Avoid the tax consequences of not distributing a TFSA quickly after the account holder dies
When a TFSA account holder dies, the tax implications can vary based on the beneficiary named, the amount of income earned after death, how long it takes to distribute the amounts and even the type of TFSA. In all cases, the fair market value (FMV) at death can be distributed tax-free — but any increase to the FMV after death is taxable.
Types of beneficiaries
There are two types of beneficiaries: a successor holder and a designated beneficiary.
Only the account holder’s spouse or common-law partner can be a successor holder. A designated beneficiary can be anyone (including the spouse or common-law partner).
A successor holder or designated beneficiary can be named on the TFSA directly (where available) or in a will.*
Where possible, a client with a TFSA should name their spouse as the successor holder. When that happens, the entire TFSA becomes the successor holder’s immediately upon the account holder’s death, even if the spouse doesn’t have sufficient contribution room. All amounts earned after death remain tax-free.
When you don’t name the spouse as a successor holder
Things become more complicated when no successor holder is named.
A spouse or common-law partner designated as a TFSA beneficiary can transfer the FMV of a TFSA at death to their own TFSA as an exempt contribution — even if they don’t have contribution room. The transfer must be completed during the rollover period, which lasts until Dec. 31 of the year following the spouse’s death.
However, any increase in the FMV during the period before the deceased’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 term deposit), an annuity contract (such as a segregated fund) and an arrangement in trust. An arrangement in trust may include mutual fund or brokerage accounts, and their documentation likely includes a trust agreement. (This is not unique to TFSAs. Both RRSPs and RRIFs have the same three account types with slightly different nomenclature.)
There are slight differences in the treatment of beneficiaries depending on the type of TFSA. With all three types, the FMV of the TFSA at death is tax-free.
The difference is what becomes of the TFSA itself. Arrangements in trust continue to be treated like a TFSA until Dec. 31 of the year following the holder’s death or when the TFSA is wound up, whichever is earlier. That period is known as the exempt period. Undistributed income and capital gains remain tax-free until they are paid to the beneficiary during this time.
If the exempt period ends and the TFSA hasn’t been paid to a beneficiary, the TFSA becomes a taxable inter-vivos trust. The FMV of the TFSA at death remains tax-free and the undistributed income from the exempt period and after will be taxable to the trust itself. The trust will also be required to file a Trust Income Tax and Information Return and to prepare T3s for any distributions of taxable amounts to beneficiaries.
For deposit and annuity TFSAs, the account is no longer considered a TFSA after the holder’s death. The FMV remains tax-free and is paid to the beneficiary as such. However, all future earnings (income and capital gains) on the amount will be taxable to the beneficiary.
Avoid unintended consequences
Advisors should regularly review beneficiary designations to make sure they are accurate, updated and aligned with the client’s estate plan. Making TFSA distributions in a timely manner keeps exempt contributions intact for spouses and avoids any unnecessary tax reporting or administrative delays for arrangements in trust.
*The rules are slightly different in Quebec: a successor holder or beneficiary can be named in the product itself or in the will for annuity contract TFSAs; for deposit and arrangement-in-trust TFSAs, the beneficiary of the estate is named in the will and a successor holder cannot be named.
Curtis Davis, FCSI, RRC, CFP, senior consultant for tax, retirement and estate planning services, retail markets at Manulife Investment Management