What The New TFSA Rules Prevent

by Tax Guy - Burlington Accountant on October 20, 2009 Print This Post Print This Post

Since the Minister of Finance announced changes to the TFSA rules on Friday a number of questions about how the TFSA was being abused have surfaced that I’d like to address for you.

The strategies employed were taking advantage of the existing rules and were being used to generate tax-fee income or were being used to melt down RRSPs and eliminate income tax in retirement.

RRSP Meltdown Strategy

An RRSP is a savings vehicle that allows you to deduct contributions from your income and defer the tax until you with draw it at retirement. However, the introduction of the TFSA and combination of the asset swap rules meant some taxpayers using the rules to meltdown the value of the RRSP by taking advantage of changes in the value of securities.

Here is how it works:

Assume you have $100,000 of cash inside your RRSP and $5,000 of cash in your TFSA. You begin by purchasing the fictional stock XYZ Co. inside your TFSA.

RRSPFMV TFSA FMV
Buy 100 XYZ Co.@ $50/share In TFSA

Cash

$100,000

$0

Securities

$0

$5,000

$100,000

$5,000

Value of XYZIncreases to$60/share

Cash

$100,000

$0

Securities

$0

$6,000

$100,000

$6,000

Swap XYZ intoRRSP

Cash

$94,000

$6,000

Securities

$6,000

$0

$100,000

$6,000

Value of XYZFalls to$40/share

Cash

$94,000

$6,000

Securities

$4,000

$0

$98,000

$6,000

Swap XYZ backto TFSA andbuy 50 more shares.

Cash

$98,000

Securities

$0

$6,000

$98,000

$6,000

Repeat until the RRSP is fully depleted and the TFSA has all of the assets.

If these transactions were permitted to continue, the government would see the future tax base from RRSPs and RRIFs seriously eroded. The prohibition of asset transfers between accounts effectively eliminates this strategy.

TFSA Contribution Level Increase Strategy

The meltdown strategy has the by-product of increasing the TFSA contribution level. The original $100,000 in the RRSP is shifted to the TFSA and can then be withdrawn tax-free. Presumably, the your could then re-contribute the same amount back to your TFSA.

TFSA Over Contributions and Speculating

The next strategy again involves taking advantage of changes in the price of stocks in an attempt to generate tax-free income.

Here is how it works:

You believe a stock will increase significantly over the next couple of months and contribute your allotted $5,000 to your TFSA plus an additional $5,000. You will pay a penalty tax of 1% on the excess each month you are in an over contribution position ($50 per month). If you can earn more than the $50 per month, you can then withdraw the excess tax fee.

Here is an example using the recent change in the value of Apple Inc.

  • You purchase 55 shares of Apple for $188 per share on October 26, 2009 and contribute a total of $10,340 to your TFSA to fund the trade. Since this is your first, TFSA contribution this year, you have over contributed by $5,340.
  • Today (October 20, 2009) you sell your shares of Apple for $200 per share and realize a profit of $660.
  • You then withdraw the over contribution amount and are left with $5,660 in your TFSA.
  • Since you’re over contribution and withdrawal occurred in the same month you are NOT subject to the 1% penalty tax and have made a tax-free profit of $660.

Again, you have also inflated the value of the TFSA by $660 that a little more than half was due to your over contribution.

In-Kind Contributions Unaffected

One question I fielded recently about these changes was the impact of making an in-kind contribution from an open account to a TFSA. The answer is none. If you have shares in an open account, you can contribute the shares to the TFSA and any gain is taxable but any loss is superficial and denied.

About The Tax Guy...

Dean Paley CGA CFP is a Burlington accountant and financial planner who services individuals and business owners locally, nationally and internationally. Dean has appeared in the National Post, Toronto Star and Metro News.

To find out more, visit Dean's website Dean Paley CGA CFP or connect via Twitter @DeanPaleyCGACFP.

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{ 4 comments }

CanadianInvestor October 21, 2009 at 4:54 am

What is to prevent someone from doing the RRSP meltdown simply by buying and selling in the two accounts instead of doing swaps?

Tax Guy October 21, 2009 at 3:09 pm

It appears the point of the exercise is to shift RRSP money to the TFSA or to get open funds into the TFSA using the swap strategy. The cash in one account is swapped for assets in another.

deno2009 January 20, 2010 at 7:20 pm

Hi, just looking for clarification about contributing shares into a TFSA. as per the comments about any gain is considered taxable but losses are not deductible. So with respect to the gains, would the person doing my taxes deem the shares to have been sold at fair market value on the day the transfer into the TFSA took place? And then from that point, any further gain in value would accumulate tax free?

Tax Guy January 20, 2010 at 8:14 pm

@ deno2009 – Yes fair market value on the date of transfer is the value used. And yes, the investment grows tax free from that point on.

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