A Tax-Free Savings Account ("TFSA") is a registered investment account that allows a taxpayer to participate in eligible investments, and withdraw the account's investment growth, capital gain and any other earnings on a tax-free basis. The contributions made to a TFSA account are not deductible, neither are any expenses associated with the set up or maintenance of the account.
This article briefly discusses just how the death of a TFSA-holder impacts the tax treatment of this type of registered account. Furthermore, the article outlines the tax implications of inheriting a TFSA account from deceased spouse or common law partner.
Tax Treatment of TFSA upon Death of the TFSA-Holder: What Happens to the TFSA Account?
Generally, when a taxpayer dies, his or her TFSA ceases to exist. This statement is true for deposit and contract TFSA accounts. So long as the TFSA-holder did not make any excess contributions during his or her lifetime, there are no other tax implications for the deceased. If at the time of death, there are excess TFSA contributions, the outcome is different.
When a taxpayer contributes amounts in excess of his or her TFSA contributions room, the taxpayer will be subject to a special tax. A taxpayer's TFSA contribution room is the maximum amount of funds that a taxpayer can contribute to his or her TFSA at any given point in time. The special tax is equal to 1% of the highest amount of excess TFSA in the month. This special tax continues to apply on monthly basis so long as the excess contributions remains in the taxpayer's TFSA. In fact, if the excess is not removed, the special tax continues to apply up to and including the month of TFSA-holder's death.
Inheriting the Deceased Spouse's or Common Law Partner's TFSA Account: What are the Tax Implications?
A deceased may bequeath a TFSA to his or her surviving spouse or common law partner by naming him or her as either a successor holder or a designated beneficiary. This designation must be made during the deceased lifetime in the TFSA contract or deceased's will.
A surviving spouse's designation, either as a successor holder or a designated beneficiary, has important implications.
First, the type of designation determines how a surviving spouse is taxed upon receipt of a TFSA gift from his or her deceased spouse
Second, type of designation dictates how a gift of TFSA affects the unused TFSA contribution room of the surviving spouse.
So, who can be a successor holder?
A successor holder is the individual who is the spouse or common law partner of a TFSA-holder at the time of his or her death, who is designated as such in the TFSA contract or the deceased's will. When a successor holder is designated, the TFSA account does not cease to exist upon the TFSA-holder's death. Instead, upon death of the holder of the account, the successor holder becomes the new holder of the account. This means that the successor holder becomes the new owner of the account.
It is important to note that not all provinces and territories permit the "successor holder" designation. This label is effective only if the applicable provincial and territorial laws recognize and permit a TFSA-holder to designate his or her spouse or common law partner as such. In the absence of this type of legislation, this designation has no effect. At the time of writing, Ontario is one of the provinces where the designation of a spouse or common law partner as a "successor holder" is recognized.
A successor holder, in essence, becomes the owner of two separate accounts: his or her own TFSA account (if there is one) and the deceased's TFSA account. The successor holder can withdraw funds from the inherited account on a tax-free basis. More importantly, the successor holder's TFSA contribution room is unaffected by the inheritance of the deceased's TFSA account.
When the TFSA-holder has not designated a successor holder but has instead name designated beneficiaries, the deposit or annuity contract ceases as a TFSA upon death of the TFSA-holder. After the holder's death, a new deposit or annuity contract is deemed to continue but is no longer considered a TFSA (i.e. earning in the account and the withdrawals are no longer tax-free).
Unlike a successor holder, a designated beneficiary does not inherit a TFSA account. Instead, he or she receives distributions from the deceased's TFSA. So long as the distributions are equal to or less than the fair market value of the TFSA at the time of the TFSA holder's death, the designated beneficiary receives the distributions on a tax-free basis. In other words, the beneficiary is not required to include the amount of distributions in his or her income. However, any earnings accrued in the account after the date of death that are subsequently distributed must be included in the beneficiary's income in the year of receipt. In other words, the designated beneficiary is required to include these distributions in his or her income in the year of receipt.
A TFSA-holder can name the designated beneficiaries of his or her choice in the TFSA contract or his or her will. Designated beneficiaries can contribute any amounts they receive from a deceased's TFSA to their own TFSA without any tax implications so long as they have TFSA contribution room available. This is so because unlike a successor holder, a designated beneficiary does not inherit a separate TFSA account.
Tax Tips: Even After Death, Excess Contributions Can Give Rise to a Special Tax – A Remedy Be Available
If a TFSA-holder has made excess contributions to his TFSA during his lifetime, and has failed to withdraw the excess amounts upon death, the 1% special tax applies up to and including the month of the TFSA-holder's death. Additional penalties and interest may also apply. Together, the amount of special tax, penalties and interest can be quite significant.
The Income Tax Act provides relief from the 1% special tax and the associated interest and penalties if the entirety of the taxpayer's circumstance meets certain criteria. Consult one of our experienced Canadian tax lawyers to determine your eligibility for this type of relief application.
If you are currently in dispute with the Canada Revenue Agency about your TFSA contributions, our experienced Canadian tax litigators can help you navigate the intricacies of the Income Tax Act and the remedies that may be available to you.