Why making a deliberate TFSA overcontribution isn’t a good suggestion

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A latest case involving an enormous overcontribution right into a tax-free financial savings account (TFSA) generated quite a lot of attention-grabbing questions from readers about how the ensuing penalty tax works, and the way greatest to attenuate it. We’ll reply a few these questions under, however first let’s assessment the TFSA contribution (and overcontribution) guidelines.

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The TFSA annual greenback restrict for 2023 is $6,500, however you could possibly contribute greater than this quantity in case you have unused TFSA contribution room carried ahead from prior years. In case you’ve by no means contributed to a TFSA earlier than, and have been not less than 18 years of age and a resident of Canada since 2009, your cumulative TFSA restrict is presently $88,000.

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One other level to remember is that for individuals who have withdrawn funds from their TFSAs, the total quantity withdrawn (that’s, each your contributions and any tax-free earnings or development) is added again to your contribution room starting the calendar yr after withdrawal.

In case you mess up and overcontribute, there’s a penalty tax of 1 per cent monthly for every month there’s a TFSA overcontribution. The Earnings Tax Act, nevertheless, permits the Canada Income Company the discretion to grant reduction, and states the CRA could waive or cancel the penalty tax if the surplus arose by way of “cheap error,” and is corrected by the person “immediately.”

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The case I wrote about final week concerned a taxpayer who overcontributed to his TFSA to the tune of $639,308 and invested the funds into shares. He was reassessed by the CRA and hit with an overcontribution tax of $6,393.08, which is one per cent of the overcontributed quantity, relating to at least one month of overcontribution in 2020.

After he was reassessed by the CRA and advised to instantly withdraw his extra contributions, the taxpayer declined to take action, preferring to attend till “the market improved.” At one level, his portfolio was down 50 per cent, which might be about $320,000.

Many readers questioned why the taxpayer didn’t merely withdraw the surplus contribution “in-kind,” after which look forward to the shares to rebound outdoors his TFSA. There are two probably causes.

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The primary is that if the shares contained in the TFSA bounced again, the following restoration can be tax free. If, alternatively, the dropping shares had been withdrawn “in-kind” from the TFSA, their price for tax functions, or adjusted price base, can be set on the honest market worth on the date of withdrawal, or $320,000. If the shares absolutely recovered to $640,000, then a capital achieve of $320,000 would consequence when the shares had been offered, half of which might be taxable.

However the larger downside is {that a} withdrawal of the shares in-kind, when they’re price solely $320,000, would nonetheless go away a $320,000 TFSA overcontribution, which might generate an extra penalty of 1 per cent monthly till sufficient new TFSA room is generated. Ignoring periodic inflation changes to the annual TFSA restrict, it will take almost 50 years for sufficient TFSA room to be generated to cease the penalty tax. If this seems like an absurd consequence, it’s. And it’s one thing I formally posed to the CRA at a convention in 2021.

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I envisioned a situation the place a taxpayer moved to Canada in, say, 2023, and opened a TFSA quickly afterwards. As a result of he was beforehand a non-resident, the taxpayer’s TFSA contribution room for 2023 was solely $6,500. On account of a misunderstanding of the foundations, the taxpayer contributed $19,500 to his TFSA and invested all of it within the shares of 1 firm. Earlier than he had an opportunity to withdraw his $13,000 overcontribution, the corporate went bankrupt and the worth of the shares in his TFSA dropped to zero. How can the taxpayer cease the TFSA overcontribution tax, or request a waiver of the tax, if he can now not withdraw the overcontribution? Or does he merely want to attend it out for 2 years, accruing the month-to-month penalty tax, till new TFSA contribution room opens up?

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The CRA responded that the taxpayer on this case is unable to withdraw any quantities from their TFSA and, due to this fact, “can be unable to mitigate the tax on this method. Solely new TFSA contribution room that turns into accessible to the person in future years will serve to scale back the surplus TFSA quantity … (Since) the person is unable to withdraw any quantities from their TFSA … (the CRA) would don’t have any authority to waive or cancel the tax.”

Assuming the person doesn’t make any extra contributions to his TFSA earlier than 2026 and the TFSA greenback restrict for every of 2024 and 2025 remained at $6,500, the surplus TFSA quantity can be lowered to $6,500 as of Jan. 1, 2024, and absolutely eradicated as of Jan. 1, 2025. The web result’s that the person can be chargeable for the one-per-cent month-to-month tax in 2023 and 2024. The person may resume making TFSA contributions once more in 2025.

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That is really an absurd consequence and requires a legislative repair. Within the meantime, a taxpayer in this kind of state of affairs may apply for a remission order.

The opposite query some readers had was whether or not it ever is sensible to intentionally overcontribute to a TFSA within the hope that any penalty tax might be offset by the tax-free achieve within the TFSA.

For instance, let’s say Katy receives a scorching tip a few penny inventory anticipated to double inside a month. She’s absolutely maxed out her TFSA contribution room, however intentionally overcontributes $500,000 into her TFSA in Could 2023, and invests all of it in that one inventory. Certain sufficient, a month later, the inventory doubles to $1 million inside her TFSA. She’s more than pleased to pay a one-per-cent penalty tax of $5,000 on her $500,000 overcontribution.

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However Katy must know there’s a particular anti-avoidance rule within the Tax Act that states that any earnings or achieve arising from a deliberate TFSA overcontribution is taken into account to be an “benefit,” and is taxed at 100 per cent. Thus, making a deliberate TFSA overcontribution isn’t a good suggestion.

Jamie Golombek, CPA, CA, CFP, CLU, TEP, is the managing director, Tax & Property Planning with CIBC Non-public Wealth in Toronto. Jamie.Golombek@cibc.com.

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