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Don't Make THIS Mistake With Your TFSA: The importance of understanding the TFSA Successor Holder.




Hello everyone and welcome to the Retiring Canada Podcast. In today’s episode, we're going to discuss a common mistake Canadians make when setting up their Tax-Free Savings Accounts (TFSAs).


Specifically, we are going to cover:


- What is a TFSA and why should you care?

- Why it’s a great income planning tool for retirees.

- Understanding beneficiary designations.

- What newcomers to Canada need to consider when opening a TFSA.

- Penalties to avoid and how to fix mistakes that can happen.

- And lastly, some action items for you to take today to make sure everything is in order.


For all the links and resources mentioned in today's episode, please check out the link in the show notes.


Let's get into it.


Alright, before I chat about this common mistake I see time and time again when clients bring their assets to our firm, let me first give you a 30-second crash course on what the Tax-Free Savings Account (TFSA) is and how it can be a huge benefit to retirees.


First off, to be very straightforward, the name is misleading. Please don’t think of this solely as a savings account as the name implies. The truth is that this account can hold nearly any qualified investment, including stocks, bonds, mutual funds, exchange-traded funds, and more. If you look at your TFSA and all you see is cash or high-interest savings, it’s time to talk with a professional.


Second, the TFSA allows your investment growth to be TAX-FREE, a term I don’t get to say too often in the world of personal finance. This tax-free growth can be of substantial benefit, especially to retirees creating a steady stream of income. It can be a great tool to supplement lump sum purchases in retirement without driving up your marginal tax rate.


Lastly, be sure that you are contributing and maximizing this account early and often. If you have surplus cash in your bank account or a non-registered account generating taxable investment income, don’t delay this TFSA top-up. The goal on our team here is to have all of our clients’ TFSAs topped up in January every calendar year. So, if you haven't done so already, review your contribution room and get the TFSA accounts topped up ASAP.


As a quick reminder for all of you before I get into the purpose of today's podcast: if you’ve never contributed and have been a Canadian resident age 18 or older since 2009, the cumulative TFSA contribution limit for 2023 is now $88,000. That is up $6,500 from 2022. This is the first increase to the annual dollar amount since January 2019.


Ok, now many of you are familiar with the TFSA and the amazing ability that it has to help you create a tax-free pool of retirement assets that can be used to create a sustainable retirement income. Besides being such an amazing tool to grow tax-free wealth, it also has a benefit that is often overlooked by Canadians: the successor holder beneficiary designation.


You are probably familiar with the beneficiary designations on your defined contribution pension plans, your RRSPs, or even your RRIF accounts. If you have a spouse or common-law partner, it's likely that you have named them as the direct named beneficiary on these retirement accounts. With the TFSA, you can also name direct beneficiaries; however, there is a special designation unique to the TFSA that could reduce the impact of taxation on your spouse and your final estate.


This unique designation is called a successor holder, and it is very different from a “regular” beneficiary. Let’s go through an example.


Let's say my wife and I each have a $50,000 TFSA, so between both of us, we have $100,000 in TFSAs. Now, I will pick on myself here because I love my wife. Let's say something tragic happens to me and I pass away prematurely. There are two scenarios that would then take place.


**Scenario 1**: I named my wife as a regular beneficiary. She would receive the FULL $50,000 tax-free. However, there may be a few added tax consequences she could now be exposed to.


1. Any investment growth in my TFSA between my passing and the date my wife gets the funds would be taxable as income back to my wife. So, say my $50,000 grew by $1,000 after my passing; my wife would be sent a T4A slip to have this investment growth added to her income for that calendar year.

2. If my wife decides to reinvest these funds in a non-registered account (a taxable account), the underlying investment would generate investment income in the form of interest, dividends, or capital gains. This additional income could bump her up into a higher marginal tax rate. For retirees, this could potentially trigger a clawback of Old Age Security or loss of the Guaranteed Income Supplement in some cases.


3. There is now a potential tax liability I have passed on to my wife. The new non-registered account my wife opened is now a pending tax liability to her final estate. You cannot name a direct beneficiary on a non-registered account, meaning the account would be subject to probate and potential tax implications on her final tax return.


Granted, it would make the most sense for my wife to top up her own TFSA account before utilizing a taxable non-registered account. However, if she does not have the available contribution room in her TFSA, amounts invested in the taxable account will generate a future tax liability.


**Scenario 2**: I named my wife the successor holder on my TFSA account.


1. My wife would still receive the $50,000 tax-free. However, she now also receives my TFSA contribution room, meaning she now has her TFSA worth $50,000 and my TFSA worth $50,000.


2. All investment growth after my passing and into the future is never taxed, as now the full amount remains inside the TFSA, growing tax-free.


3. She doesn't need to concern herself with additional taxation to our final estate mentioned in the previous scenario, as the TFSA accounts bypass probate when a beneficiary is named.


In this scenario, it would not be advisable for my wife to name our minor child as the beneficiary after her hypothetical passing, as there are numerous pitfalls in doing so.


What I mean by this is my wife could name a direct beneficiary to her TFSA after my passing, ensuring the funds would be sent directly to them at my wife's passing and not be subject to probate. Again, there is a huge asterisk on this comment if considering naming a minor here.


I am starting to venture into building a proper estate plan, so by no means should you simply name direct beneficiaries to any accounts until a proper estate planning review is completed by a professional advisor.


I recently completed a Chartered Life Underwriter (CLU) designation that gives me the knowledge to help construct an efficient estate plan that ensures your wishes are being met and taxation is being minimized. So, if this is something you need, please reach out to a professional like myself to set the wheels in motion on creating an estate plan.


Ok, if you are unsure whether or not your spouse or common-law partner is a successor holder, be sure to review your last statement. Do you see the designation on there?


If you didn’t name your spouse or common-law partner as the successor holder and just had them as a regular beneficiary, there is still an opportunity for the surviving spouse to benefit from the TFSA's tax benefits. The surviving spouse can complete a number of steps with CRA to ensure they receive similar privileges as the successor holder beneficiary. This process includes filing documents with CRA and being subject to time constraints. If completed correctly and within a certain time limit, the spousal beneficiary can receive the TFSA at fair market value and roll over the amount into the TFSA without using their own TFSA room.


With all of the added steps and the potential to lose the tax-preferred treatment of the TFSA, you can see why in most cases the successor holder designation is the preferred choice for spouses and common-law partners.


A few other key aspects to this process you should be aware of, especially if you and/or your spouse are new to Canada:


You will need to be careful when naming a Canadian resident without a Social Insurance Number (SIN) or a survivor who is a non-resident. Your survivor will want to be sure they apply for a valid Canadian SIN. If they are a non-resident, they should ask for an individual tax number from CRA by filing a specific form called T1261. Having an individual tax number for non-residents is needed to benefit from the successor holder designation.


Another pro tip you should know is that you can have more than one TFSA account. So my wife could have two TFSAs: mine and hers. There is no rush to change anything after my passing. However, she could merge the two together using a direct transfer form, sometimes called a qualifying transfer, as she is adding my TFSA room to hers.


Generally speaking, I suggest utilizing one TFSA account over the long term. Tracking contributions and withdrawals from multiple TFSAs can be tricky, and if you make a mistake and overcontribute, CRA will penalize you 1% per month on the overcontribution. This is where keeping things simple and having one TFSA will mitigate the chances of an overcontribution.


Alright, there is a lot to unpack in today's episode. Before we finish off, let's cover a few action items you can take today to better your situation.


1. If you don’t already have a TFSA, you should strongly consider opening one. The long-term benefits of tax-free investment growth on your retirement plan are substantial.


2. If you have a TFSA set up already, review the beneficiary designation on your most recent statement. If you have a spouse or common-law spouse, you may want to consider naming them as a successor holder rather than a regular beneficiary.


3. Review how the money inside your TFSA is invested. Is it just sitting in cash or savings? Does this align with the risk tolerance and time horizon for this account, or should it be invested differently?


For the links and resources discussed in today's podcast, please check out the link in the show notes or visit retiringcanada.ca.


If you enjoyed the show, please subscribe and leave us a review on your favorite podcast app. If you have a question you would like me to answer on a future episode, please click the link in the show notes to submit your question, and I will do my best to answer it in a future episode.


And hey, when it comes to your retirement, don’t take chances.


Make a plan so you can retire with confidence.


All comments are of a general nature and should not be relied upon as individual advice. The views and opinions expressed in this commentary may not necessarily reflect those of Harbourfront Wealth Management. While every attempt is made to ensure accuracy, facts and figures are not guaranteed, the content is not intended to be a substitute for professional investing or tax advice. Please seek advice from your accountant regarding anything raised in the content of the podcast regarding your Individual tax situation. Always seek the advice of your financial advisor or other qualified financial service provider with any questions you may have regarding your investment planning.  

 

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