This week, tens of thousands of Canadians began receiving letters from the Canada Revenue Agency as part of a TFSA over-contribution package regarding their 2010 TFSA activity and the resultant penalty taxes which now may be owing.
A typical package is eight pages long and contains a proposed TFSA Return for 2010, a TFSA Detailed Excess Amount Calculation, a TFSA Transaction Summary containing your 2010 contribution and withdrawal history and a pre-addressed envelope.
The letters and calculations are based on information the CRA receives from financial institutions, which report all TFSA contributions and withdrawals.
Under the TFSA rules, each Canadian 18 or over may contribute up to $5,000 annually to their TFSA. If you didn't contribute in particular year, any unused contribution room is automatically carried forward to be used in a future year.
Any withdrawals of TFSA monies increase your available TFSA contribution room, but only beginning the following calendar year, which continues to trip up confused TFSA investors and in some case, even their advisors. This was the subject of the recent special report issued by the Taxpayers' Ombudsman earlier this month and discussed in a prior column.
Since its launch in 2009, approximately 6.7 million Canadians have already opened a TFSA. Of these TFSA holders, approximately 1.5% will be receiving a letter from the CRA this year asking them to provide further information about their accounts.
In a press release issued last week, the CRA acknowledged that "some genuine confusion about the rules for the TFSA in these initial years will naturally occur. We understand that it may take time for some Canadians to learn about the program."
As a result, the CRA confirmed that, just like last year, it would continue to be "as flexible as possible" in cases where overcontributions were the result of a genuine misunderstanding of how the rules work.
A typical scenario giving rising to an inadvertent penalty tax can occur when a TFSA contribution of, say $5,000, was made in January 2010, was subsequently withdrawn in March and then recontributed in July of the same year. If the TFSA holder did not have unused TFSA contribution room available, then the July recontribution could attract a penalty tax of 1% per month, or in this scenario, a $300 penalty tax.
The CRA indicated that if you receive a TFSA overcontribution package, you can ask the CRA to review your file and, where appropriate, waive the penalty.
If you have received such a letter, you have sixty days to respond.
To avoid this problem in the future, if your intention is merely to move your funds from one TFSA to another, be sure you do this via a direct transfer between financial institutions, which is not considered a TFSA withdrawal and contribution and therefore won't attract this harsh penalty tax.