TFSA tax exposure if spouse is not successor holder

Executors need to avoid delays, else unexpected taxes arise

From its humble beginning in 2009 and that first $5,000 of contribution room, the Tax-Free Savings Account (TFSA) has grown to become an increasingly important component of our savings. Annual room for Canadian residents age 18 and over is $7,000 in 2024, with cumulative room up to $95,000 for those who were eligible in 2009, which means investment accumulation could be well into six figures.

And the investment accumulation could be double that for couples who can use the survivor rollover rules on death without affecting the TFSA room of the spouse/common-law partner (CLP). The qualifying rollover amount is the lesser of the TFSA’s fair market value (FMV) at death and the amount paid to the survivor. It’s a generous feature, but the “lesser of ” constraint can be problematic, in addition to tax leakage when income is earned while awaiting transfer to the survivor.

Though these concerns may be minimal if the transfer happens quickly, they can become costly if the proceeds go through an estate, particularly when there are delays in administration. Fortunately, there are some things an executor can do to limit the risk.

Taxable events

It may seem odd to think of a TFSA as taxable, given its name. But it can happen, either through over-contributions during the holder’s life, or following the holder’s death. For couples, the easiest solution in the case of death is to designate the spouse/CLP (the survivor) as successor holder, either on the plan or through the holder’s will. The TFSA continues to exist in its current form, with the survivor carrying on as its new holder.

The use of a beneficiary designation does not have the same continuity effect, even if the survivor is the beneficiary. Such designation assures that the plan proceeds go to whoever is named, including avoiding probate tax in provinces where that is an issue. But income tax will still apply on earnings after death.

A TFSA may be in the form of a deposit, annuity, or trust. For deposits and annuities, the holder’s death causes a disposition of the TFSA at FMV, with any subsequent earnings taxable to the beneficiary(ies) or estate.

TFSA trusts

A TFSA trust continues as a non-taxable trust after the holder’s death. Though this sounds like a positive result, it simply means that any income arising after death will not taxed be to the TFSA trust, but rather to the beneficiaries when the TFSA is distributed to them. However, if the TFSA trust has not been distributed by December 31 of the year after the year of death, known as the “rollover period”, it is deemed disposed, with all after-death growth and income taxed to the trust – at top tax bracket!

As the owner of a TFSA can name a successor holder or beneficiary, one might ask why a TFSA would end up in an estate. Apart from Quebec (where one cannot legally make such designations), the simplest answer is that the holder may not have been aware of this option, or that the named person is pre-deceased.

Alternatively, it may be a conscious intention to allow for the TFSA to fall into the estate to be managed according to the terms of the will. This may be a strategic move to provide more flexibility in caring for heirs, possibly driven by mixed family considerations, a late-life marriage, disability issues, spendthrift concerns, charitable planning, or just general liquidity.

Whatever the reason, the executor now has control, so what then can be done — and why?

Risks and responses

With the understanding that the executor’s first obligation to the estate is legal in nature, these tax issues offer extra impetus to obtain the official appointment as executor without delay. Within those boundaries, here are some tactics that may then be considered.

If an estate holds a TFSA trust, the after-death growth and income will, as discussed above, eventually be taxed to beneficiaries when distributed to them. That distribution is treated as regular income, taxed at marginal tax bracket rates. Alternatively, an executor could close the TFSA and deposit the proceeds to a non-registered estate account that can at least take advantage of the preferred treatment of Canadian dividends and capital gains for those components of any income earned.

The executor could face a dilemma if the TFSA has fallen in value since death, as crystallizing that loss will reduce the eventual exempt contribution available to the survivor, due to that “lesser of” calculation. On the other hand, assuming the TFSA has at least held its value, the exempt contribution will be unaffected, and the move out of the TFSA will protect against a future loss that could reignite this concern.

The additional benefit is if the new account is opened within the first 36 months of a graduated rate estate, low tax bracket rates will be available to use against this income. Still, a sufficient estate distribution would have to be made to allow the spouse/CLP to make an exempt contribution within the rollover period, again being up to December 31 of the year after the year of death.

As noted above, the executor’s first duty is to the estate, and in turn its beneficiaries. Of course, the executor and spouse/CLP are often one and the same. Whatever the makeup of the estate, any tax-driven actions should first be discussed with legal counsel.

Three questions to help you find the right financial advisor

Right for you

As innumerable Hollywood romantic comedies have shown us, sometimes the one who appears to be Mr. or Mrs. Right, is not necessarily right for you.  When it comes to managing your finances, you can’t afford for that to be a laughing matter.

Finding the ‘right’ financial advisor can be a challenging task. On top of confirming that the person has the proper education, license to operate and relevant experience, you’re looking for a personal connection so you can work together effectively.

Here are three questions to ask yourself and your candidates, to help you hone in on who may be right for you.

1.    Where are you and where are you going?

The search for an advisor can be an especially scary prospect if you have limited financial experience.  What you do have though, is experience in yourself.

Before speaking or meeting with anyone, take a moment to consider where you are at and where you are going in your life – on a personal level – so that you have clarity to evaluate the financial decisions necessary to get you from where you are to where you wish to progress.

This is also the starting point for your advisor-candidates to understand the business engagement you are putting before them. They cannot offer you suitable options without first knowing who they are working with, where they are working from and what they are working towards.  Require this as a baseline for all your candidates, and hold your chosen advisor to this standard once you are underway.

2.    What are you paying for?

Before asking about how much you may be paying (which we’ll come to shortly below), you first need to know what product or service you are purchasing.

You may be looking for specific investments for your existing portfolio, or … a recommendation for an entirely new portfolio, or … maybe some preliminary questions like, what is a portfolio?  Maybe you’re trying to decide whether you should be investing at all, or if there are other more pressing concerns, like paying down debt, managing taxes, protecting family income or making ends meet day-to-day.

Some advisors are paid for giving you access to products, while others are paid for the advice they provide about product choices or broader financial issues.  Ask your candidates where they lie in this universe of possibilities, in particular whether they are paid by product suppliers, by salary from an employer, or if they will be charging you directly.

And obviously, inquire about the actual or expected cost. Ask how that’s determined, why it’s calculated that way, and when and how you will pay.  Assess whether all that makes logical sense, and whether it is an acceptable cost for what you receive in exchange.

3.    How do you communicate?

Ask this of yourself first, then be ready to pose it to the candidates you meet – and you should meet at least three to be able to compare approaches.

In terms of frequency, do you want your advisor on speed dial, or will it be a monthly, quarterly or annual check-in? Then there’s the matter of how, ranging from in-person meetings to phone calls to online video chats, with newsletters and social media in between. Finally, how often will you deal with the advisor personally, and how often will support staff be involved?

Poor communication is one of the most frequently cited reasons why people change advisors. A false start could waste time and money – yours! – so be conscious in those interviews whether the two of you are ‘clicking’. The better the personal connection, the greater the prospects that the appropriate financial products and strategies will be matched up with you and your personal goals.

Rebalancing a portfolio: Is doing nothing … doing something?

A Seinfeld inspired tax insight on staying the course

None of us will look back on the COVID-19 pandemic with a feeling of nostalgia. Apart from the health dangers, many struggled with self-isolation and social distancing. Still, for many families like ours, we cherished the opportunity to re-connect in ways we hadn’t in years, like dusting off board games, semi-regular family walks, and catching up on some classic TV, like Seinfeld.

In fairness, the show had a bit of a slow start, but it didn’t take long for it to hit the stride that took it to the top over its ten-year run. Now more than three decades since it hit the air, there really is something about the sitcom that came to be known as a show about nothing.

That worked in the world of sitcoms, and may give us something to consider in dealing with investment portfolios.

A conscious nothing

I’m certainly not suggesting that investors set up portfolios once, and ignore them thereafter. On the contrary, it’s imperative to be conscious of economic developments – such as how a global pandemic can derail global financial markets – as well as any developments in the businesses behind individual securities held.

The investor can look to her financial advisor as a source of this kind of information. Together they can review the information to determine what’s relevant (including the effect on the investor’s appetite for risk) and decide if adjustments are warranted. Those may be portfolio changes, behavioural changes, or both – or nothing at all.

The critical point is to resist the urge to make change for the sake of change alone.

Nothing and taxes

That urge to ‘just do something’ can be particularly harmful to a non-registered portfolio. Unlike registered accounts, changes to non-registered holdings can result in taxable dispositions. Tax deferral that an investor enjoyed while holding rising securities over the course of years will be realized when those securities are sold.

If those portfolio changes are based on an informed and focused review, then the tax implications should not stand in the way of taking that action. However, if the original portfolio continues to suit the investor’s planning needs then a premature change not only drifts away from the plan, but also compounds that diversion by triggering taxes unnecessarily.

This was complicated enough over the last couple decades or so since 2000 when half of capital gains were taxable. Then came the 2024 Federal Budget that increased the inclusion rate to 2/3 of realized capital gains, while preserving the 1/2 rate on the first $250,000 of an individual’s capital gains in a year. For modest portfolios, this change will have little effect on decisions, at least for now. But as compounding continues over many years and decades, this dual-rate structure will become more of a factor in portfolio decisions.

A tale of two investors – Gerry & Jorgé

Consider sister and brother investors, Gerry and Jorgé, 40-year-old fraternal twins saving for a big trip together for their 50th birthday. Both are high income so we’ll assume a 50% marginal tax rate, while using the 1/2 capital gains inclusion rate as neither expects significant capital gains any time soon.

Ten years ago, each used $10,000 to buy 1,000 units of VanDelayed mutual fund for $10 per unit. The price rose as high as $18 but has since come back to $14. It pays no dividends. Despite the recent price decline, Gerry leaves her investment alone.

Jorgé, on the other hand, is convinced that VanDelayed will continue to fall, so he sells. With a fair market value of $14,000 and a $10,000 adjusted cost base, he realizes a $4,000 capital gain. As half the capital gain is taxable, he has a $2,000 taxable capital gain that costs $1,000 in tax, leaving him with $13,000.

A couple months later Jorgé reconsiders and decides that Gerry was right. As it turns out, the price is again $14 when he reinvests his $13,000.

Ten years later when it’s time to book the trip, VanDelayed is at $28.

    • Gerry’s $28,000 holding realizes a $18,000 capital gain, resulting in $4,500 in tax, netting to $23,500.
    • With the price doubling from $14 to $28 from the time Jorgé reinvested, his $13,000 rose to $26,000. Taking away $3,250 tax due to the $13,000 capital gain, Jorgé is left with $22,750.

Despite that Jorgé got back in at the same price as when he exited, the early tax payment hampered his growth, in this example putting him $750 behind Gerry. And though the amount of difference would vary depending on the growth rates at the two time points, as long as there was growth then the difference would never come out to nothing … which is something to think about.