Though tax-free savings accounts (TFSAs) have been around for a while, there’s still some confusion about what happens on the death of a TFSA holder. The tax consequences and opportunity for continued tax-free growth in the hands of the inheritor will depend on who receives your TFSA proceeds.
A recent tax case, decided late last year, shows what can happen when a TFSA holder dies and the funds are incorrectly handled by the beneficiary.
As a refresher, under the tax rules, when the holder of a TFSA dies the fair market value of the TFSA immediately before death is considered to be received by the holder tax-free. The holder had the choice of naming either a “successor holder” or beneficiary.
The successor holder can only be your surviving spouse or common-law partner. If you name a successor holder, the TFSA continues growing tax-free after you’re gone, and they become the new TFSA holder.
If you don’t name your spouse as the successor, you can name them as the beneficiary of your TFSA. If so, they have until Dec. 31 of the year following the year of your death to contribute any payments received out of your TFSA, up to the date of death value, into their own TFSA without affecting their unused TFSA contribution room. This is known as an “exempt contribution,” and the surviving spouse must report it to the Canada Revenue Agency on Form RC240, Designation of an Exempt Contribution TFSA, within 30 days after the contribution is made.
The disadvantage here is that all income earned inside the TFSA, as well as any increase in the fair market value of the TFSA’s assets from your date of death until the date the TFSA is paid out to your beneficiary, will be taxable as ordinary income to the beneficiary. This includes amounts that otherwise may be tax-preferred Canadian dividends or 50 per cent taxable capital gains. That’s why if you have a spouse, it’s generally best to name them as a successor holder instead of the beneficiary.
If you don’t plan to leave your TFSA to your spouse, and either name someone other than your spouse as your TFSA beneficiary or you simply don’t name anyone and the TFSA proceeds are paid to the estate, any income earned in the TFSA after the date the holder died will simply be taxable to the beneficiary (or the estate) as ordinary income.
A failure to understand these rules can lead to TFSA trouble, as one taxpayer found it in a case decided in December 2024. The taxpayer went to federal court seeking a judicial review of the CRA’s decision not to cancel the penalty tax imposed upon him related to excess contributions he made to his TFSA after the death of his mother.
Under the Income Tax Act, an individual who overcontributes to their TFSA is required to pay a tax on the excess amount equal to one per cent per month of the excess contributions. The Tax Act, however, gives the CRA the discretion to waive or cancel this penalty tax if the taxpayer can establish that the tax liability arose as a consequence of a “reasonable error,” and the excess TFSA funds are removed from the TFSA “without delay.”
The taxpayer’s troubles began back in 2019. On January 1, 2019, the taxpayer contributed $6,000 to his TFSA account, his limit for the year. The taxpayer’s mother died on June 7, 2019, and he was the designated beneficiary of her TFSA. As a result, the taxpayer received her TFSA proceeds, tax-free, in the amount of $59,779. He chose to transfer this amount to his TFSA account on June 18, 2019, despite not having any available TFSA contribution room.
This resulted in an immediate overcontribution, which was caught by the CRA the following summer when the taxpayer was assessed overcontribution tax, and was advised to withdraw the amount immediately.
In late July 2020, the taxpayer requested that the CRA designate the TFSA proceeds he had received from his mother’s TFSA as an exempt contribution on the basis that he was a survivor of his mother such that there would be no penalty tax for 2019. He removed the overcontribution from his TFSA on September 23, 2020.
The following month, in October 2020, the taxpayer requested that the CRA cancel the tax assessed on the overcontribution for the 2019 taxation year. The Applicant based his request on three factors: he was suffering from mental distress, he relied on incorrect information, and he had removed the overcontribution “without delay.”
In November 2020, the CRA notified the taxpayer that his request to treat the contribution as an exempt contribution could not be processed because the taxpayer was not the spouse or common-law partner of the deceased, and therefore did not qualify as a “survivor.” The CRA advised the taxpayer that a TFSA beneficiary can contribute any of the amounts received upon the death of a TFSA holder to their own TFSA, but they must have contribution room available to do so, which was not the case here.
In February 2021, the CRA issued a first level review decision refusing the taxpayer’s request to cancel the overcontribution tax for the 2019 taxation, as this was not the first time the taxpayer had overcontributed. According to the CRA’s records, excess contributions were made to the taxpayer’s TFSA back in 2015, and the taxpayer had been sent an “education letter” in May 2016, which warned him of his overcontribution and potential penalty tax.
In March 2021, the taxpayer asked the CRA to reconsider its decision not to waive the tax, explaining that he had been suffering from mental distress. The CRA requested some type of medical evidence, but the taxpayer was unable to provide any, saying that “it was impossible to get doctor’s appointments during the COVID-19 pandemic and (that)… he was too overwhelmed to deal with the CRA’s request at the time.”
The CRA denied his second-level request, so the taxpayer sought a judicial review of the CRA’s decision. As in prior such cases, the taxpayer bears the burden of showing that the CRA’s decision was unreasonable in that it “lacks the hallmarks of justification, intelligibility and transparency.”
While the judge was sympathetic, noting that “while the circumstances under which the (taxpayer) made the overcontribution were unquestionably stressful,” she concluded that the CRA’s decision not to waive the tax was reasonable.