- Canadian Tax Resource Blog - http://blog.taxresource.ca -

What The New TFSA Rules Prevent

Since the Minister of Finance announced changes to the TFSA rules [1] 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 The original $100,000 in the RRSP is shifted to the TFSA and can then be withdrawn tax-free.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.

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.

[2]