There's a difference between what you should put in your Tax Free Savings Account (TFSA) versus what you can legally hold in this relatively new savings vehicle.
Contrary to popular belief, the TFSA is not merely a savings account, as its name seems to suggest, but rather can be used as a vehicle to hold all kinds of qualified investments, similar to an RRSP or RRIF.
The options for TFSA investment are virtually endless: from cash and GICs, to stocks and bonds, along with mutual funds and ETFs.
But the rules concerning qualified investments can be complex and detailed, especially when your investment is something other than a plain-vanilla, blue-chip Canadian stock. Take the controversy that arose online this past week stemming from the revelation in these pages that a reader's TFSA had grown to over $172,000 by investing in shares of Fannie Mae, the U.S. housing lender that has been placed into the conservatorship of the Federal Housing Finance Agency.
The Income Tax Act states that in order for a stock to be a qualified investment for a TFSA, it generally must be listed on a designated stock exchange. The Department of Finance maintains a list on its website of designated exchanges, which includes 41 exchanges in 28 countries, ranging from the U.S. Nasdaq to Israel's Tel Aviv Exchange. The list includes most Canadian and U.S. stock exchanges, but over-the-counter facilities such as the Nasdaq OTC Bulletin Board facility and the Canadian OTC Automated Trading System are not on the list.
Fannie Mae, which used to be traded on both the New York Stock Exchange and the Chicago Stock Exchange, was delisted in June 2010 and began trading on the OTC Bulletin Board, which is not a designated exchange; however, because it also listed on the Stuttgart Stock Exchange in Germany, it appears its shares do qualify for investment by TFSAs, regardless of which exchange the shares are purchased through.
The consequences of investing in a non-qualified investment inside your TFSA can be quite severe. First of all, there is an automatic penalty of 50% of the fair market value of the non-qualified investment in the year it is purchased by the TFSA. Fortunately, as long as you can demonstrate that it was purchased inadvertently, this penalty can be refunded in the year the non-qualified investment is disposed of by the TFSA. But the real problem is that the TFSA itself must pay tax, at the top marginal tax rate, on any income or capital gains earned from the non-qualified investment. To make matters worse, the capital gain is taxed in full, and not at the normal 50% inclusion rate.