08/28/2011 10:59 EDT | Updated 10/28/2011 05:12 EDT

Tax-Free Savings Accounts Cause Confusion As Revenue Canada Sends Warning Letters

OTTAWA - Contribution rules for a popular tax shelter continue to perplex ordinary Canadians, despite a year-long information blitz by the Canada Revenue Agency and the big banks.

The agency sent out almost 103,000 letters to holders of tax-free savings accounts this month warning they likely over-contributed in 2010 — and now must pay additional tax.

That number is up sharply from the 72,000 letters issued on June 1 last year for the same excess contribution problem in 2009.

The tax shelter "is still a relatively new program and, naturally, some misunderstandings might still exist regarding the rules and may have led to inadvertent over-contributions," said spokesman Noel Carisse.

The over-contribution issue, which cropped up last year, prompted the Canada Revenue Agency to revamp its TFSA website and issue brochures and tip sheets, while the big banks made similar web changes.

But thousands of Canadians are still tripping over a little-understood wrinkle about 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they do so in the same year, they face a tax hit for their "over-contribution," even though they're only replacing the withdrawn funds.

Focus-group surveys commissioned by the agency last year indicated Canadians found the official TFSA website confusing and difficult to navigate, even after it was revamped to better highlight the over-contribution rule. Other internal reports suggested the agency's language in describing TFSAs to the public has been unclear.

Millions of tax-free savings accounts were set up after they came into effect on Jan. 1, 2009. Canadians can deposit up to $5,000 each year, and any earnings in the account attract no taxes, though deposits do not reduce taxable income as do RRSP deposits.

In the campaign for the May 2 election this year, Prime Minister Stephen Harper promised to double the annual contribution limit to $10,000 once the federal deficit is eliminated.

The current crop of warning letters was mailed Aug. 18, the day before a news release from Revenue Minister Gail Shea and Finance Minister Jim Flaherty advising Canadians the government would consider waiving extra taxes owed.

"We will once again be as flexible as possible in cases where a genuine misunderstanding of the TFSA contribution rules occurred," said the joint release. "It is important that we hear from you if you want to be considered for this administrative relief."

Of the 72,000 Canadians issued warning letters last year, 43,000 sent in cheques for the extra tax amounts. Another 23,000 successfully applied for tax waivers, for an average of $235 each.

Carisse noted that of the 6.7 million Canadians who currently have tax-free savings accounts, fewer than 1.5 per cent fell afoul of the rules this year, a slightly lower percentage than last year.

And he said only 10,000 of the letters issued this year went to people who got the same letter last year.

"This indicates that approximately 90 per cent of individuals contacted last year took steps to comply with the TFSA rules, which also suggests that the CRA's education efforts in regard to the TFSA have been largely successful," he said.

Letters that were sent Aug. 18 also contained detailed individual forms outlining the excess contributions, along with a pre-addressed envelop for those sending in a cheque. Excess amounts are taxed at the rate of one per cent for each month there is an over-contribution.

This year's letters were issued more than two months later in the season than last year's because the agency dealt with many more TFSA accounts that were opened in 2010, and because the Aug. 18 mail-out package was revised to include more explanatory material, Carisse said.

"In future, we expect to mail the packages earlier in the year."

He added that the agency is stepping up education efforts, including web-based seminars with financial institutions this fall to provide more technical information about the accounts.

A spokeswoman for the Canadian Bankers Association says members increased efforts to explain the rules to clients when the over-contribution problem first arose last year.

"While banks provide advice to their clients, since taxpayers can open multiple TFSAs at multiple financial institutions, a bank can never be certain of a client's aggregate TFSA contributions," said Maura Drew-Lytle, director of media relations, in Toronto.

"We also recommend that if people do want to move funds from one TFSA to another, they do it by direct transfer rather than a withdrawal and a recontribution. Doing this will not affect their contribution room."