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The TFSA can play an important part in your personal tax planning but it is important to remember the key rules that apply. |
Many individuals have taken advantage of the Tax-Free Savings Account (TFSA) introduced by the federal government for years starting in 2009. The TFSA is a tax-paid savings vehicle that allows individuals to save for many purposes, such as buying a home, starting a small business, buying a new car or putting money away for a child’s wedding. Your contributions to a TFSA do not give rise to a tax deduction and when money is withdrawn, the accumulated contributions and income you receive will not be taxable.
It also appears that there have been some misunderstandings on how the rules work. You may have seen recent articles in the press discussing the fact that approximately 70,000 TFSA account holders have been assessed with overcontribution penalties by the Canada Revenue Agency (CRA) as a result of not knowing all the rules related to the operation of a TFSA. As such, we thought it would be an opportune time to provide a brief refresher of the basic TFSA rules (for those of you who received a notice, we assume you have already been in touch with your BDO advisor).
Key Rules to Remember
- TFSA holder: Any individual (other than a trust) who is resident in Canada and 18 years of age or older can open a TFSA. You can hold as many TFSA accounts as you want as long as you do not exceed the contribution limit on a combined basis.
- Contribution limit: The amount you can contribute annually will be governed by your contribution room for the year. Your TFSA contribution room will be made up of three amounts:
- The annual contribution room for the year. Each year, you will be entitled to a contribution limit of $5,000. According to the government, this limit will be indexed to inflation and rounded to the nearest $500 on a yearly basis. With our current low inflation rates, the limit will likely be $5,000 for 3 years at least.
- Any withdrawals made in the previous year will be added to the contribution room for the current year.
- Any unused contribution room from the previous year will be added to the contribution room for the current year.
The CRA indicated that it will track TFSA room in the same sort of way it tracks RRSP contribution room. Based on information provided by TFSA issuers, the CRA will determine your TFSA contribution room and your annual contribution limit will be provided on your notice of assessment.
- Types of investments: A TFSA will generally be permitted to hold the same investments as an RRSP, including mutual funds, publicly-traded securities, GICs, bonds and certain shares of small business corporations. Note that unlike RRSPs, there are additional rules for investments that are not available on the open market. The specific investments available to you could also be governed by the terms of your TFSA agreement with your financial institution. You will be subject to penalties on any investments which are not permitted to be held in your TFSA.
- Overcontributing to a TFSA: TFSA overcontributions will be subject to a penalty tax for excess contributions, calculated at 1% per month on the highest amount of excess TFSA contributions in that month. For example, if you contributed $5,000 to your TFSA on February 1, 2009, then withdrew $4,000 from your TFSA on June 30, 2009 and then re-contributed the $4,000 on August 1, 2009, you will have made an excess contribution of $4,000 to your TFSA for the period from August 1, 2009 to December 31, 2009. So, you will have to track your TFSA limit and carefully compare it to the contributions you make. Note that a direct transfer between your TFSAs is not considered a contribution or withdrawal and is allowed by the CRA as a qualifying transfer.
Avoiding Excess Contributions to Your TFSA
Earlier this year, a number of TFSA contributors were identified by the CRA as having made possible excess contributions to their TFSA accounts. It appears that many of them got into trouble by using their TFSA as a savings account or by moving amounts between plans without a direct transfer. To avoid making excess contributions to your TFSA and subjecting the excess balance to a penalty by the CRA, you should keep the following points in mind:
- Watch your timing when replacing TFSA funds withdrawn: While you may withdraw money from your TFSA and recontribute that amount to your account, it is important to watch the timing of when you recontribute these funds in your TFSA. As mentioned previously, withdrawals made in a year do not get added back to your available contribution room until January 1st of the following year. As such, if you withdraw funds from your TFSA in a particular year and you have already contributed the maximum amount allowed to your TFSA for that year, you must wait until January 1st of the following year before you can put the withdrawn amount back into your TFSA. Failing to do so will subject you to the penalty for excess contributions (and in fact was one of the primary reasons that so many individuals made an overcontribution).
- Ensure that direct transfers between your TFSAs are reported properly by your financial institution(s): As noted previously, direct transfers between your TFSAs are allowed by the CRA. You should have your financial institution(s) do the direct transfer and not withdraw and contribute the funds between the accounts yourself. If the CRA charges you a TFSA overcontribution penalty for a direct transfer, it is possible that the transfer was incorrectly recorded by one or both of the financial institutions involved in the transfer and you should contact them to correct the reporting of the transfer with the CRA.
Excess Contributions Made in 2009 and 2010
For excess contributions made in 2009, the CRA put a process in place to review each situation on a case-by-case basis, and where appropriate, waive the penalty for excess contributions for those who overcontributed in 2009 due to a genuine misunderstanding of how the TFSA rules worked. Two common misunderstandings cited that would qualify for relief were using a TFSA as a regular bank account (i.e. making deposits and withdrawals on a frequent basis), and transferring funds between TFSAs using a withdrawal and contribution rather than a direct transfer. For further details, refer to our July 16, 2010 Tax Tip.
As for people who went over their TFSA contribution limit in 2010 and didn’t realize they were making mistakes until half way through this year, we’ll have to wait and see what the CRA will do with respect to any excess contributions made in 2010. As many people would not have realized they were misinterpreting the rules until they received the CRA letter, we would hope the CRA will use a similar approach for 2010 excess contributions. On a go forward basis, we expect that the CRA will apply the rules more strictly. If you still currently have excess amounts in your TFSA, you should contact your financial institution and arrange for the amount of your excess contribution to be withdrawn from your account as soon as possible in order to minimize the amount of penalty on excess contributions that may be payable for 2010.
The TFSA can play an important part in your personal tax planning but it is important to remember the key rules that apply. For further information on TFSAs, read our tax bulletin titled “Answering Your TFSA Questions”. If you have any questions on these rules, contact your BDO advisor.
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