TFSA Confusion – Contribution Limits, Withdrawals and Re-Contributions

John Heinzl of the Globe and Mail has an annual Investor Clinic Quiz. He stated that the quiz question he received the most emails and inquires about was a question he had on TFSA contribution limits. His readers’ confusion with this question reflects the continuing misunderstanding that exists in relation to TFSA contribution limits, withdrawals and re-contributions.

Thus, today I will revisit his question and add a variation on the question to try and further promote TFSA literacy. Finally, I have a quick comment on how many people still pay no attention to their investment strategy in their TFSA.

Question #1 – TFSA Contribution Limits

John’s question was as follows:

Dorothy is 25 years old and has contributed $3,000 to her tax-free savings account. Her TFSA is now worth $3,800. As of January 1, 2014, the maximum she could contribute would be:

a)$5,500
b)$26,000
c)$27,200
d)$28,000

Please note your answer now, before you continue reading. John states that only 40% of the respondents chose the correct answer.

Question #2 – TFSA Withdrawal and Re-contribution Limits

I am going to ask a second question, before I reveal the answer to the first question.

If Dorothy withdrew her initial $3,000 contribution in 2013: (1) what would be the maximum she could contribute in the remainder of 2013 if she suddenly came into an inheritance and (2) what would her maximum contribution room be on January 1, 2014 if she decided against using her inheritance to contribute to her TFSA in 2013?

You can try and answer this question now if you are confident you got the first question correct, or wait until I reveal the correct answer to question #1 before attempting this question.

Answer to Question #1

As John notes in his discussion of this question, the $3,800 value of the TFSA is a red herring for purposes of this question. The contribution limit when TFSAs were launched in 2009 was $5,000 a year. The limit was increased to $5,500 effective January 1, 2013. It is very important to note that TFSA contribution limits are cumulative.

Therefore, Dorothy could have made full TFSA contributions of $20,000 ($5,000 a year for 4 years)+ $11,000 ($5,500 for each of 2013 & 2014)=$31,000. As she has made $3,000 in actual contributions, her maximum contribution room is $28,000 as of January 1, 2014.

Answer to Question #2

Question #2 reflects the most common error made by Canadians each year with respect to TFSA’s – the withdrawal and re-contribution rules. According to this article in Maclean’s, last year 76,000 Canadians were issued TFSA letters by the CRA for over-

contribution penalties. I would suggest most of the letters relate to TFSA re-contributions.

As described in this CRA document, TFSA withdrawals can only be returned to your TFSA at earliest, on the first day of the next year after you  made a TFSA withdrawal. This is because the contribution room formula increases your TFSA room for any withdrawals made only in the previous year, not the current year.

For example. If you take out $5,000 from your TFSA in 2013, the $5,000 is not added to your contribution room until January 1, 2014. You cannot re-contribute the $5,000 in 2013 unless you have not made full TFSA contributions in prior years and have additional contribution room totally unrelated to the withdrawal.

Okay, back to the answer. If Dorothy received a large inheritance and decided to put the maximum amount into her TFSA in 2013, her contribution room would be $22,500 calculated as follows:

Dorothy could have made full TFSA contributions of $20,000 ($5,000 a year for 4 years)+ $5,500 (2013) less her $3,000 actual contribution (the $3,000 she took out in 2013, is not added back to her contribution room until January 1, 2014).

If Dorothy decided to wait until 2014 to use her inheritance to make her TFSA catch-up contribution, her maximum contribution limit on January 1, 2014 would be $31,000. This is the total of $28,000 as per question #1, plus the $3,000 she withdrew in 2013 that is added back to her contribution limit on January 1, 2014.

It should be noted that if Dorothy had withdrawn the entire $3,800 in her TFSA in 2013, her January 1, 2014 contribution limit would be $31,800.

Pretty easy to see why 76,000 people received TFSA over-contribution letters.

Savings Account vs Alternative Retirement Fund

TFSAs have different uses for different people. For some people it is used a rainy day fund, for others it is just a fancy savings account and for others, it is an alternative retirement fund they don’t plan to access until retirement.

The problem I see on a daily basis is that even though people as of 2013 could have contributed as much as $25,500, they still in general treat their TFSA as a daily savings account; at best they put their money in a GIC and at worst, just leave it in the account. If you look at your TFSA as a retirement account, you need to consider investing as if it were your RRSP and fully diversify your investments and maximize the tax-free aspect of the account.

As an accountant I cannot provide specific investment advice, but you need to consider whether you diversify your TFSA of its own accord, or look at the account as part of your overall diversified portfolio. For example, say you have a total portfolio of $300,000, made up of a $30,000 TFSA, $70,000 in investments and a $200,000 RRSP and your investment mandate is 10% foreign, 10% real estate, 40% equity and 40% bonds. Do you allocate your $30,000 TFSA in the 10/10/40/40 ratio, which may be impractical, or do you just have the real estate holdings in your TFSA ($300,000 x10%=$30,000).

Either way, don’t let the funds sit there and gather dust.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

Hot off the Press - 2012 TFSA Penalty Statements are Arriving at a Mailbox Near You

The CRA has started issuing penalty statements for excess TFSA contributions made during 2012. Canadians who have over-contributed to their TFSA are subject to a penalty of 1% per month on the excess contribution.

The covering letter, detailed excess amount calculations, TFSA transaction summary for 2012 and the RC243-P-E(13)X forms can total seven or more pages and are chock full of calculations and numbers. In many cases, the format of the penalty calculation is causing the recipients of the forms confusion and anxiety. The reason for this stress is as follows:

If someone over-contributed say $5,000 for all of 2012, you would think the CRA would multiply $5,000 x 12 (the number of months of over-contribution) x 1% a month penalty to come to the $600 penalty. However, the CRA statements run a cumulative contribution total such that the final over-contribution number at the bottom of the page is $60,000. Even though the CRA then just multiplies the $60,000 grand total by 1% to come to the correct $600 total, people are freaked out that they somehow over-contributed by $60,000.

Excess TFSA contributions and the related penalties have been thoroughly discussed by many newspaper journalists and bloggers over the past few years. I also covered this topic in my blog post “Canadians Continue to Break TFSA Rules” but I took a slightly different tack in that I postulated that if institutions offering TFSAs were required to ask the two questions below, most over-contributions would be prevented. 

Those questions were: 

1. Have you confirmed your yearly TFSA contribution room with your income tax assessment or with the CRA through your online account or any other means?

2. Does your contribution include an amount designed to replace funds withdrawn during the current calendar year? If so, do you understand that those funds cannot be replaced until next year unless you have other contribution room or you will be subject to penalties for over-contribution?

For the do it yourself (“DIY”) investor, you may have to ask and answer both these questions yourself if you have self-directed online accounts. However, what if you use an investment advisor or make your TFSA contribution at your local bank?

For the non-DIY investor, these may be loaded questions. For example, last year, a client over-contributed to their TFSA because their investment advisor suggested they catch-up on their TFSA contributions. The advisor thought or understood that their client had not made a TFSA contribution as of December, 2012 (some people felt the TFSA contribution limits were too small initially to worry about and only started catching up last year or currently), but a contribution had been made in 2009, the first year for TFSAs. I would hazard a guess that when the client went to the bank in 2009, their teller told them about this great new tax-free program and they setup an account with the bank they forgot about.

The issue that arises is whose fault is the over-contribution. The client or the advisor? Most advisors would probably suggest it is the client’s responsibility; and as with RRSPs, the client should know their limit, go online or check with their accountant to determine their available TFSA contribution room. The client, on the other hand, thinks their advisor should have been clearer about what they needed to do to confirm their TFSA limit.

Personally, in these types of cases, I think the over-contribution is both parties’ fault. Some people do not convey the proper information to their advisors, but their advisors, especially those with less sophisticated clients, need to ask “Have you confirmed your yearly TFSA contribution room to your income tax assessment or with the CRA through your online account?” and if not, can you please confirm such with your accountant. More importantly, even if the advisors think they did nothing wrong, they have inadvertently upset a client because of the penalty fees.

Whether you self-direct your TFSA or have an investment advisor manage the account, you need to be vigilant about confirming your TFSA balance with the CRA. Advisors need to realize something as innocuous as a TFSA contribution can sour a relationship with a client and they need to be diligent in ensuring their clients do not over-contribute and face penalties.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

Canadians Continue to Break TFSA Rules -So Why not Help Them?

Last week it was widely reported by several media outlets that thousands of Canadians have once again broken the TFSA rules. More specifically, they have breached the over-contribution rules. Dean Beeby of the Canadian Press notes in this article that the Canada Revenue Agency (“CRA”) sent out 76,000 letters (down from the 103,000 letters last year) informing Canadians they have over-contributed to their TFSAs and are subject to penalties of 1% per month on the excess over-contribution (The CRA may waive a penalty if they consider there to be a genuine misunderstanding and the over-contribution is removed within a reasonable period of time).

Generally, I believe blame should start and stop with yourself. However, where thousands of people are making the same mistake, it is obvious the CRA and the institutions administering TFSAs are still not enunciating and communicating the rules clearly to Canadians, despite their good intentions in some cases.

In general, there are two ways over-contributions arise in a TFSA:

1. Individuals contribute an amount greater than their yearly contribution limit.

As described in this CRA document on TFSA contributions, your yearly TFSA contribution room is made up of the following: 

•  your TFSA dollar limit ($5,000 per year plus indexation, if applicable);
• any unused TFSA contribution room from the previous year; and
• any withdrawals made from the TFSA in the previous year, excluding qualifying transfers or specified distributions.  

2. Withdrawn TFSA contributions are “put back” in the wrong year

As described in this CRA document, TFSA withdrawals can only be returned to your TFSA in the year after you have made a TFSA withdrawal. This is because in the contribution room formula noted above, your contribution room increases for any withdrawals made only in the previous year, not the current year.

For example: if you withdrew $3,000 from your TFSA in February, 2012 and you put back any portion of that $3,000 (assuming you have no other contribution room) at anytime in 2012, you will have over contributed in 2012. The over-contribution results because the $3,000 withdrawal should not be added to your contribution room until 2013.

So, after several years of thousands of Canadians misunderstanding the withdrawal rules for TFSAs, why doesn’t the CRA request, or financial institutions on their own volition, take the simple step of requiring its representatives to ask the following two questions before a TFSA contribution is accepted?

1. Have you confirmed your yearly TFSA contribution room to your income tax assessment or with the CRA through your online account or any other means?

2. Does your contribution include an amount put back on account of funds withdrawn during the current calendar year? If so, do you understand the current year withdrawal does not increase your contribution room until next year and unless you have other contribution room, you will have an over-contribution subject to penalties?

I would suggest that if these two simple common sense questions were mandatory questions financial institutions asked its customers before they made TFSA contributions, the CRA would have no need for 76,000 letters next year and taxpayers would have no one to blame, but themselves.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.