Written by: Methusan Thiruchelvanathan
The Tax-Free Savings Account (TFSA) is a program in Canada that allows Canadian residents who have a valid SIN and are over the age of 18 to open a tax-deferred savings account with a financial institution, credit union or insurance company. Any income earned in this account is generally tax-free. In addition, withdrawals from the account are also tax-free – meaning the growth on TFSA investments is never taxed. The allowable contributions to the account are limited to a specific amount set annually by Canada Revenue Agency (CRA). If the contributions within a year, plus unused portions from prior years, less withdrawals, are in excess of the allowable limit, the excess balance in the account is subject to penalty.
Your contribution room begins accumulating in the year in which you turn 18. The contribution room grows each year, based on an amount set by the CRA for that year (currently at $6,000/yr). As long as the contributions you make toward your account do not surpass the limit of your account, you will not be taxed on any of the income (i.e. interest, dividends, etc.) made on the account, nor will you be taxed when you withdraw from the account.
What if you over-contribute?
If you’ve unknowingly over-contributed to a TFSA, it is best to withdraw the amount over-contributed as soon as possible. Over-contributions are subject to a 1% tax per month, on the amount in excess of the limit. The CRA will send you a notice if they identify that you have over-contributed, proposing a TFSA return showing the penalty fee that will be accrued on the account if the over-contribution is not withdrawn.
Since TFSA contributions are usually used to purchase investments inside a TFSA, it is possible for your account value to dip below the value that you had contributed (i.e. if the investments you bought go down in value). In such cases, it is then possible to be in an over-contributed position on your TFSA, yet not have sufficient funds in your TFSA to withdraw the excess!
An Example of Over-Contribution With Insufficient Funds to Correct
For example, an individual who just turned 18 decides to contribute $10,000 into their account and invests it in public securities. Their total contribution limit would be only $6,000 since it is their first year of eligibility for an account, so they have over-contributed to their account by $4,000. They must withdraw $4,000 in order to avoid penalties being assessed by CRA. However, suppose that the $10,000 public securities investment turns out to be a poor investment and the value declines to just $2,000. There is now only $2,000 in the TFSA but the account holder needs to withdraw $4,000 in order to rectify the over-contribution.
The taxpayer will still be subject to penalties on over-contributions of $4,000! The penalties that the CRA assesses must then be paid, and it is important that they are paid in a timely manner or interest will also accrue. The taxpayer will then have to wait for their contribution limit to increase in the following years, to the point where their previous contribution is now within the limit.
You may notice that next year, you will receive an additional $6,000 of TFSA contribution room. In the new year, your overcontribution position will be recalculated, so that the additional room will cure the overcontribution of $4,000. But what if you DON’T get more contribution room next year?
It is important that if this scenario occurs, that the taxpayer stay resident in Canada. In order for the contribution room to increase annually, the taxpayer must be a resident of Canada. If the taxpayer were to leave Canada with an over-contribution, they will be subject to penalties with no way of stopping the penalties, since non-residents cannot accumulate additional contribution room each year.
In these situations, an appeal can be filed with the CRA. But you should always pay the penalty fee even if an appeal is planned so that interest does not accrue on the penalties. The CRA can reimburse the penalties on amounts appealed But beware of this position – any relief is entirely up to CRA’s discretion.
Contact Sloan Group LLP in Toronto for Personal Financial and Accounting Advice
While the TFSA provides a great benefit for Canadians to invest in ways that are tax-free, it is important to be aware of the rules surrounding the TFSA so that you do not end up being penalized for misusing your TFSA. At Sloan Partners LLP, our team of accounting professionals are dedicated to delivering reliable solutions to our clients and identifying the best financial planning solutions. If you would like to discuss how partnering with us could benefit you or your business, contact Shawn Bausch to schedule a consultation or you can reach out to us online, or by phone at 416-665-7735.