Canadians who contribute too much to their Tax-Free Savings Accounts (TFSAs) are subject to a 1% tax each month on the over-contribution. A quirk in the way that this tax is calculated means that it is possible to be in a state of “over-contribution” even after emptying out a TFSA.
The rules for how to calculate the TFSA over-contribution tax are explained in the form RC243-SCH-A Schedule A - Excess TFSA Amounts. How these rules can lead to getting taxed on an empty account is best explained with an example.
Sally and her husband Tony opened a joint TFSA in January 2009 with the plan to invest in ABC stock. They opened an account and deposited their combined TFSA limit of $10,000. Unfortunately, there was a misunderstanding with their bank and the account was not a trading account.
Sally and Tony withdrew the money, opened a self-directed TFSA, and deposited the $10,000 not realizing that this was considered an over-contribution. The withdrawal amount of $10,000 was added to their 2010 contribution room, but was not available for the rest of 2009. They could have made a proper transfer between TFSAs but didn’t realize that this would make a difference.
They went on to buy $10,000 worth of ABC stock. Toward the end of January, they found out that they had made a TFSA over-contribution of $10,000 and would pay a $100 tax each month. So, they sold the stock and withdrew the proceeds from the TFSA.
Unfortunately, ABC stock had lost 20% of its value before they sold it. Their withdrawal was only $8000. So, by the TFSA rules, they still had an over-contribution of $2000 as of the end of January. This was true even though the account was empty!
In addition to the $100 tax for January, Sally and Tony were hit with another $20 tax for each of the remaining 11 months of the year. At least the pain stopped in January 2010 when they got more TFSA room and the over-contribution tax stopped at a total of $320.
This type of situation seems like a logical case to waive penalties for the rest of the year, and it could be that CRA has policies to deal with empty TFSAs, but there is nothing in the information I’ve read about the 1% tax that allows for leniency when the TFSA is empty.