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RRSP Over Contribution & Decline In Market Value

A recent visitor to The Canadian tax Resource Blog [1] found himself in a difficult situation when he over contributed to his RRSP and then his investments fell in value.

Question: I mistakenly contributed to an RRSP when I had no earned income last year and no RRSP contribution room.  I received a notice from the Canada Revenue Agency indicating that I must pay a penalty of 1% per month due in the amount that I had originally over contributed. I had invested the contribution in some mutual funds and with the markets the way they are right now the value of my investments have since fallen quite substantially and I’m not sure what to do.

There are two issues at play here:

It is important to understand the difference and connection.

RRSPs & Contributions

In order to contribute to an RRSP [2] you must have earned income [3] in the prior year and the amount you can contribute is the lesser of 18% of your prior year’s earned income or the yearly maximum. The maximum contribution you can make is listed on your last Notice of Assessment from the CRA. If you had no RRSP contribution room, you cannot contribute to an RRSP. The contributions you do make are considered over contributions which are subject to a penalty tax of 1% per month for the amount of the over contribution.

How To Fix An RRSP Over Contribution

RRSP contributions (aka deposits) are deducted from your taxable income for the year. Investments purchased inside the RRSP are not taxed as income. If you have over contributed to an RRSP you have 2 choices: (a) Continue to pay the penalty tax until you have accumulated enough earned income and contribution room to account for the over contribution, or (b) withdraw the excess amount.

If The Investments Fall In Value

If you have over contributed to your RRSP you are subject to the penalty tax of 1% per month. If the value of your RRSP is less than the amount of your over contribution you will not be able to withdraw enough to offset the excess amount.

S. 204.1 – The Saving Grace

The CRA has the ability to waive the penalty tax under 204.1(4) of the Income Tax Act if the excess contribution arose as the consequence of a reasonable error or reasonable steps are being taken to eliminate the excess. The CRA will probably not waive the penalty tax due to reasonable error under 204.1(4)(a). However, you may find relief under 204.1(4)(b) if you withdraw the excess amount.

The $2,000 Over Contribution Limit

Administratively the CRA permits over contributions to an RRSP of $2,000.  If a contribution were made of say $5,000 and the value of the investments had fallen to $3,000.  Withdrawing the $3,000 would effectively eliminate the penalty tax. Although there would still be an over contribution of $2,000 and no funds in the RRSP.