TFSAs are a great savings vehicle, but a couple of quirks make it possible to accidentally over-contribute—a mistake that incurs tax penalties.
At the start of every tax year, your TFSA contribution room is reset; and for 2017 the limit is $5,500. That’s the total amount you’re allowed to put in, and once you max it out the contribution limit is static for the remainder of the year—even if you make a withdrawal from your TFSA to pay for a major purchase like a car or home renovation.
You can eventually recontribute the withdrawn amount (or, put another way, the withdrawal technically increases your future contribution room), but you can’t do so until the next tax year.
And the Canada Revenue Agency (CRA) means business. Tax on an over-contribution is assessed at 1% per month, which means an excess contribution of $4,500 results in a monthly tax penalty of $45. And that tax is applicable even if a TFSA holder realizes the mistake and withdraws those excess funds within the same month. If the mistake goes unnoticed for two months, the account holder would owe a $90 tax penalty, and so on.
Sometimes, CRA will send letters to taxpayers who over-contribute to their TFSAs, most commonly for those residing outside Canada. You should view this as good customer service, since a lot of tax agencies worldwide would just sit back and collect the penalties.
If you get one of these letters and you’ve already withdrawn your excess contribution, do nothing. But if you haven’t, take care of it right away. If you get the letter on June 25 about a June 3 over-contribution and don’t bother going to the bank until July 5, you’ll be paying the 1% penalty for both June and July. Quick action can save you money.
You also can request forbearance from the CRA, in writing, if you’re able to show your excess contribution resulted from a reasonable error; and that you’ve taken—or are taking—steps to eliminate the over-contribution.
Your letter will have to outline the reasons for your mistake and detail each step you’re taking to correct the problem. CRA also will expect supporting documents, including your TFSA account statements showing when you withdrew the excess funds and any other correspondence—with the financial institution or with CRA itself—that show the over-contribution was unintentional.
Another way an account holder can goof up and owe tax penalties is by abruptly switching a TFSA between financial institutions.
Assuming you’ve maxed your contribution room, you can’t just withdraw the funds from a TFSA at one bank, open a new TFSA at another bank, and redeposit those funds in the same tax year. Doing that will count as an over-contribution.
Technically, you could pull this maneuver at the end of one tax year and then redeposit funds at the start of the next; but you’d have to ensure you sold any investments housed within the TFSA soon enough for the trades to settle before year’s end.
Plus, you’ll pay fees when selling off those investments—including early redemption fees for many mutual funds. In some cases, the receiving institution will cover certain fees; but for those who’ve maxed their contribution room, a move like this should be saved for when you’re legitimately angry with an institution or if another bank offers an exclusive, must-have investment opportunity.
For taxpayers in difficult personal situations, CRA isn’t heartless. It does provide exceptions for instances in which TFSA funds need to be transferred between accounts as the result of a marriage or common-law partnership breakdown.