Death of a TFSA Holder: You Can't Take It With You, But Can Your Heirs? A Canadian Tax Lawyer's Guide
The Tax-Free Savings Account ("TFSA") offers numerous tax benefits. But many Canadiantaxpayers neglect to consider their TFSA when devising an estate plan. This article discusses the basic Canadian tax implications following the death of a TFSA holder.
When the owner of a TFSA dies, the tax consequences turn primarily on whether the owner had a surviving spouse or common-law partner who qualified as the TFSA's "successor holder."
"Successor Holder"of a TFSA
An individual is the "successor holder" of a Tax-Free Savings Account if the individual:
- was the spouse or common-law partner of a TFSA holder at the time of the holder's death;
- was named by the deceased TFSA holder as the TFSA's successor holder; and
- acquired all the deceased's rights under the TFSA—especially the right to revoke a beneficiary of the TFSA.
The successor holder of a Tax-Free Savings Account basically becomes the new account holder on the death of the account's original owner. As a result, the account retains its status as a TFSA, and the successor holder doesn't incur tax for receiving the deceased's TFSA funds or on any income earned in the TFSA after the original owner's death.
Moreover, the newly acquired Tax-Free Savings Account doesn't affect the successor holder's TFSA contribution room. But, if the deceased over-contributed into his or her TFSA, the over-contributed amount will reduce the successor holder's contribution room.
No Successor Holder
The deceased holder of a Tax-Free Savings Account may name someone other than his or her spouse or common-law partner as the TFSA beneficiary, or the deceased's spouse or common-law partner may not have acquired the right to revoke a beneficiary under the deceased's TFSA. In these cases, no one qualifies as a "successor holder" of the deceased's Tax-Free Savings Account.
The absence of a successor holder has implications for both the account itself and the account beneficiaries. The account loses its status as a TFSA following a one-year grace period, after which the account is (i) deemed to dispose of its holdings for fair market value and (ii) treated as an intervivos trust for tax purposes. The beneficiaries need not report as income any TFSA proceeds from among the TFSA capital or earnings that accrued before the holder's death.
Exempt Period, Taxation as a Trust, and Deemed Disposition
If the holder of a Tax-Free Savings Account dies and no one qualifies as the successor holder, the account will lose its status as a TFSA. Yet the Income Tax Act effectively extends the life of the TFSA until the end of the first calendar year beginning after the holder's death (the "exempt period"). Income earned in the TFSA remains non-taxable for the account during the exempt period. Although the TFSA's income remains non-taxable during the exempt period, a beneficiary who receives proceeds from the deceased's TFSA may attract tax liability. (The following section discusses the implications on beneficiaries in greater detail.)
Typically, the person in charge of the deceased's estate will distribute the holdings of the deceased's Tax-Free Savings Account and close the account long before the exempt period expires. But, if the account still exists after the exempt period, any income earned from the account holdings are subject to tax. In particular, the account is taxed in the same manner as an intervivos trust beginning on January 1st of the year after the year in which the exempt period expired. And the trust must, in its first tax return, report any undistributed income or gains that accrued in the TFSA during the exempt period.
(An inter vivostrust—also known as a living trust—is basically any trust that doesn't arise as a consequence of an individual's death. Atestamentary trust, in contrast,is one that comes into existence when a person dies. These two kinds of trusts receive different tax treatment in Canada. For more on taxation of trusts in Canada, see here.)
Moreover, when the exempt period expires, the Income Tax Act will deem the account to have disposed of and subsequently reacquired any remaining holdings for fair market value at that time. So, the account may realize a taxable capital gain.
Implications for Beneficiaries
If a beneficiary receives proceeds from the TFSA, the beneficiary must include in his or her income the amount of any proceeds exceeding the fair market value of the TFSA immediately before the holder's death. In contrast, a beneficiary need not report as income a payment from among the TFSA capital or earnings that accrued before the holder's death.
A non-spouse beneficiary can contribute the proceeds from the deceased's TFSA into his or her own TFSA only if he or she has contribution room. In addition, contributed proceeds will reduce the beneficiary's contribution room for that year.
But, if the beneficiary is the deceased's spouse, he or she can contribute the proceeds from the deceased's TFSA without affecting his or her contribution room. Essentially, the deceased's TFSA funds rollover to the surviving spouse's TFSA as an "exempt contribution" if:
- the surviving spouse makes the contribution before the end of the year beginning after the deceased's death;
- the surviving spouse received the funds as a consequence of the deceased's death and out of the account ceasing to be a TFSA because of the deceased's death;
- the surviving spouse designates the contribution within 30 days after making the contribution; and
- the contribution doesn't exceed the fair market value of the deceased's TFSA at the time of death.
But an exempt contribution may be unavailable if the deceased exceeded his or her TFSA contribution room before his or her death. The CRA, however, has the discretion to permit the surviving spouse to make an exempt contribution despite the deceased's over-contribution.
If you intend to pass your Tax-Free Savings Account to your spouse under a will, ensure that your will expressly says that your spouse shall acquire the right to revoke a beneficiary of the TFSA.