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.

In most parts of Canada, that had not happened by the time TFSAs were launched at the beginning of 2009. Only a handful of provinces had passed legislation to allow successor holders to be named (and not by that specific term); the rest dragged their heels. There was no excuse for this delay; in most cases, the provinces only had to add TFSAs to the list of registered plans that can transfer assets outside of probate.

The result was widespread uncertainty when TFSAs were launched. Residents of some provinces were allowed to make successor holder designations as part of their TFSA application. But in most regions, including populous Ontario, they were not. Only British Columbia, Al¬berta, Nova Scotia, New Brunswick and Prince Edward Island were ready to go. The rest of the provinces slowly signed on in the months that followed. Ontario was the last of the stragglers. Now that the process is complete, every couple in Canada, except residents of Quebec, can name a successor holder, and probate fees should not apply to TFSA transfers on death. (Quebec, which has a different set of laws under the Civil Code, never took action to allow for successor holders and never will; residents of that province must name a beneficiary in their will.)

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.

Tax experts warn not to name your spouse/partner as beneficiary but rather to use the successor holder designation. If you make a mistake and name the spouse as a beneficiary, the CRA will probably interpret that as meaning successor holder, but why risk complicating matters? And don’t name your spouse and someone else as joint beneficiaries. If you do, the rules of the game may change, and the transfer of assets may become more complicated.

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.)

3. The status of the TFSA is not resolved by the end of the year following death. This will be a rare occurrence, but if it happens, the rules state that the TFSA becomes a taxable trust. The money that was in the plan at the time of death retains tax-exempt status. Any gains earned in the plan after death become taxable at trust rates. This sta¬tus will continue until such time as the trust is liquidated.
Hopefully, this clarifies the situation — at least to the extent possible in the context of our jurisdictional divisions and provincial law variations. The key point is that if you have not yet named a successor holder or a beneficiary for your TFSA, do it now.