Over the past couple weeks, CRA has mailed 103,000 letters to Canadian taxpayers penalizing them for over-contributing to their Tax-Free Savings Accounts (TFSA).  About 6.7 million Canadians have a TFSA, so this represents around 1.5% of all accounts.  Most of these penalties are the result of innocent mistakes where account holders simply didn’t know or understand the rules. 

We’ve all heard the basics of the program by now: It started in 2009, you can contribute $5,000 a year, any income and growth is tax sheltered, and the money can be withdrawn tax-free at anytime.

It all sounds pretty straight-forward.  However, certain assumptions have been made that have resulted in costly mistakes. 

By far, the most common and dangerous assumption with the TFSA is that you can take the money out and put it back in the same year.  This is not the case.  If you make a withdrawal, that contribution room does not get added back to your account until the following year.

For example, let’s say you had $10,000 in a TFSA on December 31st, 2010 (I’m ignoring any growth).  You then add another $5,000 on January 2nd, 2011 for a total of 15k (maximum room).  Something comes up and you withdraw $2,000 from your account in February, so now you have $13,000 in a TFSA.  Can you add back $2,000 at any point in 2011?  No you can not.  The $2,000 room does not get reapplied to your account until the following year (2012).  If you put $2,000 back in your TFSA at anytime during 2011, you will be over contributing.

How is the penalty assessed on an over contribution?  CRA takes the over contribution amount, multiplies it by the number of months you were over limit, and multiplies by 1%.  Using the above example, if you re-contribute the $2,000 to the TFSA in March 2011, that puts you 10 months over limit (March – December 2011). 

So, $2,000 x 10 months x 1% = $200!

That’s right, a $200 penalty, for a $2,000 over contribution over 10 months.  That’s pretty severe considering most Canadians are only using the TFSA as a high interest savings account, earning around a 1.5% interest rate annually. 

Here are some tips on how to avoid making a TFSA mistake:

1.  DO NOT use this account as a daily/monthly transfer in, transfer out type account.  We’re all used to transferring money from savings to chequing or vice versa with our financial institutions, but you simply cannot do this with a TFSA.  Put in $5,000 at the beginning of the year, and then forget about it.  That’s the best advice I can give you.

2. If you do make a withdrawal, remember that you only gain back that contribution room the following year.  Only use this account for withdrawals as a last resort.  It puts you in a situation where you have to make a note of not re-contributing until the next year. 

3.  Avoid having more than one TFSA account.  Do not open a TFSA high interest savings account, a TFSA investment account and a TFSA vacation fund account.  It makes keeping track of contributions and staying within your limits that much harder and may ultimately result in a mistake.

4.  If you want to transfer your TFSA from one institution to another, make sure to go through the proper transfer procedures.  Do not simply take out all your money from one TFSA, close the account, and place it in a new TFSA, not in the same year.  It’ll result in an over contribution.  There is paperwork you can fill out to transfer TFSA money in a way that doesn’t trigger a true withdrawal (it’s the same transfer paperwork used to transfer RRSPs from one institution to another).

5.  Work with whole numbers.  If you can’t contribute the full 5k at the beginning of the year, or if you have to withdraw some money, use a nice round figure: $500, $1000, $3000, etc.  It will make your job much easier in terms of tracking your contributions and staying within your limits. 

6.  Find out if you have a TFSA!  I’ve heard the same story several times where someone goes into their bank, the teller or account manager sees their normal savings account, and they’ll kindly suggest that the money can be placed in a TFSA where it can benefit from tax-sheltering.  The bank employee is only trying to help and doesn’t know that you may already have a TFSA (although they should ask).  The client will accept the advice of the bank employee, forgetting or not knowing that they already own a TFSA.  Find out if you have one, maybe your advisor or your spouse opened one for you and you forgot about it. 

Fortenately, CRA has announced that for a second consecutive year, they won’t penalize excess contributions to TFSAs in situations where taxpayers misunderstood the rules.  Of course, the onus will be on you to prove your case.  For those who have received a penalty letter, you know that you have to write a letter explaining your situation and to attach supporting documentation, and to send it to the TFSA Processing Unit address.

If you have recently received a letter, please contact us and we can look at it together.  If it was a situation where you misunderstood the TFSA rules, we can help you write a letter to CRA explaining your case and requesting “administrative relief”.  After that, we can only hope that CRA will be forgiving and waive your penalty.

Enjoy the long weekend!