When the Government of Canada introduced the Tax Free Savings Account (TFSA) in 2009, the response was positive. Although contributions to a TFSA are not deductible for income tax purposes, the income generated in the account – such as interest and capital gains – is generally tax-free. True to its name, the TFSA is a vehicle that lets you invest your money tax-free during your lifetime. As well, the notion that the TFSA can operate like a "savings account" can be appealing, as it appears to offer the flexibility of making contributions and withdrawals.
Unfortunately, appearances can be deceptive. While the TFSA is a tax-saving vehicle, one must exercise diligent care where there is a series of withdrawals and contributions. A penalty on excessive contributions applies if an "excess TFSA amount" existed at any time in a month, and equals 1% of such amount in that month. The 1% tax continues to apply for each month that the excess amount remains in the TFSA.
Consider John's situation. He contributed $5,500 (the annual limit) to his TFSA in January 2013, withdrew $4,000 in mid-March, and re-contributed $4,000 in late March. Meanwhile, his wife Molly also contributed $5,500 in January, and contributed another $4,000 in mid-March and withdrew $4,000 in late March. John was convinced that he was compliant, and suspected that his wife had gone offside by over-contributing. In June 2014, John and Molly received their 2013 assessment notices with two surprises:
- Both were assessed penalties;
- Molly's penalty was only $40, but John's was $400!
The common misconception lies in the confusing definition of "excess TFSA amount". In simple terms, it equals total contributions minus the $5,500 limit. Total contributions include amounts contributed at any time during the year – even after first withdrawing an amount. However, only withdrawals made after contributing more than the $5,500 limit reduces the excess amount. This is why Molly's entire $4,000 withdrawal qualified, while none of John's did. Therefore, John ended up with an excess TFSA amount of $4,000 for 10 months, resulting in a $400 penalty ($4,000 x 1% x 10 months), while Molly's was only $40 ($4,000 x 1% x 1 month). The logic employed here may seem counter-intuitive, but taxation is rarely designed for clarity.
For any year in which tax is payable on an excess TFSA amount, you must complete and file Form RC243 "Tax-Free Savings Account (TFSA) Return", along with accompanying schedules. Under proposed changes, a TFSA return must be completed and filed by June 30 of the year following the calendar year in which the over-contribution happened. If the return is filed after the due date, a late-filing penalty will be charged.
Amidst the confusion surrounding the TFSA rules, the government's message is clear in at least one area: Contribute, but with caution. For this reason, individuals are encouraged to consult their tax advisors on their TFSA matters.
In Summary:
- TFSA is a great way for Canadian residents to invest money tax-free.
- As of January 1, 2013, you can contribute up to $5,500 annually to a TFSA.
- Unused TFSA contribution room is carried forward and accumulates in future years.
- Withdrawals from a TFSA are tax-free.
- Full amount of withdrawals can be put back into the TFSA in future years.
- Re-contributing in the same year may result in an over-contribution amount and a penalty tax.
Charles Fu is the Senior Tax Manager at Sloan Partners. Contact Charles today for an analysis of your family's tax savings opportunities.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
