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Avoiding TFSA Penalties: Understanding Contribution Limits Thumbnail

Avoiding TFSA Penalties: Understanding Contribution Limits

When the Tax-Free Savings Account was first introduced in 2009, I remember I had to blink twice, because I couldn’t believe it was true. The CRA was allowing you to deposit your money into a TFSA, invest it however you wanted, earn money and keep it all for yourself with a promise to allow you to continue to fund the account annually – inflation adjusted. It all seemed too good to be true. Shockingly, it actually wasn’t. As we sit today the annual allowable contribution is $7,000 with a total cumulative contribution room of $95,000. Depending on your tax bracket, and how you invested your $95,000 the savings could be in the 10’s of thousands in income tax and growing. For those who have taken advantage of the only investment account where CRA allows you to earn money and not pay a dime in tax, ever, good for you, you’re putting your money right place!

However, we have a surprising problem with tax-free-savings account, call it over- enthusiasm on the part of contributors. Canadians are adding too much to their TFSAs and paying big penalties.

The system for keeping people updated on their TFSA contribution room could certainly be better, but TFSA holders themselves should pay closer attention to what they’re doing. A good start for many would be to ask themselves if they’re juggling too many separate TFSA accounts with separate institutions.

The most recent CRA full report on TFSAs, for the 2020 tax year, shows there were 16 million TFSA holders with 24.3 million accounts. That’s 1.5 TFSAs per account holder, a reasonable number that hides the fact that 14,100 people had accumulated 10 TFSAs or more. Almost 245,000 more people have between five and nine TFSAs.

A lot of TFSA holders are still very confused about what a TFSA is and how they work. Just like an RRSP you can set up as many TFSA’s as you want, however the contribution limits still apply, it’s not per account. Many people are falling into the trap of over contributing to their TFSA just by virtue of having too many accounts set up.

Managing multiple TFSAs increases the risk of making an inadvertent overcontribution. People with multiple TFSAs sometimes misunderstand how contribution limits apply to them. The limit covers all your TFSAs in aggregate, not per individual account. 

A penalty of 1 per cent a month applies to excess money added to a TFSA. The total amount of overcontribution penalties paid in 2022 was $132.6-million, Canada Revenue Agency numbers show. That’s more than triple the $41.7-million paid in 2019 and 38 per cent higher than the $96.2-million paid in 2021.

CRA reports that the average penalty in 2022 was $1,461.18, up from $1,239.02 in 2021, $1,063.72 in 2020 and $885.32 in 2019.

To avoid penalties account holders also need to keep in mind that yes you can put back what you took out, but only in the subsequent year to avoid overcontributing – for those who have maxed out already.

As an example, if you have maxed out your contributions and decide to take out $10,000 this year, you can only put it back the following year, if you put it back in the same year you have over-contributed. You have to wait until the following year where you can deposit $10,000 + whatever the current year contribution limit is.

TFSA contributions are tracked by the government, and although you can log online to your CRA My Account to find your contribution room the amount you have access too will be your contribution room as of the first of the year, including the current year’s amount and unused room accumulated in previous years. If you have made a contribution in the current year, it will not reflect in the number you see when you log in online. If you’re checking your room limit, make sure you take into account the number that shows up in your account + any contributions you might have made after the first of the year. This is where a lot of people are getting caught over-contributing. This is especially made tricky to track when dealing with multiple accounts.

The average size of TFSA penalties suggests that sizable overcontributions are being made and that CRA is taking a while to notify people of their mistakes. If you’re a TFSA investor who routinely makes maximum contributions, a good rule is to monitor both your TFSA room and your contributions at least once or twice a year. This is doubly important if you make automatic contributions each payday or month and also make occasional lump-sum contributions.

CRA will notify you of an overcontribution with an “excess TFSA amount letter.” Included is a calculation of the penalty tax you owe, based on contribution data from the financial companies where you have accounts.

If you find out on your own that you’ve overcontributed, make the withdrawal immediately. Don’t wait for the letter to come in the mail. The best way to avoid penalties is to limit the TFSA accounts you have and check your balance at the beginning of the year before making a new contribution.