This article appeared in the May 2022 issue of the monthly magazine Advisor’s Edge magazine. Sign up for the print edition, read the digital edition or read articles on the Internet.
When a TFSA holder dies, the tax consequences can vary depending on the beneficiary’s name, the amount of post-death income, the time it takes to distribute the amounts, and even the type of TFSA. In all cases, fair market value (FMV) at death can be distributed tax-free, but any increase in FMV after death is taxable.
Types of beneficiaries
There are two types of beneficiaries: the successor holder and the designated beneficiary.
The legal successor can only be the spouse or partner of the account holder. Anyone (including a spouse or common-law partner) can be a designated beneficiary.
The successor holder or designated beneficiary may be named directly in the TFSA (if available) or in a will.*
If possible, a client with a TFSA should name his or her spouse as legal successor. When this happens, the entire TFSA becomes the property of the successor immediately upon the account holder’s death, even if the spouse does not have enough room for contributions. All amounts earned after death remain tax-free.
If you do not name your spouse as your legal heir
The matter becomes more complicated when no successor holder is named.
A spouse or partner designated as a TFSA beneficiary can transfer the TFSA’s FMV at death to his or her own TFSA as an exempt contribution – even if there is no room for contributions. The transfer must be made within the transfer period, which lasts until December 31 of the year following the death of the spouse.
However, any increase in FMV during the period before the decedent’s TFSA is transferred to the spouse’s TFSA is taxable to the spouse.
Different types of TFSAs
There are three types of TFSAs: a deposit (an interest-bearing account or time deposit), an annuity (such as a segregated fund), and a trust. The trust agreement may include mutual fund or brokerage accounts, and their documentation likely includes the trust agreement. (This isn’t exclusive to TFSAs. Both RRSPs and RRIFs have the same three account types and slightly different nomenclature.)
There are slight differences in beneficiary treatment depending on the type of TFSA. For all three types of FMV, the TFSA is tax-free at death.
The difference is what happens to the TFSA itself. Trust agreements continue to be treated as TFSAs until December 31 of the year following the death of the holder or until the TFSA is terminated, whichever comes first. This period is called the exempt period. Undistributed income and capital gains remain tax-free until distributed to the beneficiary at that time.
If the exemption period ends and the TFSA is not distributed to the beneficiary, the TFSA becomes a taxable trust between survivors. The FMV TFSA remains tax-free at death, and undivided income during the exemption period and thereafter will be taxable to the trust itself. The trust will also be required to file an income and information tax return and prepare a T3 to distribute taxable amounts to the beneficiaries.
In the case of TFSA deposits and annuities, the account is no longer considered a TFSA after the holder’s death. FMV remains tax-free and is paid to the beneficiary as such. However, all future gains (income and capital gains) on this amount will be taxable to the beneficiary.
Avoid unintended consequences
Advisors should regularly review beneficiary designations to ensure they are accurate, current, and consistent with the client’s estate plan. Making timely distributions to a TFSA keeps exempt contributions intact for spouses and avoids unnecessary tax reporting or administrative delays in the case of trust agreements.
*The rules are slightly different in Quebec: the successor holder or beneficiary may be named in the product itself or in the will of the annuity TFSA; in the case of a TFSA with a deposit and a trust deed, the beneficiary of the estate is named in the will and a successor cannot be named.
Curtis Davis, FCSI, RRC, CFP, Senior Consultant, Tax, Retirement and Estate Planning Services, Retail Markets at Manulife Investment Management
