Overcontributed to your RRSP? Here’s how to fix it to avoid tax problems and penalties

Introduction: The Tax Risks of Overcontributing to an RRSP

A Registered Retirement Savings Plan (“RRSP”) is the first and most powerful tax planning tool for many Canadians planning for retirement. Any income that is earned on investments held in an RRSP (e.g. dividends) is not taxable in the hands of the RRSP holder at the time the income is earned. This allows a taxpayer to reinvest any gains on RRSP investments back into the plan on a tax-free basis and to accelerate growth of that taxpayer’s savings faster than with a non-registered plan.

A taxpayer’s RRSP is not a means of avoiding tax all-together, merely deferring tax until a time later in life, and typically for retirement. The tax deferral mechanism of the Canadian RRSP is the result of two intersecting rules:

1. Paragraph 56(1)(a) of the Canadian Income Tax Act ensures that any withdrawals eventually made from an RRSP are fully taxable in the hands of an RRSP holder at the time of withdrawal.
2. Subsection 146(1) of the Canadian Income Tax Act sets out a taxpayer’s RRSP Deduction Limit, which determines the maximum amount that a taxpayer can deduct from taxable income for contributions made to an RRSP in a given tax year.

The income earned in an RRSP will eventually be taxable when an RRSP holder makes withdrawals from an RRSP or that RRSP holder converts the plan into an RRIF or annuity at age 71 and starts withdrawing funds on an annual basis as required. Without additional relief, that RRSP holder would be subject to double taxation on the same income: first when it is earned, and again after it is contributed to and withdrawn from that RRSP. The RRSP Deduction Limit prevents double taxation by allowing a taxpayer to back out the value of contributions made to an RRSP in a tax year from taxable income, up to a defined limit. In situations where a Canadian taxpayer contributes to an RRSP above and beyond the RRSP Deduction Limit, then that taxpayer may very well face double taxation, because there will be no deduction available for those contributions and any subsequent withdrawal will still form taxable income under paragraph 56(1)(a). But this system alone is not very helpful where an RRSP holder accidentally contributes to an RRSP above the RRSP Deduction Limit. The Canadian Income Tax Act provides one additional mechanism for relief under subsection 146(8.2) for accidental RRSP contributions, but only in very narrow circumstances and only where the RRSP holder acts quickly to withdraw those accidental contributions.

This article will first discuss in a broad sense the RRSP Deduction Limit and how RRSP contribution rules actually work under Canadian tax law. This article will then explore what relief is available under subsection 146(8.2) of the Canadian Income Tax Act where a taxpayer accidentally overcontributes to an RRSP in excess of that taxpayer’s RRSP Deduction Limit, and what conditions must be satisfied to qualify for relief. This article will then conclude with some pro tax tips from our top Canadian tax lawyers concerning RRSP overcontribution tax, and some frequently-asked questions concerning RRSP overcontributions.

How RRSP Contribution Room Works

At the heart of the RRSP system is the RRSP Deduction Limit, which provides a ceiling for taxpayers to contribute to an RRSP on a tax-deferred basis. Subsection 146(1) defines the RRSP Deduction Limit by a technical formula with several major moving parts:

1. RRSP Dollar Limit: The amount of RRSP contribution room that a taxpayer can earn in a given tax year is capped at the RRSP dollar limit. The RRSP dollar limit is defined under subsection 147.1(1) of the Canadian Income Tax Act in reference to the Money Purchase Limit, another indexed amount under the Canadian Income Tax Act. For 2022, the RRSP dollar limit was $29,210.
2. Earned Income: Earned income represents the income an individual earns rather than as the result of owning property. Only specific types of income, such as employment income, income from an active business, and rental income from immovable property will be considered when determining whether a Canadian taxpayer has earned income in a given taxation year.
3. Unused RRSP Deduction Room: A taxpayer’s unused RRSP deduction room at the end of the preceding tax year is in effect carried forward and becomes available for use by an RRSP holder in subsequent years. Thus, RRSP contribution room is cumulative so long as a taxpayer continues to earn RRSP contribution in each taxation year.

In a very simplified sense, a taxpayer will accrue contribution room at the rate of the lesser of: (1) the RRSP dollar limit for that taxation year; and (2) 18% of the taxpayer’s earned income in the preceding tax year. A taxpayer’s RRSP Deduction Limit will be the combined value of the taxpayer’s contribution room earned in that tax year and the taxpayer’s unused RRSP deduction room carried forward from prior years. The formula for the RRSP Deduction Limit includes additional adjustments for a taxpayer’s various pension adjustments that might result from contributing to a Registered Pension Plan (“RPP”), or a Deferred Profit Sharing Plan (“DPSP”), and by “prescribed amounts” that may arise when an individual transfers accumulated benefits between RPPs. These adjustments fall outside the scope of this current article.

Relief from Tax on Withdrawals of RRSP Overcontribution: Subsection 146(8.2)

What happens in situations where a taxpayer accidentally overcontributes to an RRSP and wants to withdraw those overcontributions without triggering double taxation? Subsection 146(8.2) of the Canadian Income Tax Act provides a narrow means by which a taxpayer can reverse the income inclusion of withdrawals made from an RRSP if the taxpayer acts quickly to correct the error. The deduction under subsection 146(8.2) is available for any contributions made to an RRSP, including overcontributions, and is not capped like a taxpayer’s RRSP Deduction Limit.

In order to qualify, a taxpayer must meet four conditions:

1. the taxpayer must not take or have taken a deduction for the RRSP contributions to the taxpayer’s RRSP or a spouse or common-law partner’s RRSP that are being withdrawn;
2. the withdrawal made from the RRSP must be regarded as being paid from the same type of savings plan (i.e. personal RRSP, spousal RRSP), and must not with respect to any amounts that were transferred to the RRSP from an RPP, DPSP or the Saskatchewan Pension Plan;
3. payment for the RRSP contributions withdrawn and never deducted must be received by the taxpayer or the taxpayer’s spouse or common-law partner, as the case may be, in: (1) the taxation year the contribution was made; (2) the year in which a notice of reassessment or notice of reassessment was issued by the Canada Revenue Agency concerning the year the RRSP payment was received; or (3) the year that follows either of the prior two circumstances; and
4. the payment must be included as part of that taxpayer’s income for the relevant year in question under condition (c).

In essence, a taxpayer may be entitled to take a deduction from income for the full amount of an RRSP where that income presumably relates to an accidental contribution. The withdrawal must be made in the year of or the year following the initial contribution, and the taxpayer must actually withdraw the amount contributed to the RRSP and include it as taxable income on a tax return. Further, the deduction under subsection 146(8.2) is mutually exclusive from the taxpayer’s RRSP Deduction Limit. A taxpayer cannot benefit from both deductions on the same income withdrawn from that RRSP.

If the laundry list of conditions above are met, a deduction may be taken by the taxpayer that serves to offset part or all of the income inclusion of the RRSP contribution. However, the Canada Revenue Agency has the authority to deny the deduction if the following conditions are present:

• the taxpayer did not reasonably expect that the full amount of the contributions would be deductible in the taxation year in which the contributions were paid or in the immediately preceding taxation year; and
• the taxpayer paid all or any portion of the contributions with the intent of receiving a payment that, but for this rule and the above-mentioned rule, would be deductible.

Paragraphs 146(8.2)(e) and (f) of the Canadian Income Tax Act focus on the subjective intentions of the taxpayer in contributing to an RRSP. Paragraph 146(8.2)(e) requires the taxpayer have an unreasonable belief concerning the deductibility of the contributions to the RRSP, and in essence requires the taxpayer be aware of or wilfully ignorant of the rules concerning deductibility of contributions for tax purposes. Paragraph 146(8.2)(f) requires the taxpayer’s payments, in whole or in part, are made for the purpose of receiving a deduction from income under subsection 146(8.2). In essence, the taxpayer must understand or have no rational basis for expecting that a deduction would be available, and the taxpayer must nevertheless have made the payment for the purpose of taking a deduction under subsection 146(8.2) at a later date. These additional conditions target cases where a taxpayer contributed to an RRSP and claimed a deduction to gain some deliberate or perceived tax advantage. A taxpayer who made a genuine mistake of fact concerning that taxpayer’s contribution room and did not take a deduction from income for RRSP contributions should otherwise be entitled to a deduction under subsection 146(8.2).

Claiming a deduction under subsection 146(8.2) for RRSP contributions should not be undertaken without appropriate tax planning and it is highly recommended that an expert tax lawyer in Toronto be consulted. Under subsection 163(2) of the Canadian Income Tax Act, where the Canada Revenue Agency determines that a taxpayer either knowingly or under circumstances amounting to gross negligence participated in or made a false statement or omission on a tax return, then the taxpayer may be liable for harsh penalties. These penalties are otherwise referred to as gross negligence penalties. A gross negligence penalty can equal the greater of: (1) $100; and (2) 50% of the total amount of tax that would otherwise be payable by the taxpayer. Failing to complete your due diligence before claiming an RRSP overcontribution deduction under subsection 146(8.2) can result in significant fines being levied if the Canada Revenue Agency takes the position the deduction is unjustified, or the conditions under paragraphs 146(8.2)(e) and (f) are satisfied. Given the complex factors that must be satisfied to be entitled to a deduction under subsection 146(8.2), it is essential that you consult with an expert Canadian income tax lawyer before taking action to correct your RRSP overcontribution mistakes, so you can avoid landing yourself in further hot water.

Pro Tax Tip – Be Wary of Additional RRSP Overcontribution Tax

There is an additional reason to be careful about accidentally overcontributing to an RRSP. Under subsection 201.4(2.1) of the Canadian Income Tax Act, where an individual has made cumulative excess contributions to an RRSP, that taxpayer is liable to pay a tax equal to 1% per month on the cumulative excess amount exceeding $2,000. The 1% tax is triggered only at the end of each month for which the cumulative excess amounts remain in the RRSP.

While 1% overcontribution tax may be low, the tax can add up quickly. It is almost certain that the overcontribution tax will quickly wipe out any tax deferral benefits that the RRSP offers to an RRSP holder. The overcontribution tax will also apply separately from the income inclusion for withdrawals from an RRSP. Further, and unlike penalties for overcontributing to a Tax-Free Savings Account (“TFSA”), the RRSP overcontribution tax is characterized explicitly by the Canadian Income Tax Act as a tax. Thus, the Taxpayer Relief Program also known as a fairness application, cannot provide relief for RRSP overcontribution taxes. The Canada Revenue Agency is only entitled under the Taxpayer Relief Program waive penalties and interest on taxes owing up to 10 years from the date of a tax assessment and cannot waive actual taxes. Applying for relief from RRSP overcontribution tax must instead to the CRA in accordance with subsection 204.1(4) of the Canadian Income Tax Act. Under that provision, the Minister of National Revenue is given the authority to waive excess contribution taxes owed, so long as two conditions are satisfied:

1. the excess contributions on which the tax is based arose due to a “reasonable error”; and
2. the taxpayer must be taking or must have taken reasonable steps to eliminate the excess contributions.

Obtaining tax relief under subsection 146(8.2) is an imperfect solution to resolving the issues related to an RRSP overcontribution. A taxpayer will presumably owe overcontribution tax as well and must apply for relief with the Canada Revenue Agency for those taxes and demonstrate a principled basis for obtaining relief. It is in the best interests of any taxpayer seeking relief from RRSP overcontribution tax to file the requisite T1-OVP form reporting those RRSP overcontributions and to apply for relief from those taxes. You should engage an expert Canadian tax lawyer where you have overcontributed to your RRSP, to determine the full scope of your tax obligations and whether you may qualify for relief from overcontribution tax.

FAQs:

How does the tax deferral mechanism of the Canadian RRSP work?

The tax deferral mechanism of the RRSP is the result of two intersecting rules:

1. Paragraph 56(1)(a) of the Canadian Income Tax Act ensures that any withdrawals eventually made from an RRSP are fully taxable in the hands of an RRSP holder at the time of withdrawal.
2. Subsection 146(1) of the Canadian Income Tax Act sets out a taxpayer’s RRSP Deduction Limit, which determines the maximum amount that a taxpayer can deduct from taxable income for contributions made to an RRSP in a given tax year.

Any income that is earned on investments held in an RRSP (i.e. dividends) is not taxable in the hands of the RRSP holder at the time the income is earned. Paragraph 56(1)(a) and subsection 146(1) work together to take a deduction from income for tax purposes for RRSP contributions made, and to recognize tax on that income when it is eventually withdrawn from the RRSP.

2) How can I correct an RRSP overcontribution?

Subsection 146(8.2) of the Canadian Income Tax Act provides a narrow means by which a taxpayer can reverse the income inclusion of withdrawals made from an RRSP if the taxpayer acts quickly to correct the error.

To qualify for a deduction from income under subsection 146(8.2), the taxpayer must: (a) not take a deduction from income for RRSP contributions on the amount being withdrawn; (b) the RRSP withdrawal must be paid from the same type of savings plan and cannot be with respect to any amounts transferred to the RRSP from an RPP, DPSP or the Saskatchewan Pension Plan; (c) the withdrawal must be made in the year the contribution was made or the tax was assessed for the withdrawal, or the following year; and (4) the withdrawal must actually be reported as part of that taxpayer’s income. Paragraphs 146(8.2)(e) and (f) limit relief where a taxpayer contributed to an RRSP and claimed a deduction to gain some deliberate or perceived tax advantage.

3) What is the RRSP overcontribution tax?

Under subsection 201.4(2.1) of the Canadian Income Tax Act, where an individual has made cumulative excess contributions to an RRSP, that taxpayer is liable to pay a tax equal to 1% per month on the cumulative excess amount exceeding $2,000. The 1% tax is triggered only at the end of each month for which the cumulative excess amounts remain in the RRSP.

Disclaimer:

This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult an experienced Canadian tax lawyer.