How to avoid penalties for over-contribution to tax free savings accounts

For many Canadians, the tax-free savings account (TFSA) is the vehicle of choice when saving for retirement, a down payment, or a family vacation. However, if used incorrectly they can be subject to costly over-contribution penalties.

An individual's TFSA annual contribution limit is reset each year on Jan. 1.  It is based on a formula which is the total of any carry-forward room plus any TFSA redemptions made in the previous year, plus a pre-determined allotment, which for 2019 is $6,000.

If you max out your TFSA every year and haven't made any withdrawals, your contribution limit is easily determined — it would be $6,000 for 2019.

However, many people cannot afford to max out their TFSA or some may have made withdrawals, which requires some extra calculations. 

For example, someone might have $20,000 of unused carry-forward room and then, in 2018, redeemed $10,000 from their TFSA to go on a vacation. 

For this person, their 2019 contribution limit would be $36,000: $20,000 carry forward room + $10,000 redemption + the new 2019 allotment of $6,000.

Determining your TFSA contribution limit each year can be complicated. If you register with the Canadian Revenue Agency (CRA), it will help you track your TFSA contributions and provide TFSA contribution limits. 

However, I never rely on their number because in many cases it is incorrect.

For example, I logged into my CRA account today and it notes: "Your 2019 TFSA contribution room is $11,500," but I know it should actually be $6,000. 

Never assume that CRA's numbers are correct — if I had relied on its figure, I would have over contributed by $5,500 and would now be subject to a one per cent penalty each month. 

The CRA is not deliberately trying to deceive us, its information is simply not up-to-date. In reference to the TFSA contribution limits, its website states, "your previous year's transactions may not have been received or processed by CRA and therefore would not yet be reflected in your (2019 Contribution) limit." 

That's exactly what happened to me.

If you think you may have over contributed to your TFSA, withdraw the extra funds as soon as possible to avoid or reduce the over-contribution penalty. 

Ultimately, it is your responsibility to track your TFSA contributions and withdrawals. If you perform a lot of transactions, this can get confusing, so try to keep things simple. I recommend holding only one TFSA account to reduce the risk of errors. 

If you have more than one TFSA, consolidate them. If you use an adviser, keep your TFSA with them, so they can help you track your transactions.

Be aware that if you end up over-contributing, the penalties can be severe. 

An over-contributed term deposit that earns two per cent in your TFSA would result in a penalty of up to 12 per cent. You would earn the two per cent on the deposit but the net return after the 12 per cent penalty would be -10 per cent for the year. Penalties of thousands of dollars are not uncommon.

An unintended consequence of the over contribution penalty is that many people have given up on TFSAs.  They would rather pay more tax than risk being penalized again. This is unfortunate as TFSAs are one of the best savings vehicles when managed properly.

This column is part of CBC's Opinion section. For more information about this section, please read our FAQ.