Thousands of taxpayers broke TFSA rules last year

The number of problem accounts identified is down from the 103,000 warnings sent out in August last year, but up from 72,000 the year before, suggesting the overcontribution problem is becoming chronic.

About 15,000 people who got warning letters this June also received similar letters last summer, indicating a slow learning curve for some taxpayers.

A spokesman for the agency notes the number of problem accounts is a tiny fraction of all the TFSA accounts opened by 8.2 million Canadians by the end of the 2011 tax year.

“The proportion of individuals who received a proposed return (i.e., a mailout warning) was less than 1% of the total number of TFSA holders,” Philippe Brideau said in an email response to questions.

“This figure is significantly lower than the 1.5% who received proposed TFSA returns in the previous contribution years. … While there are instances of misunderstanding, it is apparent that the vast majority of contributors understand the rules.”

Tax-free savings accounts, which became available on Jan. 1, 2009, allow Canadians to earn money on deposits inside the account without attracting any income tax, even when money is withdrawn. The current maximum annual contribution is $5,000.

But there is a poorly understood wrinkle in a rule governing the timing of deposits.

The rule says account holders can put back the amounts they withdraw from a TFSA only in a later calendar year. If they do so in the same calendar year, they face a tax hit for their “overcontribution,” even though they’re only replacing the withdrawn funds.

Canada’s banks and the tax agency itself highlighted the rule on websites and financial brochures once the widespread misunderstanding first became apparent in June 2010. But despite those efforts, tens of thousands of account-holders continue to fall afoul.

The agency says it will continue to be flexible for those Canadians with a “genuine” misunderstanding of the rules.

“In situations where a genuine misunderstanding of the rules has occurred and the overcontribution removed within a reasonable period of time, the tax may be waived,” Brideau said.

Of the 103,000 cases identified last year, 38,000 Canadians have sent in payments for the extra tax due on their overcontributions, while at least 22,500 asked for – and were given – waivers on the extra taxes. The waived amount averages $318.

In the previous year, 23,000 Canadian successfully requested waivers, for an average of $235 each.

Excess amounts are taxed at the rate of 1% for each month there is an overcontribution.

A Harris-Decima poll commissioned by CIBC (TSX:CM) and released last month found 47% of respondents had set up a TFSA, but only about half had actually made a deposit so far this year.

The savings vehicle was most popular among British Columbians, and least popular among Atlantic Canadians, the survey found.

The Canada Revenue Agency says more than $60 billion in assets is currently held inside TFSAs.

During the campaign leading to the May 2, 2011, federal election, Prime Minister Stephen Harper promised to double the annual TFSA contribution limit – to $10,000 – once the federal deficit is eliminated.