TAX NEWS - 2010

Tax Free Savings Account (TFSA) penalties may be waived, Canada government says

Confusion leads ministries to issue joint statement on application of tax rules

Tax relief appears to be in sight for taxpayers who've been hit with big penalties for what are technically overpayments to their new Tax Free Savings Accounts.

The government is promising to be "as flexible as possible in cases where a genuine misunderstanding of the Tax Free Savings Account (TFSA) contribution rules occurred," says a statement from Revenue Minister Keith Ashfield and Finance Minister Jim Flaherty.

"Our intention is to to review each situation on a case-by-case basis and, where appropriate, waive taxes on excess contributions for this year."

I wrote about this issue earlier this week, and I was researching a followup column when the ministers' statement arrived in my inbox. And I can tell you that the case for many, maybe all, of the taxpayers who were hit with these penalties should be a slam-dunk.

A Tax Free Savings Account (TFSA) allows Canadians to salt away up to $5,000 a year in special accounts that offer some tax advantages. We don't get a deduction for the money deposited, as we do with an RRSP. But the money our Tax Free Savings Account (TFSA) deposit earns won't be taxed, not even when it's withdrawn. And it won't impact eligibility for income-dependent retirement benefits.

What tripped up many taxpayers -- as many as 70,000 of the 4.6 million who bought into the scheme in its first year -- are the restrictions on the timing of withdrawals and redeposits.

The rules do allow a tax-free withdrawal at any time. But replenishing your account is another story. If you've already deposited $5,000 during the year, you can't redeposit until the following year.

This rule makes no sense to me. Unlike with an RRSP, there's no possibility of a fraudulent or inadvertently improper claim for a tax deduction, because there's no deduction for any Tax Free Savings Account (TFSA) deposit. And there's no restriction on how much you can redeposit -- you can put it all back on Jan. 1, but you can't put in even a fraction on Dec. 31.

As I noted in my earlier column, it isn't always easy to understand -- or even find -- information on this technicality unless you know you need to go looking for it.

What I've learned since is that anyone who took the trouble to seek information in advance may well have been led down the garden path. Two versions of a brochure that was printed and distributed by the finance department -- and that may be still obtainable at some banks -- notes no less than four times the Tax Free Savings Account's flexibility that allows withdrawals and redeposits. Yet there's no hint of warning that you must time your redeposit correctly or pay a stiff penalty.

Indeed, even a new brochure, available at www.tfsa.gc.ca, is only marginally better than the two out-of-print versions. The new one has a single reference to being able to redeposit "in future years" and one of three examples has a woman redepositing "a number of years later." But the other two examples are as vague as in the first iterations of the brochure, and there's no warning or explanation of the rule.

This being the case, I don't think the government has any choice but to back down on the penalties for this year. It was probably unintentional, but the brochures leave a seriously misleading impression.

Ministers Flaherty and Ashfield should not, however, consider their timely intervention to be the last of it. They need to get rid of this silly rule altogether.

Tax Free Savings Accounts were -- and are -- a good idea, especially for lower-income earners who tend to lose more in the long run than they gain in the short term when they buy into RRSPs. You must be able to build up a sizable nest egg for RRSP tax advantages to kick in, whereas Tax Free Savings Accounts work for every income level.

The fact that 4.6 million Canadians bought into TFSAs last year shows just how welcome they are. But the fact that they're meant to appeal to lower-income earners -- for the most part inexperienced and unsophisticated investors -- means the rules must be kept as clean and simple as possible.