Ah, the tax-free savings account (TFSA). Who doesn’t love it? With thousands in annual contribution room, the TFSA lets you keep 100% of your stock market returns forever… right?
Well, not quite. Once you put your money into a TFSA, the CRA can find out that it’s there. TFSAs are administered by Canadian brokers, who report account data to the agency. If the CRA finds out that you’ve been breaking the account rules, you may very well be taxed.
For many TFSA millionaires, it’s a lesson they’ve had to learn the hard way. There have been several cases of Canadians running up their TFSA balances into the millions, only to have the CRA come after them for tax money. One trader named ‘John’ ran up a $1.25 million balance and received a CRA inquiry.
It might not seem fair, but the underlying rationale is sound. The TFSA was designed to shelter passive savings. It was not built for day trading. If you spend all day in front of a computer trading options, you look more like a business owner than a passive stockholder. In the CRA’s eyes, you’re not using the TFSA as intended.
How to avoid being taxed for day trading in your TFSA
There are several ways to avoid being taxed for day trading in your TFSA. The most obvious one is to simply buy and hold stocks, rather than attempt to trade them frequently. Studies show that less than 1% of people who try day trading ever make money at it. Meanwhile, countless investors make money sitting on diversified portfolios, such as index funds. The “buy and hold” portfolio strategy makes sense, is profitable, and makes it harder for someone to accuse you of running a day trading business. It’s a no-brainer.
We can illustrate the wisdom of the “buy and hold” strategy by considering the case of Shopify Inc (TSX:SHOP). Shopify stock has done incredibly well since its IPO. SHOP stock has risen 2,971% in the markets. The e-commerce platform has grown its profit by over a thousand percentage points. It was for a time the largest publicly traded company in Canada.
By simply buying and holding Shopify stock from 2019 or earlier, you’d have done well.
Major volatility
However, Shopify’s run has been very volatile. There have been several 10% daily swings in its price. There was one point when the price declined 82% in a few months. Basically, there have been plenty of opportunities to lose money in Shopify stock. As the legendary Howard Marks says, it’s possible to earn sub-par returns in great stocks by trading in and out of them too often. That’s a lesson most day traders learn the hard way.
And if you do succeed in day trading? Beware the CRA. If you day trade options and realize superior returns, that’s when the tax agency could come knocking. So, day trading in a TFSA is risky no matter what. If you’re like most day traders you’ll lose money. If you’re in the elite 1%, you may lose your TFSA account benefits. Ouch.
Foolish takeaway
The bottom line on TFSAs is that they can save you a lot of money if you use them right. Hold a diversified TFSA portfolio and you’ll probably do well. Follow an ill-advised strategy, such as day trading, and you might get burned.
