making profits on it over time. Shopify is a highly volatile stock meaning that it can provide high profits for option traders. Starting with as little as $10,000, you might well run your balance up to $1 million or more over time. “Hooray” you think, “I’m really making it.”
It might feel like you’re winning if you find yourself in such a situation. But the CRA might see your trading as a business and tax you accordingly. In that scenario, you might find yourself giving up as much as 50% of your Shopify gains to the taxman. It’s sad but it’s true.
Foolish takeaway
As a concluding note, this article is by no means meant to advocate day trading in an RRSP. Day trading is a losing strategy for 99% of investors, and most of the 1% are likely just lucky. However, reaping huge profits in an RRSP is less likely to draw the CRA’s ire than day trading in a TFSA.
