The Tax-Free Savings Account introduced in 2009 was thought to be one of the best new programs created by the federal government in years.
Similar to a Registered Retirement Savings Plan, TFSAs can contain different types of investments, such as guaranteed investment certificates, bonds, mutual funds and stocks.
TFSAs offer flexibility, with a $5,000 limit each year that can be contributed and allowed to grow tax-free. Money can be withdrawn tax-free, and the amount withdrawn is added back to the TFSA contribution room in the following year.
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However, adding the withdrawal amount back to the contribution room is where confusion can arise, potentially resulting in penalties.
Taxpayers will be subject to the TFSA tax on excess contributions if at any time their contributions exceed their TFSA contribution room for the year.
The tax is similar to the tax of one percent per month on excess RRSP contributions. For a TFSA, the one percent is on the highest excess amount in the account for that month. This tax will accumulate until the excess amount is withdrawn.
Unlike RRSPs, there is no $2,000 “grace” over-contribution amount for a TFSA. Taxpayers who have excess contributions should withdraw the funds immediately to avoid additional tax.
The one percent tax on an excess TFSA amount applies from the first dollar of excess contributions. It is also based on the highest excess TFSA amount in an account for each month in which an excess exists.
This means that the one percent tax applies for a particular month, even if an excess amount was contributed and withdrawn later during the same month.
Taxpayers who have more than one TFSA can transfer funds directly from one to another without affecting their contribution room, provided their financial institution completes the transfer.
If a taxpayer withdraws funds on his own from one TFSA and contributes those same funds to another TFSA, the re-contribution will be considered to be a new contribution. As a result, TFSA contribution room will be affected and the taxpayer may be subject to a tax on excess contributions.
Like an RRSP, the yearly contribution limit of $5,000 is cumulative for a TFSA. Any amount not used in one year is carried forward to the next year.
For example, if a taxpayer contributed $5,000 to his TFSA in 2009 and $4,000 in 2010, the contribution room for 2011 would be $5,000 plus the $1,000 shortfall for the previous year. If he contributed the full $6,000 at the beginning of 2011 and then withdrew $2,000 during the year, he would be allowed to do so tax free.
The problem occurs if the taxpayer tries to replace the withdrawal before the end of 2011. Then he would have over-contributed by $2,000, according to the Canada Revenue Agency, and would be subject to penalties.
If the taxpayer waited until this year to make good on the withdrawal, his contribution room would be $5,000 plus the $2,000 withdrawn in 2011.
In addition to the tax on over-contributions in a TFSA, any earnings or increase in value reasonably attributable to “deliberate excess contributions” will be considered a tax advantage and taxed accordingly. The tax rate on an advantage is 50 percent of the income generated.
