Thursday, October 22, 2009

TFSA Rule Changes Likely Helpful to Investors

The Canadian government’s planned TFSA rule changes have been described as needed to prevent sophisticated abuses by savvy investors, but on closer examination, the biggest effect may be to protect investors from themselves.

The penalty for over-contributions to a TFSA used to be 1% each month, but this has been changed to taxing any return on the excess amount at 100%. Apparently, some investors were deliberately over-contributing looking for short-term gains that would then be tax-free, except for the 1% each month.

However, most investors who chase short-term gains lose money. This new rule will have the effect of saving many reckless investors from following a strategy that has a built-in 12% per year drag on returns. This is almost like borrowing on a credit card to invest.

The new rule against swaps between RRSPs and TFSAs is designed to prevent a scheme to shift money from an RRSP to a TFSA as I explained previously. For an investor who tried this and failed to execute it well, the result was just paying a bunch of fees to a brokerage for shifting stocks around.

Canadian Capitalist observed that one could achieve a cash for stock swap between an RRSP and a TFSA by just selling stock in one and buying the same stock in the other. This raises the question, why ban swap transactions? I have three possibilities:

1. The government hasn’t thought of this.

2. The new rules will actually cover this kind of dual activity in an RRSP and TFSA.

3. The government thinks that the costs of commissions and spreads will make it impossible to profit from this strategy.

UPDATE:  A 4th potential reason: investors may be able to play games with the fair market value on a swap by picking either end of the day's trading range after the fact.  This would not be possible if the swap is accomplished virtually by buying and selling stock in the two different accounts.

Overall, the new rules may prevent some sophisticated investors from exploiting TFSAs, but for most investors who try such games, the rules will save them from themselves.


  1. This comment has been removed by a blog administrator.

    1. Here is Patrick's comment with a broken link removed:

      I think CC's idea of buying and selling is severly limited, while the swap scheme is unlimited. When you withdraw from your TFSA, you get that contribution room back for the next tax year. That means you can't just freely add and remove assets from a TFSA all year long; eventually you run out of room for that year and need to wait until the next year.

      The swapping scheme doesn't have this limitation.

    2. Here is Canadian Capitalist's reply to Patrick:

      @Patrick: The buying and selling is done *within* a RRSP and TFSA to simulate a swap without any withdrawals. The only limitation is the cost of the trade and bid-ask spreads, which in many cases may be less than the cost of a swap.

      For instance, say you hold ABC within your TFSA. You have cash in your RRSP. You sell ABC in your TFSA and buy it in your RRSP. Now, you have essentially swapped the contents of a TFSA with a RRSP.

  2. Patrick: I think CC intended his buying and selling scheme to not involve any actual withdrawal from the TFSA. Instead of swapping cash in one account for shares in the other, you buy shares in one account and sell shares in the other (leaving the cash from the sale in the account). This way there aren't ever any withdrawals. There is just activity within each account.

  3. It looks like CC got in there with a clarification before I did.