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Capital Losses in the Tax-Free Savings Account (TFSA)

Today’s post comes courtesy of a question from The Personal Finance Clinic held by the moneygardener, Canadian Capitalist and Triaging My Way To Financial Success.

Stephan writes,

My question is related to the TFSA. I am currently debating whether or not I should trade stocks within a TFSA or an un-registered account. I understand the benefits of having your ROE grow tax-free which is great. However, if I’m not mistaken, the TFSA doesn’t allow you to claim your losses against your growth. Of course, I wish every trade was a winning one then the answer would be easy but that’s not the case. I consider myself a swing trader so I do not normally hold long position except for a few ETFs. So the question is, is it worth it to trade within a TFSA?

Stephan,

A TFSA (tax free savings account) is a relatively new savings option for Canadians and many investors are asking themselves this very question when trying to plan how to utilize various investment accounts such as registered savings plans (RSP’s), non-registered investments and a TFSA.

Capital gains are not taxed within the account, but on the other hand an investor is not able to capture capital losses like they are in a non-registered account. For a non-registered portfolio you can match a capital loss against a capital gain to cancel out any taxes paid on gains from a trade or investment. In a TFSA that privilege doesn’t apply so the question you really need to answer for yourself concerns risk.

Capital losses, when investing, are inevitable and every investor should realize this. Whether you lose money due to inflation, a decreasing price of an investment or fees there will always be many opportunities for you to lose a portion of your investment. What a conservative investor wants to do is minimize risk and exposure to losses within a TFSA and maximize the benefits that the TFSA offers.

My initial thoughts are that an investor wants to keep only conservative investments within the TFSA to avoid, as best as they can, any capital losses against that stock, bond, ETF or mutual fund since there’s no downside tax advantage for aggressive trading. This is where an indexed strategy (the couch potato) would perform very well. By investing in index ETF’s and mutual funds and rebalancing each year an investor is not concerning themselves with capital gains or losses but methodically applying a conservative strategy that moves gains from some funds to losses of another. Over time the portfolio grows tax free and your losses are kept to a minimum because you’re simply investing with the market.

If you do choose to invest in individual stocks within the TFSA I would encourage you to choose very conservative stocks that over the long-term have great investment prospects. Large cap companies in the insurance, telecom, utilities and energy industry might be good choices if you have the room in a few years to diversify your portfolio into 10-12 stocks. Until then I would advocate, as I have already, that a TFSA be used as a savings vehicle or for an indexed investment strategy.

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{ 4 comments… add one }
  • BIGINTOBONDAGE June 30, 2009, 7:24 pm

    "Capital losses, when investing, are inevitable and every investor should realize this"

    oh man, don't know where to begin with that line.
    who was the sage that convinced you of that 'truth'?

  • Nurseb911 June 30, 2009, 11:29 pm

    I don't think that line is either incorrect or misleading. The fact is that no investor experiences zero losses no matter their skill, strategy or luck. Whether you look at fees, inflation, price loss, etc. Readers can make the judgement for themselves, but I think my comment is both fair and accurate. Have you never lost any money while investing to any source?

  • BIGINTOBONDAGE July 1, 2009, 9:38 pm

    lol.
    there is a clear difference between the cost of doing business and losses.
    i think of it like a business and something like the idea of 'opportunity cost', you have to be willing to put your time and money in (educating yourself, finding a proper advisor, paying their fees) to generate revenue in the first place.
    once your revenue exceeds your expenses every year, you are always earning a tidy profit (aka. a sustainable business model) and (wrt to personal finance) are likely rich and retired. this is actually the opposite of money just evaporating in your investment account because of opaque macroeconimc forces.
    losses are unanticipated downturns that result from naivety or overconfidence. expenses (like fees and taxes) are fully knowable in advance and hence i wouldn't classify it as a 'loss' unless i was feeling extremely miserly.
    maybe it's just my view of paying for quality.
    and i did experience losses regularly when i followed conventional wisdom and invested heavily in the stock market- i got sick of it so i changed my perspective and strategy, since then it's been up up and into my wallet.

  • Colin July 2, 2009, 1:29 pm

    It is interesting to me that people seem more concerned about being able to write off their capital losses for tax purposes rather than protecting the capital gains they should be getting… this seems like completely backwards thinking! To me, investing is not about trying to get the biggest tax refund by the end of the year.

    The goal of investing is to make profits and grow your money. That being the case, in a growth portfolio, any tax benefit from losses should be more than outweighed by the tax penalites from your capital gains. You're only offsetting your tax burden if you are breaking even in the account. If that is all you're doing then I think you need to be more concerned with your lousy investment strategy rather than how much you're paying in taxes!

    In addition, it seems to me that the more heavily traded account would benefit the most from the tax shelter because of high turnover. Contrast this with investments that you intend to hold for years that then receive less tax penalties on its growth overtime.

    Thus, using your TFSA for a trading account seems like a reasonable idea to me.

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