By Scott Ronalds

The Globe and Mail recently reported on an issue that all investors who own a Tax-Free Savings Account (TFSA) should be aware of – over-contribution penalties. Canada Revenue Agency (CRA) has informed 70,000 investors that they may have to pay a penalty, of up to several hundred dollars, for over-contributing to their plans. The surprise tax bills have left many investors confused and angry.

As a reminder, you can contribute up to $5,000/year to a TFSA. You can also redeem the money at any time without any tax consequences. And as a nice bonus, you can re-contribute any money that you withdraw without impacting your contribution room. This feature, however, is the source of the confusion and penalties. If you withdraw funds from your plan, you have to wait until the start of the NEXT calendar year to deposit the money back in the account (if you already contributed the maximum amount in the year of the withdrawal).

Let’s clarify. Say you contributed $5,000 in March 2009. Two months later (May), you decided to withdraw half of the account ($2,500). You are permitted to add back the amount you withdrew ($2,500), BUT you would have had to wait until January 2010 to do so. At such time, you could contribute $7,500 to your account (the amount you withdrew plus your allowable contribution for 2010). If you added $2,500 back to your account in June 2009, you would be on the hook for an over-contribution penalty tax of 1% a month. In this case, the penalty would be $175 ($2,500 x 1% x 7 months).

Investors transferring TFSA accounts from one institution to another must be careful to complete the proper paperwork in order to avoid potentially nasty penalties. If you redeem your account and subsequently use the proceeds to open a plan with another institution in the same year, the transaction will be viewed as a ‘double contribution’ by CRA. To avoid this, you must complete a Transfer Form for Registered Investments (along with an application form) issued by the firm that you are transferring the money to. This is the same process that must be followed when transferring RRSPs and other registered accounts.

TFSAs are great investment vehicles. Just make sure you know how to drive them.