For most Canadians, a TFSA is a truly tax-free account. But for others, there are instances where you might have to pay tax.
The first instance is if you make an over-contribution to your account. This can be done by going over your TFSA contribution limit.
Let’s assume you have $5,500 in contribution room and you deposit $5,500 into your account at the beginning of the year. The next day, you decide to buy something and withdraw $500 from your account. You later find out what you wanted to buy is no longer available so you deposit the $500 back into your TFSA. However, the $500 you put back into your account is considered an over-contribution by the Canada Revenue Agency (CRA).
“If you decide to replace or re-contribute all or a portion of your withdrawals into your TFSA in the same year, you can only do so if you have available TFSA contribution room,” says the CRA. “If you re-contribute but do not have contribution room, you will have over-contributed to your TFSA in the year.”
You’ve technically contributed $6,000 ($5,500 + $500) to your TFSA this year. As a result, you’ll have to pay a tax equal to 1% of the highest excess TFSA amount for each month the excess remains in your account. You can avoid paying the tax by withdrawing the $500 and waiting until next year to re-contribute that amount.
There’s also another way to go over your contribution limit. You can do that by withdrawing money from a TFSA at one financial institution and depositing it into a TFSA at another financial institution.
Let’s assume you have $50,000 in your TFSA and $2,000 in contribution room. You decide to switch banks and withdraw the $50,000 from your account and put it into a TFSA at a different bank. Again, this is considered an over-contribution. In this case, it’s an over-contribution of $48,000 ($50,000 – $2,000).
To avoid paying tax, you’ll have to withdraw the over-contribution and wait until next year to contribute that amount back into your TFSA. Withdrawals made from your TFSA this year will be added back to your contribution room at the beginning of the following year.
There’s an easier way to avoid this problem altogether. You can transfer the account from one institution to another. There might be a fee for this, but the institution that receives the transfer may be willing to pay the fee for you.
Another way you can be taxed is if you’re considered to be carrying on a business (day trading, for example) in your TFSA. There have been cases where Canadians with financial industry experience have accumulated hundreds of thousands of dollars in their TFSA and are being told to pay taxes on their investment gains (such as the trader with $1.25 million in his TFSA).
According to the CRA, some of the factors to be considered in ascertaining whether the taxpayer’s course of conduct indicates the carrying on of a business are as follows:
- Frequency of transactions—a history of extensive buying and selling of securities or of a quick turnover of properties;
- Period of ownership—securities are usually owned only for a short period of time;
- Knowledge of securities markets—the taxpayer has some knowledge of or experience in the securities markets;
- Security transactions form a part of a taxpayer’s ordinary business;
- Time spent—a substantial part of the taxpayer’s time is spent studying the securities markets and investigating potential purchases;
- Financing—security purchases are financed primarily on margin or by some other form of debt;
- Advertising—the taxpayer has advertised or otherwise made it known that he is willing to purchase securities; and
- In the case of shares, their nature—normally speculative in nature or of a non-dividend type.
The bottom line
TFSAs can be complicated unless you know the rules. If you follow the rules, you won’t have to pay tax.