The Deathbed TFSA: Death, Taxes - and Lost Optionality.

By: Jason Periera Editor & Contributor: Alexandra Macqueen

Consider the following scenario: Two spouses, one healthy; the other terminally ill and not expected to be around much longer.

In preparing for the imminent demise of the terminally-ill spouse, the couple should ensure they have an up-to-date estate plan. This means updating their wills, as required; taking steps to minimize the administrative burden of dealing with the estate when the time comes (by confirming executor arrangements, for example), and, finally, undertaking any tax planning to reduce the potential future tax bill.

In completing that last step, however, one tax planning opportunity is often overlooked. Worse still, if this opportunity isn’t seized before death, it is lost forever.

What is this tax-planning opportunity? Using the deceased spouse’s unused TFSA room.

Death, TFSAs, and the path not taken

At the death of one spouse, the surviving spouse can transfer the assets within the deceased spouse's TFSA to their own TFSA – by being named either the successor account holder or the beneficiary – without requiring new TFSA contribution room.

If a spouse dies with unused TFSA room, however, that room dies with them and, unlike with an RRSP, an estate cannot contribute to a TFSA. Instead, the unused room is simply gone forever.

So, if the opportunity to contribute to a “deathbed TFSA” is lost, what’s the opportunity cost? As of 2020, if no previous contributions have been made to the terminally-ill spouse’s TFSA, up to $69,500 can be contributed today (assuming the individual was born in 2001 or earlier).

But the size of the opportunity isn’t limited to $69,500. Instead, the real potential is in the tax-free compounding over time which, depending on the age of the surviving spouse, could last decades, providing tax- and probate-free distributions to their own eventual estate.

The size of the opportunity lost – or gained

Let’s work through an example.

If one spouse hasn’t used their TFSA and then the account is maxed out with $69,500 just before their death, and then the surviving spouse lives another 20 years during which they earn a 5% annual rate of return, at their (the second spouse’s) death the original $69,500 would have grown to $184,404.

Their estate would also save up to $3,125.65 in probate (estate administration) fees, depending on their province of residence.

Five funding options

As our example shows, a couple in this (unfortunate) position should, if possible, fund the terminally-ill spouse’s TFSA to the maximum. But if you don’t have surplus funds readily available (such as in a savings account), how can you accomplish this?

We’ve identified five different potential funding sources. Let’s consider each one in turn:

1 - Spouse’s TFSA

Many spouses choose to fund their individual TFSAs “evenly” as cash becomes available. As a result, they may each have TFSAs that are not fully maximized.

In this case, the answer is simple and painless: the healthy spouse can withdraw funds from their TFSA and gift it to the ill spouse who then, in turn, contributes the funds to their TFSA.

This transaction does not attract attribution, and the healthy spouse loses nothing, as the withdrawn amount then gets added to their room at the start of the next year.

No tax, no attribution rules, preservation of the survivor’s contribution room, and (potential) maximization and preservation of the ill spouse’s room: a quick and painless win.

2 -Taxable Assets With Unrealized Gains

While assets with unrealized gains can be rolled over to the surviving spouse at their cost base, thereby deferring taxation, opting to pay tax prior to death could be a good idea if the funds are used to maximize the “deathbed TFSA.”

While the investor’s tax rate, the asset’s cost base, and the expected rate of return over the expected holding period all have an impact on this decision, the biggest factor at play here is the life expectancy of the surviving spouse.

Let’s consider a worst-case scenario in which the cost base of an asset is $1, the taxpayer is already in the highest tax bracket, and the TFSA has yet to be opened.

In this case, to fund $69,500 in the most highly taxed province would require the taxpayer to liquidate a total of $95,205 (after taxes are taken into account).

The question then becomes: is it worth taking the $25,705 tax hit now to maximize the benefits of the TFSA over time?

To answer that question, we need to consider the expected rate of return and the expected timeframe, which might be as long as the survivor’s life expectancy.

Using the 5% rate of return from our previous example, it would take just 6.45 years to break even on this strategy. The timeline is longer if we consider the opportunity cost of investing the lost tax, and longer still if the surviving spouse would be subject to a lower tax rate should they inherit and sell the assets.

So does realizing tax now to maximize the TFSA before death make sense? As always, it depends. What’s clear is a break-even analysis should be at least considered.

3 - RRSP/RRIF Withdrawal

There are very few times it makes sense to pull money out of an RRSP solely to fund a TFSA – but this could be one of them.

Given that RRSP withdrawals are fully taxable (compared to the capital gains in our previous example), excess RRSP withdrawals usually means more tax payable, potentially taking this option off the table.

However, if the surviving-spouse taxpayer has no other income, and contributing to the “deathbed TFSA” is the sole reason for making the withdrawal, the amount that would need to be withdrawn is a worst-case scenario of $95,500.

In that case, we’re left with a breakeven period of approximately 6.45 years, just like in our last example. But at the highest tax rate in the country (sorry, Nova Scotians), however, the required pre-tax withdrawal amount climbs to $151,087, and the breakeven at 5% climbs to 15.92 years.

Tack on the opportunity cost of paying the tax now versus later, and yet again the timeline stretches onward.

So in this case, whether you should use RRSP or RRIF withdrawals to fund a “deathbed TFSA” depends – but in most cases, RRSPs/RRIFs will be a far less favourable funding option than other alternatives.

4 - Insurance Terminal Illness Benefit

Most Canadian life insurance carriers offer what is known as a “Terminal Illness Benefit.”

If you’re close to death (typically understood as your death is expected within two years), you don’t have to wait until you die to get some of the death benefit provided by your policy. Instead, the insurer will give you an advance against the death benefit while you are still alive.

In some cases, this advance is structured as a loan. Given the short time this loan would be in place, however, the current low-interest-rate environment, and the fact that the proceeds would be invested in the TFSA, the interest cost of implementing this strategy is relatively inconsequential. As a result, if you can access a Terminal Illness Benefit, this can be a good way to fund a “deathbed TFSA.”

5 - Temporary Borrowing

The final funding option to consider is borrowing the funds to make the contribution. Now, I’m not advocating that someone go into prolonged debt to finance this opportunity. Instead, I’m recommending a short-term loan.

For example, the terminally ill spouse could borrow funds from their joint home equity line of credit to maximize their TFSA. Then, once they’ve passed on, the survivor can transfer the deceased’s TFSA into their own TFSA, withdraw the funds, and pay off the debt.

This maneuver allows the surviving spouse to maintain the deceased spouse’s TFSA room, but now in their own name. Then, they can re-fund (or “re-fill”) the TFSA using that contribution room if and when they have available funds in the future.

Bottom Line: Don’t let this opportunity slip away

The bottom line is this: under the current tax code, Canadians who don’t fully fund their TFSAs before death are permanently depriving a surviving spouse of a lucrative tax shelter.

If you’re in this unfortunate situation and you don’t have a fully funded TFSA, making a (near) deathbed contribution can be a wise financial move. It leaves a maximized TFSA as part of your financial legacy, and preserves optionality for the surviving spouse going forward –

but the source of funds has a substantial impact on the soundness of this strategy.