Confusion lingers over TFSAs

Although Canadians’ over-all familiarity with the TFSA continues to grow, some TFSA holders remain unclear about the rules that govern the account, particularly regarding contributions and withdrawals. Clients who overcontribute to their TFSAs can find themselves on the hook for an unwelcome tax bill.

“Usually, overcontributions are inadvertent on the client’s part,” says Sara Kinnear, director of tax and estate planning with Investors Group Inc. in Winnipeg. “And clients don’t realize [they have overcontributed] until they get a letter from the Canada Revenue Agency [CRA].”

If your client finds himself or herself having made excess contributions and facing a potentially hefty tax penalty, you can let the client know how to get onside with the CRA and stay that way with TFSA rules in the future.

“Take the opportunity to educate the client,” says Wilmot George, vice president of wealth planning, with CI Investments Inc. in Toronto. “You can say, ‘OK, the TFSA still is a relatively new plan, but here are some things to be mindful of’ and bring the client up to speed.”

Unlike RRSPs, withdrawals from a TFSA are tax-free. In addition, an amount equivalent to the withdrawal amount is added to contribution room for the following year. However, withdrawing funds and recontributing within the same year, if a TFSA holder has exceeded his total contribution room for that year, can lead to an overcontribution to the TFSA.

Last May, the CRA sent out 67,000 “education letters” to first-time overcontributors for the 2015 taxation year, informing them of their TFSA contribution room limit and asking them to “remove any excess contributions.”

In addition, last July, the CRA issued 20,000 notices of assessment to Canadians who had, according to the CRA, “overcontributed significantly or [had] overcontributed on more than one occasion.” These notices included the taxes payable associated with the overcontribution, plus applicable penalties or interest. In total, there were 12.7 million TFSA holders as of Dec. 31, 2015.

The penalties associated with TFSA overcontributions is 1% for each month the excess amount remains in the TFSA, calculated on the highest excess amount in a given month. That means even if a TFSA holder had an excess contribution for only a few days in any given month, he or she still would be liable for penalties equal to 1% of the highest single excess amount in that month.

If a TFSA holder has overcontributed, he or she must file a TFSA return to report the over-contribution and calculate the associated penalties by June 30 of the following year. Failure to do so may result in additional penalties and interest.

The best way for your client to deal with an overcontribution is to withdraw the excess amount as soon as possible. Such a withdrawal is known as the “qualifying portion” of a withdrawal, as it results in the reduction or elimination of an existing excess amount. However, this withdrawal does not result in new contribution room being added the following year.

However, even if your client did nothing about an excess contribution, new contribution room in the next year would reduce or absorb that excess. For example, if your client had $3,000 of excess contributions as of Dec. 31, 2016, the $5,500 in new TFSA contribution room for 2017 would eliminate the excess amount, leaving $2,500 in contribution room for this year. But the client still is liable for the penalties for each month the account held an excess amount.

TFSA holders who face penalties and taxes on excess contributions may ask the CRA in writing for a waiver if the overcontribution was the result of a “reasonable error” and if the TFSA holder took or is taking steps to remove the excess.

There’s no hard and fast rule regarding whether the CRA will grant a waiver, but being proactive tends to strengthen a client’s chances, George says: “It’ll come down to the facts in each case. But the CRA tends to provide a little more leniency when you go to it as opposed to when it comes to you.”

Some TFSA holders, however, will remain completely unaware of having made an excess contribution until the CRA contacts them. Issuing financial institutions must report all of their customers’ previous year’s TFSA transactions to the CRA by the end of February of the following year. That means that the earliest the CRA would contact a TFSA holder about an overcontribution in the 2016 taxation year, for example, would be the summer of 2017. However, in some cases, the CRA may take longer to contact a TFSA holder.

“I’ve seen the CRA inform taxpayers way too late – sometimes waiting many years – to tell individuals to take the [overcontributed] money out,” says Evelyn Jacks, tax expert and president of Winnipeg-based Knowledge Bureau, an educational institute for financial advisors. Jacks says she would like to see the CRA inform taxpayers in a more timely fashion. Issuing financial services institutions also could help by becoming more proactive in helping TFSA holders understand and manage their TFSAs, Jacks adds.

TFSA holders who are unsure about their current contribution limit can contact the CRA either online through My Account, via a mobile device through MyCRA or by phone through the Tax Information Phone Service. Accountholders also can ask the CRA to send them a contribution room statement or a TFSA transaction summary.

However, because the CRA might be unaware of a taxpayer’s most recent TFSA transactions and, therefore, may be unable to provide the correct current contribution room, your clients should track their transactions and contribution limit themselves. The CRA provides a TFSA contribution room worksheet (Form RC343) to help taxpayers do just that.

“We have a self-assessment system,” Jacks says, “and the broad responsibility remains ours.”