Finance & Investing: Pass It On

By: Gordon Pape

Provinces and territories finally Clarify tax-free savings account beneficiary rules. Gordon Pape suggests you act now…

Finally, we have some clarity when it comes to passing on the assets in a Tax-Free Savings Account (TFSA) to your heirs. Too bad it was so long in coming. For the first six months of 2009, millions of Canadians were trapped in federal-provincial limbo when they tried to name a beneficiary for their accounts. I received dozens of emails from people asking why their financial institution would not allow them to name a TFSA beneficiary, just as they could with RRSPs and RRIFs, even though Ottawa had made provision for this in the legislation.

Blame the provinces. Their foot-dragging created a legal mess, which wasn’t fully resolved until June 16 when the Ontario government announced that residents of the province could name a beneficiary and that assets within a TFSA would not be subject to probate. That was more than 15 months after Finance Minister Jim Flaherty announced that TFSAs were on the way.

Ottawa’s original intent was to allow anyone opening a plan to designate their spouse or common-law partner as the “successor account holder.” Successor holders receive all the assets in the TFSA when the plan holder dies. The problem is that succession laws are a provincial responsibility. Ottawa can say what it likes on the matter, but nothing actually happens until the provinces and the territories take action.

The practical effect of this provincial tardiness is that anyone who was unable to name a successor holder when they opened an account must now go back to the plan administrator and complete the required form. I strongly advise doing this as it will make the whole transfer process much easier if anything should happen to you. Anyone opening a new account should be able to name a successor holder without difficulty.
However, there is still confusion be¬tween a successor account holder and a beneficiary. You must understand the distinction because you may have both a successor holder form and a beneficiary form handed to you when you open an account or make a designation for an existing TFSA.
To be clear, a successor holder can only be the spouse or common-law partner of the person who owns the TFSA.

(Common-law partners must have lived together for at least three years or have children together.) No one else qualifies. The successor holder will take control of the TFSA when the orig¬inal account holder dies, which means he or she can manage the assets in the plan and may make new contributions after an exemption period once it is transferred to his/her name. However, successor holders do not inherit any unused contribution room from the de¬ceased. Any new contributions will be deducted from their personal limit. The successor holder can also make a new beneficiary designation and may cash out the plan at any time tax-free.

A beneficiary is one who is named to inherit a plan’s assets: a child, sibling, relative, friend or charity. A beneficiary will receive the assets of a TFSA tax-free at death, and the plan will be terminated. However, any profits earned within the TFSA between the time the holder dies and the date it is wound up will be taxable in the hands of the beneficiary.

In general, the rules governing the tax treatment of TFSAs after death are similar to those for RRSPs. TFSAs will retain their tax-exempt status until the end of the year following the year of the plan holder’s death. So if a TFSA investor dies during 2010, the plan will keep its tax-exempt status until Dec. 31, 2011. After that, it loses its TFSA status and becomes a plain, non-registered investment account. If that happens, every security in the portfolio will be assigned a fair market value, and any interest, dividends or capital gains earned after that will be taxed at normal rates.

Let’s consider some scenarios after the death of a TFSA plan holder.

1. The spouse/partner is named as successor holder. In this case, the deceased person’s TFSA can be continued or the assets withdrawn tax-free. The survivor retains his/her own TFSA and the contribution room he/she previously had. In effect, the successor holder simply steps into the shoes of the deceased.

2. The surviving spouse or part-ner dies, and the TFSA assets are divided between two adult children. In this case, the money in the plan at the time of death remains tax-free. However, any profits earned after death are taxable as income in their hands.
But here is an angle that will likely become increasingly important in estate planning. The executor has the flexibility to decide how the TFSA assets are divided and can use that discretion to minimize the tax due. Let’s assume that the TFSA had $100,000 in assets at the time of the plan holder’s death and generated another $20,000 in gains before the estate was settled. In this case, the brother is unemployed and, therefore, has very little income. The sister is a vice-president of a large company and is in the top tax bracket. As the legislation is currently worded, the executor can direct that the sister’s share of the $120,000 in the TFSA be received as a $60,000 tax-exempt transfer. The brother receives $40,000 in tax-exempt money and $20,000 in taxable income. Since he is in a very low bracket, the amount of tax he will actually end up paying will be minimal. (This is a loophole that may be closed in the future, so estate planners will need to keep watch on the situation.)