Ghosts of the TFSA exorcized

By Vikram Barhat | June 28, 2010 | Last updated on June 28, 2010
4 min read

It seems they will beat the Tax Free Savings Account bum rap after all. The Government of Canada all but announced on Friday an amnesty on TFSA overcontribution penalties for 2009. This comes as a relief to some 70,000 TFSA holders who inadvertently fell foul of the tax law.

A statement issued by Keith Ashfield, Minister of National Revenue, and Jim Flaherty, Minister of Finance, confirms that a decision has been made by the government “to be as flexible as possible in cases where a genuine misunderstanding of the TFSA contribution rules occurred.”

The declaration should end the furious finger-pointing and colourful expressions of disagreement that dominated all the newspaper column inches not gobbled up by the G8/20 summits and the footie fest.

The statement further says “our intention is to review each situation on a case-by-case basis and, where appropriate, waive taxes on excess contributions for this year.”

Those who used their TFSA as a regular banking account in 2009, making deposits and withdrawals on a frequent basis, or who have transferred funds between TFSAs at different institutions, may not be required to pay the tax on excess contributions for this year, provided their net contributions never exceeded the 2009 limit of $5000.

Arguably one of the most powerful investment vehicles, TFSA initiative was called into question when 70,000 (2%) of the nearly 4.7 million Canadians received a letter from the Canada Revenue Agency ordering them to pay tax on so-called overcontributions.

Taxpayers were given until June 30, 2010 to pay up or contest. The deadline has now been extended to August 3, 2010, to allow ample time for Canadians to provide the necessary information about their accounts.

The confusion over overcontribution is largely attributed to the fine print of the rules, which investors say are too complex to understand. Many front-line employees of financial institutions, while aggressively promoting it, failed to grasp the subtleties and were blindsided by the complexity of calculations. Many investors, therefore, were none the wiser.

They did not clearly understand the conditions of contribution. Withdrawals, say the TFSA rules, create a contribution room, but it is only available in the next calendar year. Tax specialists say this defies logic.

“The withdrawal and re-contribution doesn’t intuitively make sense given someone hasn’t received any advantage by withdrawing and re-contributing the same amounts in a year,” says David Steinberg, co-managing partner and leader of tax for RSM Richter, an independent accounting, business advisory and consulting firm in Toronto. “One of the ways this could have been avoided is by educating the financial institutions in the rules so they wouldn’t have been able to accept the re-contribution without notification to the taxpayer.”

He says the institutions should be able to track total contributions/ withdrawals in any calendar year and as long as the net contributions – contributions minus withdrawals – do not exceed $5,000 (the annual TFSA limit) there should be no penalty.

Under the current rules the only way to avoid the penalty tax for the over contribution is to track your contributions and withdrawal in any calendar year and make sure you are within the rules.

Financial institutions should take the stick for failing to educate clients, says Saskatoon-based Mike Armstrong, vice president and investment advisor at Richardson GMP, a wealth management firm.

“Financial institutions were aggressively campaigning with customers to open the TFSA, deposit the funds and then left uneducated clients with the impression funds could be taken out and put back in without clearly describing the timelines involved,” says Armstrong.

In some cases, there was active solicitation for transfers from low-interest rate Bank TFSA to high-interest rate institutions. Those who closed their TFSA accounts, withdrew money and opened a new TFSA account with another institution in the same year were adjudged offside and slapped with tax penalty for overcontribution.

In these cases, says Armstrong, financial institutions must make sure they do not accept re-contributions until the next calendar year to stay within the rules. “Clearly following the rules in place is the best avoidance scheme.”

Technology could play an important part in forestalling such failures and that’s only one of the possible solutions.

“Financial institutions could have a system that tracks withdrawals and notifications could be sent not allowing re-contributions to the plan until the following year when the contribution room is reinstated,” says Steinberg.

Another obvious solution lies in clearly understanding the implications of withdrawals and the timelines that are critical to follow to avoid penalty.

One possible solution to the rules is to only tax someone for the withdrawal/re-contribution if they withdraw and re-contribute the ‘profits’ in the TFSA, says Steinberg. “For example, assume someone contributes $5,000 in January 2009 to the TFSA. In July they have made interest income of $150 in the plan and they withdraw $4,000. In September they re-contribute the $4,000. Rather than the penalty tax being on the full $4,000 (as the current rules read), the tax could be only on the $150 of profits above the original $5,000 that was contributed.”

Problems and solutions aside, tax experts insist the concept of the TFSA is a very useful financial/tax planning tool when used properly and followed to the letter of the regulation.

So far, angry taxpayers are refusing to take that into account. The recent government decision to be flexible, however, may change that.


Vikram Barhat