Tag: TFSA

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.

The TFSA Shuttle … channeling the Harlem Shuffle

A catalyst in concert with FHSA, RESP and RRSP tax-sheltered savings

In 1986, the Rolling Stones covered the 1963 R&B song Harlem Shuffle. While the original from the duo Bob & Earl was modestly successful, the Stones’ cover topped the charts in some places, peaking at #5 in Canada. The self-proclaimed world’s greatest rock’n’roll band had put their distinctive spin on something good, and made it even better.

Now, no-one’s about to suggest that tax planning is as enticing as a smooth groove, but magic truly can happen when good things come together. To the point, if you take one good thing
– FHSA for a home, RESP for education, RRSP for retirement – and combine it with another
– the ubiquitous TFSA – you really can produce a whole that is greater than the sum of its parts.

TFSA principles

Introduced in 2009, the tax-free savings account (TFSA) allows after-tax deposits to accumulate tax-sheltered and be drawn out tax-free. By contrast, a registered retirement savings plan (RRSP) is funded by pre-tax deposits that (also) accumulate tax-sheltered, and then are taxed on withdrawal.

Comparison of the two plans was inevitable, often framed as ‘TFSA vs. RRSP’. But rather than it being an either-or proposition, a more productive approach is to employ yes-and thinking. Specifically, if the TFSA is used as the entry point into RRSPs or other tax-sheltered plans, that routing can positively exploit a valuable feature unique to TFSAs.

The re-contribution credit

Whereas available room for other tax-sheltered plans is exhausted one-way as contributions are made, the TFSA calculation operates in both directions. For a Canadian resident over 18, annual room has three components:

    • The prescribed annual TFSA dollar limit, currently standing at $7,000, +
    • Unused room from previous years, +
    • Withdrawals made in the immediately preceding year.

It is the third component that presents the opportunity for the TFSA to be used in concert (pun fully intended) with its tax-sheltered siblings. And whereas a catalyst in the chemical sense remains unchanged after influencing a reaction, not only might a TFSA help another plan, the benefit of that interaction can also echo back to the TFSA.

Start me up! (Assumptions)

Meet 20-something Mick. He’s a serial saver for current needs, and is ready to set aside an additional $100 each week to add to his routine. He intends on using a high-interest savings account (HISA) for this, with the going interest rate in early 2024 being 4%. It’s the start of the year and he hasn’t yet used any of his annual TFSA room.

Understanding there are 52 weeks in a year, to avoid a 19th nervous breakdown doing the math, we’ll use $5,000 for the annual tally. As well, though his cash flow and the HISA terms are bound to vary, we’ll keep them constant here.

FHSA for a home

With the state of house prices, Mick knows he needs to start saving a down payment, for which he wants to use the recently-introduced first home savings account (FHSA). Base annual contribution room is $8,000, with a lifetime limit of $40,000. His plan will have him saving about $5,000 a year, using up his lifetime room in eight years.

Alternatively, Mick could open HISAs for both FHSA and TFSA. Assuming the same terms for each, weekly deposits could be directed to the TFSA, then after 50 weeks in mid-December the balance could be withdrawn and deposited to the FHSA before year-end. It’s important to be attentive to dates for two reasons:

    • The TFSA re-contribution credit occurs the next January 1st, which could be a 365-day swing if it’s missed.
    • And though the deduction for FHSA contributions may be carried forward to a later year if desired, it can’t be carried back to an earlier year (i.e., there’s no ‘first 60 days after year-end’ rule as there is for RRSPs).

Timing aside, the average TFSA balance over the year will have been $2,500. At 4% interest, the mid-December balance will be about $5,100.

    • An annual TFSA-out/FHSA-in shuttle of that full amount will allow Mick to max his FHSA in a little less than the eight years. With annual TFSA deposits of $5,000 and withdrawals of $5,100, the net re-contribution credit will be $100 each year, giving Mick $800 more TFSA room over the full duration by having used the shuttle option.
    • If instead, an even $5,000 is taken out of the TFSA annually, it will again take exactly eight years to fill the FHSA, as if the TFSA had not been involved. However, by using the TFSA as a shuttle, $800 extra TFSA balance will be created, without making any material change to Mick’s investment choices or risk exposure.

RESP for education

Now in his 30’s, Mick had been hoping his son Jack would earn an athletic scholarship for his pole-vaulting prowess. But as he’s grown, it appears that Jack’s jumping skills were just a flash in the sand, and Mick now needs to catch up on contributions to the boy’s registered education savings plan (RESP). With carryforward of past unused room, Mick plans to deposit $5,000 for the next seven years or so, to claim the maximum grant money.

As with the FHSA example above, deposits could go direct to the RESP, or route through a TFSA. The Canada Education Savings Grant (CESG) is the main support program, matching 20% of annual RESP contributions, so $1,000 in our example. By routing through the TFSA, some of that CESG will be delayed a few months as compared to direct RESP contributions. Even so, that’s a small price to pay to obtain the additional TFSA balance or room, which will sum up to just over $700 across those planned years using the same HISA terms.

Another consideration is that once Jack is enrolled in a qualifying post-secondary program, personal RESP contributions can be withdrawn tax-free. The withdrawn amount could be routed back to Mick’s TFSA, assuming there is sufficient room. While the continuing income would be tax-sheltered whether left in the RESP or moved to the TFSA, once again the availability of the re-contribution credit favours use of the TFSA.

If Mick wants to take it a step further, some of those refunded contributions could go to Jack’s TFSA. After all, Jack’s entry into post-secondary will roughly align with him hitting age 18, when he will start getting TFSA room. This could be a good time to establish the knowledge, tools and behaviours to help him on his own personal finance journey.

RRSP for retirement accumulation

As Mick travels through his 40’s, 50’s & 60’s (though some observers feel like he’s the picture of eternal youth), his savings efforts will increasingly focus on retirement. The dollars will be larger – from the amounts saved to their accumulation and on to the annual drawdowns – but otherwise the same fundamentals apply. Mick could go direct into RRSP, or use a TFSA-RRSP shuttle, bearing in mind that larger amounts mean larger re-contribution credits.

There is one more effect to consider, being the annual tax refund Mick can expect to receive after deducting those non-workplace RRSP contributions when filing his annual tax return. If that too is routed to and through the TFSA, it will provide an extra lift to the anticipated TFSA re-contribution credit generated each year.

HISA or market investing?

Saving for retirement and being in retirement can each be decades in length. While a HISA may work for shorter-term purposes like a home purchase or education, it’s not suitable as the core of retirement savings. Indeed, a diversified investment portfolio is generally more appropriate for RRSP savings. In turn, a parallel TFSA portfolio could be arranged to facilitate the intra-year shuttle. With a higher expected (though variable and not-guaranteed) return relative to a HISA, this could be one more boost to the TFSA re-contribution credit.

Mick should consult with his advisor before undertaking this more advanced version of the shuttle concept, to determine what approach best aligns with his knowledge, personal circumstances and risk tolerance.

RRIF for retirement decumulation

Into his 70’s, Mick will have migrated his accumulating RRSPs into the decumulating form of a registered retirement income fund (RRIF) with mandatory minimum annual withdrawals. By default, he would probably take a fixed weekly or monthly spending withdrawal. Alternatively, he could take a lump sum early in the year and route it into a TFSA (HISA being most appropriate for this use), still available for spending, while getting one more TFSA room kicker.

TFSA as the others’ little helper

Over its 15-year history, the TFSA has progressed from novelty to fixture in our financial landscape. By using it as a shuttle, its built-in flexibility can feed into other tax-sheltered plans, while making itself better in the process.

RRSP over TFSA as default choice – Analyzing marginal & average tax rates

Published version: Linkedin

There’s a scene in Doc Hollywood where Michael J. Fox, the fresh med school grad, is readying to airlift a young patient out of the small town for emergency heart surgery. Just before liftoff, the aging local doctor shows up and hands the boy a can of pop – Sip, burp, everybody go home.

Theatrics aside, there’s a lesson here for the RRSP vs. TFSA debate.

Since its introduction in 2009, the TFSA has proven to be a powerful tool that opens up countless possibilities for bettering our financial lives. However, when it comes to retirement savings, the tried-and-true RRSP should be the default choice for most of the population. Here’s why.

Tax treatment IN, tax treatment OUT

Both RRSP and TFSA give you tax-sheltered income and growth on the investments within them. The key difference is what happens on front and back end:

  • RRSP deposits are pre-tax, while withdrawals are taxable;
  • TFSA deposits are post-tax, but withdrawals are non-taxable.

Of course, it’s often said that RRSP contributions are tax-deductible, the appeal being the desired refund. However, to convert that to being truly “pre-tax”, all such refunds (and refunds on refunds) must in turn go into RRSPs. That’s already handled through reduced withholding tax on a work-based group RRSP, but with an individual RRSP that’s your own ongoing responsibility.

Base comparison

If your income is taxed at the same rate when contributing and withdrawing, you will net the same amount of spendable cash whether you use the RRSP or TFSA. Using $100 at a 40% rate and a 10% one-year return (for simplicity, not reality), here is what each yields:

  • RRSP  $100 deposit + $10 return = $110 taxable, netting $66 spendable
  • TFSA $60 deposit + $6 return = $66 spendable

If you are at a higher tax rate going in than out, the RRSP will do better, and vice versa. If you change the example to 40% in and 30% out, the RRSP nets you $77, but the TFSA is still $66. And if your later rate is instead 50%, RRSP nets $55, and once again TFSA $66.

Is it really that simple?

“Same rate” – Marginal or average?

Having made the point about taking care in managing the deductibility of an RRSP contribution, we can’t lose sight that it is indeed a deduction. The benefit is that your RRSP contribution comes off the top at your marginal rate, saving you tax at the highest rate you would otherwise face.

On withdrawal in your later/retirement years, the appropriate measurement is arguably (I’ll come back to this) your average tax rate. Average tax rate is total tax divided by total income. In a progressive tax system where there is more than one bracket, average rate will always be lower than marginal rate.

That in mind, imagine for a moment that there were no contribution limits for either plan type. Even if you were at the same (indexed over time) income level in retirement, the RRSP route would do better than TFSA, because the average rate out must be less than the marginal rate in.

But what’s your own average rate?

In truth, not all your retirement income will come from RRSP savings alone, which brings me back to the arguable point about whether to use the average tax rate as stated above.

Once you begin your CPP and OAS, you have no further discretion whether or not they are paid from year to year. That then forms your foundation lower bracket income, on top of which your RRSP (in the form of a RRIF or annuity draw) is layered. In that case, the applicable average rate should be calculated on the income above this non-discretionary floor. Still, as long as there are at least two brackets, and you were the higher on contribution,  this modified average rate will be below your original marginal rate.

It gets more complicated if the OAS clawback comes into play, adding about 10% net to the marginal effective tax rate (METR). But even if you were entitled to maximum CPP and OAS of about $20K, you’d be progressing up through low to mid brackets until you hit the OAS clawback as you neared $80K. Nonetheless, according to my calculations, average rate would still be materially below marginal rate at full clawback around $130K.

Default choice, not dogmatic requirement

To repeat, the point here is that RRSP is the default choice, but that it could be displaced based on other factors.

Factors that bolster RRSP include: the fact that most people live on a lower income in retirement, meaning both lower marginal and average rates; spouses using pension income splitting to bring down their combined average tax rate; and, the availability of the pension credit.

Comparatively, the TFSA may be favoured when: an income earner is at low bracket at saving age; there are already significant RRSP assets; or, a large inheritance/winfall has arisen that affects the timing and/or amount of required drawdown from existing savings.

It’s the financial advisor’s job to identify these and other relevant factors, assess the effect of each, and discuss with their client how to maneuver with that knowledge. In reality, it’s more about proportionality than a binary RRSP vs. TFSA decision. Having an appreciation for the technical underpinning will make for better-informed choices and greater confidence to stay the course.