Thursday, January 23, 2014

Long-Term TFSA Penalties

It’s possible for a combination of TFSA over-contributions and investment losses to lead to tax penalties that go on for years. Here I give the most plausible scenario I can think of that produces tax penalties that grow to six figures.

Our fictitious hero, Kevin, just got an inheritance, and he’s got big investment plans. He just got a hot tip on a gold-mining company where a friend of a friend works. If this tip pans out, he’ll be set for life.

But Kevin doesn’t want to have to pay any capital gains taxes. He’s never had a TFSA before, but he knows that the gains in a TFSA can be withdrawn tax-free. As of 2014, Kevin has $31,000 worth of TFSA room available, but this is nowhere near enough to shelter his inheritance of a little over five times that amount.

Kevin misunderstands the TFSA limit rules and thinks they are similar to the $100,000 limit on CDIC protection on bank account deposits where you can just spread your money to different banks. So Kevin goes out and opens five TFSA accounts at five different discount brokers, and he deposits $31,000 into each one. Each deposit on its own is allowed, but the TFSA limit applies to all his TFSAs together. So, Kevin doesn’t realize that he’s made a $124,000 over-contribution.

As of January 2014, the 1% per month over-contribution penalty begins. Not realizing the train-wreck that awaits him, Kevin uses all of his TFSA deposits to buy shares in the gold-mining company. He’s ready to watch the riches roll in.

By June, the stock hasn’t done much, but some questions start to surface about the company’s gold claims. The stock starts to drop, but Kevin hangs on. By December the worst has been confirmed: this is a full-on Bre-X (except that nobody falls out of a helicopter). The stock has dropped by over 99%, and Kevin only has a total of $1000 worth of stock left in his 5 accounts.

Just when Kevin thought things couldn’t be worse, his so-called friend explains the TFSA rules and points out that Kevin’s over-contribution of $124,000 creates a tax penalty of 1% per month for a total of $14,880 for 2014. (Everyone knows that if it weren’t for messengers, nothing bad would ever happen).

Once he understands the TFSA tax penalty, Kevin immediately sells all is stock and withdraws the contents of all the TFSAs. His TFSAs are now completely empty, but that doesn’t stop the bleeding. He still has an over-contribution of $123,000.

In January of 2015, Kevin gets another $5500 in TFSA room which leaves his over-contribution at $117,500. But the TFSAs are empty. He can’t make a withdrawal, and his 2015 tax penalty comes to $14,100.

In fact, assuming 2% per year inflation that increases TFSA room over the years, Kevin won’t build up enough TFSA room to eliminate the over-contribution until 2033! The total tax penalty over the years adds up to $152,040. This is just slightly less than the $154,000 that he lost on the gold-mining stock.

I’d like to think that cooler heads would prevail, and CRA would waive all penalties from 2015 on. But it would be better if there were some explicit rule in place to prevent over-contribution penalties when TFSA contents are empty.


  1. Yeah, they (the government) fscked ip, and created a system that allows the user to seriously shoot themselves in the foot.

    It's an implementation problem, they could have prevented this.

    1. @Anonymous: I agree that this problem could be remedied easily. The challenge is to find a fix that can't be cleverly exploited for unintended tax gains.

  2. Poor guy. Your thought experiment has created a pitiful Kevin in an alternate universe who will suffer TFSA penalties for the next 19 years (though thankfully in decreasing magnitude). He's fallen out of a metaphorical helicopter.