Two years after the introduction of tax-free savings accounts, they have proven to be popular — even though some clients are still unclear about contribution limits.

The issue of overcontribution — both unintentional and intentional — has recently served as an eye-opener, both for clients and for the Canada Revenue Agency.

This past June, 70,000 TFSA holders received letters from the CRA informing them that they would be assessed a penalty for exceeding the annual $5,000 contribution limit. Recipients of the letter were given until June 30 — later extended to Aug. 3 — to explain their mistake and possibly qualify for an exemption. Overcontributions have occurred in about 2% of the 4.7 million TFSAs.

Overcontributions deemed unintentional occurred as a result of clients misunderstanding the contribution rules. For example, your client might have deposited the maximum contribution amount of $5,000 in January, then withdrawn $1,000 in May and redeposited that $1,000 before Dec. 31 of the same year. Even though the TFSA’s balance never exceeded $5,000, deposits for the year would total $6,000, resulting in an overcontribution of $1,000.

The penalty is 1% of the overcontribution for each month the account is in an overcontribution situation.

Other “accidental” contributions have occurred when clients transferred money from one TFSA to another. Transfers should be handled by a financial services institution in order to avoid multiple contributions of the same funds. But if your client opened a TFSA at one institution, then withdrew that money and deposited it in another TFSA at a different institution within the same calendar year, the second deposit could be considered an additional contribution, possibly resulting in overcontribution.

Clients could be penalized. “It comes down to the question of whether [the client] meant to make a transfer or to take the money out,” says Adam Salahudeen, senior manager of taxation advisory services for wealth management with Bank of Nova Scotia in Toronto.@page_break@Confusion over the rules governing TFSA contributions has led to some leniency by the CRA, which announced in June that cases of overcontribution would be investigated on a case-by-case basis and that in most instances in which the overcontribution did not exceed $5,000, the penalties would be waived.

Not all overcontributions have been unintentional. In some cases, Salahudeen says, a client would contribute an amount far above $5,000, believing the tax-free returns on the investment would outweigh the penalty.

The federal government tabled draft legislation last April to make a distinction between honest mistakes and deliberate overcontributions. A deliberate overcontribution, the new rule states, includes any action that results in an excess of TFSA amounts “unless it is reasonable to conclude that the individual neither knew nor ought to have known that the contribution could result in liability for a penalty, tax or similar consequence.”

If it is determined that the accountholder knowingly overcontributed to a TFSA, Salahudeen says, he or she would have to pay a 100% tax on any gains made as a result of the overcontribution.

Confusion has arisen in part because of the TFSA’s similarities to other savings vehicles. “[The TFSA] has some parallels with some of the other registered plans,” says John Waters, manager of tax planning with BMO Nesbitt Burns Inc. in Toronto. “But it’s a different animal, and it’s had some growing pains.”

Despite the confusion and the new draft legislation, the CRA has not changed radically the way TFSAs operate. The agency has initiated several communication programs, including press conferences, news releases and updates to its website to educate consumers and financial services professionals.

Still, the TFSA remains a desirable savings vehicle, say tax experts. While your clients might have thought the TFSA’s $5,000 annual limit was too low to make the vehicle significant, says Sala-hu-deen, some clients are beginning to see the potential growth. For example, an accountholder who maximizes annual contributions over 35 years at a 6% growth rate can end up with $530,000 in savings. “I think as we go further along,” he adds, “this is going to be even more and more beneficial.”

For now, the CRA is mulling over suggestions it received over the summer from clients and financial services professionals, and it is working on tools to clarify the rules and benefits of the accounts.

IE