Canada: Decoding Afterlife Finances: Understanding The Tax Implications For RRSPs, TFSAs And FHSAs Upon The Holder's Death

In this article, we consider the tax and other implications of registered plans upon death, including the Registered Retirement Savings Plan ("RRSP"), the Tax-Free Savings Account ("TFSA") and the new First Home Savings Account ("FHSA").

1. RRSPS

In Canada, on a person's death, the person is deemed to have disposed of certain assets for fair market value immediately prior to death. This generally includes RRSPs. As a result, the RRSP annuitant is deemed to "redeem" the RRSP at fair market value immediately prior to death. Since RRSPs are contributed to with pre-tax dollars, the full amount of the RRSP is included as income on the annuitant's final income tax return. Large RRSPs can have large tax liabilities. The personal representative of the deceased annuitant would be responsible for ensuring that income tax is paid on this income inclusion.

Notably, there may be an income reduction available to the annuitant's estate to the extent that the RRSP proceeds are paid as a refund of premiums or deemed to be paid as a refund of premiums. Only the reduced amount would be included in the annuitant's final tax return as income. The proceeds of RRSPs that qualify as a "refund of premiums" are those that are paid to a qualified beneficiary. A "qualified beneficiary" is either (i) the annuitant's spouse or common-law partner (within the meaning of the Income Tax Act (Canada)) (the "Spouse"); or (ii) a child or grandchild of the annuitant who was financially dependent¹ on the annuitant for support.

The qualified beneficiary in turn has an income inclusion for the amount of the refund of premiums received (i.e. to the extent that the deceased received an income reduction, the recipient receives an income inclusion). If the recipient of the refund of premiums is the Spouse, the Spouse may claim a deduction if the proceeds go into a tax deferred vehicle (usually by way of a contribution to their own RRSP). Notably, a child or grandchild who was dependent on the annuitant but not for reasons of mental or physical infirmity may only receive the deduction if the funds are used to purchase an annuity, the final payment for which is made before the recipient's 19^th birthday. Therefore, there is no available deduction for an adult dependent child who is not dependent by reason of physical or mental infirmity. To the extent that the qualified beneficiary claims the deduction, the tax deferment mechanism commonly known as a tax "rollover" has been achieved.

In the circumstances described above, where the proceeds qualify as a refund of premiums, it is generally the personal representative of the deceased annuitant who makes the choice as to whether the estate claims the reduction for the refund of premiums. However there is a circumstance where the recipient effectively controls whether the estate or the recipient pays the income tax associated with the refund of premiums. This is the case in circumstances where what would have been a "refund of premiums" if paid to a beneficiary of the estate is paid to the estate (which would occur if the estate is the designated beneficiary or if there is no designated beneficiary). In such cases, the personal representative and the qualified beneficiary may jointly elect to have the eligible amount deemed to be received as a refund of premiums, allowing the rollover provisions described above to function in these circumstances. Since the election must be made jointly by the qualified beneficiary and the personal representative, the recipient effectively controls whether the reduction can be claimed by the estate.

Fewer steps are required to achieve the rollover where (i) the Spouse is the sole beneficiary of the RRSP; (ii) the proceeds are directly transferred to an RRSP under which the Spouse is the sole annuitant (or other qualifying vehicle); and (iii) the transfer occurs by December 31^st of the year following the year of the death (known as the "exempt period"). If these circumstances are met and the financial institution issues the T4RSP directly to the Spouse, the income inclusion can be that of the Spouse's at first instance, who may also claim the deduction, and the personal representative would not need to include the RRSP proceeds in the income of the estate at all.

Finally, there is another rollover opportunity from an RRSP to an RDSP for the annuitant's financially dependent, infirm child or grandchild. The deceased annuitant will have the usual income inclusion and reduction according to the "refund of premium" rules above. The child or grandchild will have a corresponding deduction. The maximum rollover amount to an RDSP is $200,000, which number is reduced by all contributions and rollover amounts made to the RDSP.

As mentioned above, the personal representative of the deceased would be responsible for ensuring that income tax is paid on this income inclusion of RRSP proceeds. Where the proceeds do not qualify as a refund of premiums or where the recipient of the refund of premiums can control whether the estate can achieve the reduction, it is important to consider whether the estate is otherwise large enough to pay the associated tax liability and whether it is equitable for the estate to potentially have to pay the tax liability. With respect to the latter consideration, this is particularly relevant where the beneficiaries of the estate are different from the recipient of the RRSP proceeds. The question should be asked: is it equitable for the estate beneficiaries to essentially pay for the income tax liability arising on an asset that passes outside of the estate? The answer to this question depends on the circumstances, preferences and objectives of the annuitant.

2. TFSAS

TFSAs carry fewer tax considerations than RRSPs because contributions to TFSAs are with after-tax dollars and the income earned in TFSAs, assuming no over-contributions were made, are not subject to income taxes, even on the death of the holder.

Generally, upon the death of a TFSA holder, the TFSA ceases to exist. If the holder of the TFSA has a Spouse, there are two options for the holder to consider: (i) naming the Spouse as the TFSA successor holder; or (ii) designating the Spouse as the beneficiary of the TFSA. The implications are as follows:

• If the Spouse is named as the successor holder, the TFSA does not cease to exist. Instead, the Spouse becomes the new holder of the TFSA. The Spouse is able to withdraw amounts from this account tax-free without impacting the Spouse's own TFSA contribution room. Essentially, naming the spouse as the "successor holder" allows the spouse to have roughly double the TFSA room.
• If the Spouse is a designated beneficiary of the TFSA, the general rule applies. The Spouse receives the fair market value at the time of death of the TFSA tax-free. Any investment income that accrued after the holder's death is taxable, and any distribution of that amount to the beneficiary must be added to the beneficiary's income in the year it is received.

3. FHSAS

An FHSA holder may designate the Spouse as a successor holder of the FHSA. So long as the Spouse is eligible (at least 18 years old, a Canadian resident, and a first-time home buyer), the Spouse then becomes the new holder of the FHSA, and the FHSA maintains its status as a tax-exempt account. If the Spouse is not eligible, if the Spouse is designated as a beneficiary instead of being named as the successor holder, or if a person who is not a Spouse is designated as a beneficiary, the recipient must instead (i) transfer their portion of the funds to an FHSA, RRSP or RRIF on a tax-deferred basis; or (ii) receive the funds as a taxable distribution. Both of these options are also available to eligible successor holders and must be completed by the end of the exempt period.

If there is no named beneficiary or successor holder, the FHSA will be distributed to the deceased holder's estate and will be included as taxable income.

4. CLOSING THOUGHTS

Where registered plans form a portion of a person's net worth, their tax treatment at death should be considered in every estate plan. There may be wealth preservation opportunities, depending on the circumstances. Additionally, there may be opportunities to create a more equitable distribution of the deceased person's estate.

While this article primarily contemplates the devolution of registered plan proceeds in a tax-efficient manner by way of designating an individual as a beneficiary, the reader should always consider whether it is more appropriate for the estate to receive the plan proceeds. Absent a valid beneficiary designation (designating someone other than the person's estate as the beneficiary), the plan proceeds devolve to the estate of the deceased holder to be used by the deceased's personal representatives to pay debts and be distributed either in accordance with the person's will or in accordance with intestacy legislation if there is no valid will. In certain circumstances (and if probate fees are not a material concern), this is the preferable result.

Footnote

1. CRA's interpretation of "financially dependent" for these purposes may be found in CRA Document, RC4177 Death of an Annuitant

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.