Ins and outs

The Tax Free Savings Account (TFSA) introduced in 2009, is another investment tool for Canadians, but as with any investment, it has accounting protocol and therefore, by default, potential CRA tax issues.

The Tax Free Savings Account (TFSA) introduced in 2009, is another investment tool for Canadians, but as with any investment, it has accounting protocol and therefore, by default, potential CRA tax issues.

Because a tax receipt for a TFSA contribution is not issued (unlike RRSP investments) – a fact that creates many queries for tax preparers each spring – the government logically allows money from a TFSA to be removed tax free. And, also unlike RRSP’s, if money is removed from a TFSA, that amount can be “replaced”, but according to timing rules – the mechanics of which are not well understood and the focus of this column.

The flexibility yielded by tax-free cash removal and being able to replace those withdrawals make TFSA’s very attractive – new truck, trip, tuition, …!  Unfortunately this latter feature also holds the greatest potential for a CRA mess up when an investor “replaces” those removed funds.

The maximum contribution to a TFSA is $5,000 per year.  If you happen to invest more, the over-contribution is subject to penalty by CRA.  Although this may be understandable, perhaps what isn’t so straightforward is how funds are replaced in the TFSA should some be removed.

Funds removed in one calendar year, cannot be replaced in that same calendar year.  That “room” must be carried forward. In other words, there is no “out and in privilege” during the year.  Money removed during the year effectively reduces the $5,000 limit for that year and is added to future years’ contribution room.

As per CRA, “The total of TFSA withdrawals in a calendar year is added to the TFSA contribution room for the next calendar year.”

In the case of over-contribution, a letter from CRA arrives asking for 1 per cent per month interest penalty for the over-contribution.  And the timing of this letter is a little frustrating since it appears to be arriving in the mail box about June of the next year.  Potentially then, interest expense could accumulate for up to 18 months.

Apparently, in 2010 CRA mailed 70,000 such letters. And, although no official figure is available, it’s suspected that about the same number went out again in 2011.

The good news, the Taxpayers’ Ombudsman continues to convince CRA to show leniency so about 140,000 over-contributors may be dealt with on a case by case basis.  CRA needs to be notified of extenuating circumstances within 60 days of receipt of the letter, and second-time offenders will likely see little leniency.

If a penalty must be paid, be kind. Don’t get upset at your tax preparer. CRA won’t accept it as a deductible carrying charge, just as the interest paid on any funds borrowed to invest in a TFSA is not a deductible expense.  And don’t forget, TFSA investments do not qualify as a tax deductible credit like an RRSP.