The Tax-Free Savings Account (TFSA) program is a financial tool in which any Canadian resident aged 18 and older holding a valid social insurance number can invest. While the program provides numerous benefits, there are common pitfalls that individuals with TFSAs should be cautious about when investing. Join us as we explore three situations where individuals were left with unexpected tax consequences due to a misunderstanding of the TFSA rules.
1. TFSA Fund Transfers
A taxpayer withdrew funds from their first TFSA and deposited it into their second TFSA, inadvertently exceeding their contribution limit, which led to penalties and interest. The taxpayer in this case had unused contribution room of $6,000 in 2020 and made a withdrawal of $46,000 from their first TFSA to transfer to the second TFSA in the same year. The $46,000 withdrawn from the first TFSA was not automatically added to the $6,000 contribution room the taxpayer had available in 2020 until January 1, 2021. This resulted in a $40,000 overcontribution in 2020 as the transfer of funds was not done by the taxpayer’s financial institution.
The taxpayer requested relief for the penalties and interest from the Canada Revenue Agency (CRA) on the grounds that they intended to make a transfer between accounts and that it was a reasonable error. Unfortunately, the CRA denied relief because the taxpayer’s ignorance of the rules was not considered a reasonable error.
It is important to note that withdrawing and depositing funds back into the same TFSA account in the same calendar year can result in similar consequences if the funds that are deposited exceed the individual’s contribution room available for the year. Further, the transfer of funds from one TFSA to another must be completed by a taxpayer’s financial institution(s) to avoid overcontribution penalties and interest charged by the CRA.
2. Trading Investments Within a TFSA
A taxpayer who was a professional investment advisor used his TFSA to trade investments. The CRA reassessed their 2009 to 2012 tax returns to include the income generated in the TFSA as business income. Despite the investments falling under the list of permitted investments for TFSAs, the income generated in their TFSA was included in their income as business income because they were considered to be carrying on a business as they were actively trading investments within the account. Since this taxpayer’s TFSA was not used as a vehicle for holding investments to passively generate income, he faced tax consequences.
This case highlights the CRA’s position that TFSAs cannot be used as an investment tool to actively trade investments, otherwise the full amount of earnings could become taxable as business income.
3. Miscalculating TFSA Contribution Room
In 2021, a new Canadian resident opened a TFSA account but misunderstood their total contribution room. As a result, they contributed $18,000 into a TFSA account that only had contribution room of $6,000, leading to an overcontribution of $12,000. Unfortunately, the investment within the TFSA went bankrupt, leaving no funds to withdraw from to correct the overcontribution. The only way to stop penalties from applying was to wait for the taxpayer’s contribution room to increase and offset the overcontribution amount.
The takeaway here is to carefully monitor your contribution room. If you overcontribute to your TFSA and your investments lose value, you may face ongoing penalties each year.
