Taxpayers, naturally, are fixated on trying to minimize tax in the current year. This is a classic scenario of someone not being able to see the forest for the trees. The forest is your ultimate final tax liability. The trees are the current year taxes. The final tax bill in Canada consists of any income up to the time of death, accrued gains are deemed to be realized at the same time and estate administration tax (probate fees).
Annually, in early June we will look at our client’s tax returns and see the level of taxable income and tax payable they incurred in the current year. When the current tax payable is too low we may schedule an estate planning meeting.
The estate planning meeting typically starts off by a rough tax calculation of what your final tax liability would be today, based on your current assets, if you were to pass away. If you have not gone through this exercise, then it is worth doing. In some cases, the government stands to inherit a significant portion of your net worth if not structured appropriately. The conversation is setting the framework for a more detailed analysis done as part of the financial planning process.
Throughout our working lives we commonly reduce our annual tax bill by making Registered Retirement Savings Plan (RRSP) contributions. An important item for people to understand is the tax consequences when withdrawals are made and also the tax consequences upon death.
Withdrawals from registered accounts are generally considered taxable income in the year the payments are made. Over time your RRSP account may have generated different types of income including dividend income, interest income and capital gains. All of this income would have been deferred. All RRSP and Registered Retirement Income Fund (RRIF) withdrawals are considered ordinary income taxed at your full marginal tax rate regardless of the original type of income.
When a registered account owner dies, the total value of their registered account is included in the owner’s final tax return. The final tax return is often referred to as a terminal tax return. The proceeds will be taxed at the owner’s marginal tax rate. The highest marginal tax rate (British Columbia and federal) is currently 49.8 per cent. An individual that has $800,000 in an RRSP/RRIF account may have to pay $398,400 of that amount to Canada Revenue Agency in income taxes. If the RRSP names the estate as beneficiary, then an estate administration tax or probate fee of approximately $11,200 would apply. Accounting, legal, and executor costs can result in less than half being directed to your beneficiaries and more than half going to taxes and other fees.
These taxes must be paid out of the estate. CRA considers you to have cashed in all of your registered accounts in the year of death. Paying over 50 per cent of your retirement savings to CRA is not something investors strive for. There are a few situations where this tax liability can be deferred or possibly reduced.
Registered assets can be transferred from the deceased to their spouse or common law spouse on a tax-free rollover basis provided they are named as beneficiary. The rollover would be transferred into the spouse’s registered account provided they have one. If the spouse does not have a registered account, they are able to establish one. The registered assets are brought into income on the spouse’s return and offset by a tax receipt for the same amount. This rollover allows the funds to continue growing on a tax-deferred basis. The rollover does not affect the spouse’s RRSP contribution room.
If your spouse is specifically named the beneficiary of your RRIF account, then you should consider designating your spouse as a “successor annuitant.” As a successor annuitant, the surviving spouse will receive the remaining RRIF payment(s) if applicable and obtain immediate ownership of the registered account on death. These assets will bypass the deceased’s estate and reduce probate fees. You should discuss all estate settlement issues with your Wealth Advisor and financial institution to obtain a complete understanding.
Minor child or grandchild
Registered assets may be passed onto a financially dependent child or grandchild provided you have named them the beneficiary of your registered account. In order to be financially dependent, the child or grandchild’s income must not exceed the basic personal exemption amount. A child that is under 18 must ensure that the full amount is paid out by the time that child turns 18.
Financially dependent child
A child of any age that is financially dependent on you can receive the proceeds of your registered account as a refund of premiums. This essentially means that the tax will be paid at the child’s marginal tax rate, likely to be considerably lower than your marginal tax rate on the terminal tax return.
Rollover to Registered Disability Savings Plan
In 2010, positive changes occurred to help parents and grandparents who have a financially dependent disabled child or grandchild. Essentially this enables the RRSP accounts of parents and grandparents (referred to as the annuitant) to be rolled over to the RDSP beneficiary. The estate benefit is that up to $200,000 of the annuitant’s RRSP can be transferred to the beneficiary’s RDSP. Care should be taken to make sure the transfer qualifies under current tax rules and thresholds. The end goal is to minimize tax and hopefully your beneficiaries receive a larger inheritance. We recommend you speak with a Wealth Advisor if you are considering naming a disabled child or grandchild the beneficiary of your registered account.
Rollover to Registered Retirement Savings Plan
The RDSP is my favourite option for rollover, but what happens if the RRSP/RRIF is greater than $200,000 (the maximum rollover for the RDSP)? Another good option to explore if the child is dependent on you by reason of physical or mental infirmity is the tax free rollover of the registered account (i.e. RRIF) into the disabled child’s own registered account (i.e. RRSP). With disabled children there are no immediate tax consequences and there is no requirement to purchase an annuity. You may want to discuss the practical issues relating to having your registered account rolled into registered account in the name of a disabled child.
Other planning options for children with disabilities
A combination of the RDSP and RRSP rollover is normally sufficient if the annuitant has a small to medium sized RRSP/RRIF account. Other planning options are available if you have a sizable RRSP and are worried about disabilities payments from the government.
Care should be taken when you select the beneficiary or beneficiaries of your registered accounts. If you name a beneficiary that does not qualify for one of the preferential tax treatments listed above, then it could cause some problems for the other beneficiaries of your estate. An example may be naming your brother as the beneficiary of your RRSP and your children as beneficiaries of the balance of your estate. In this example, the brother would receive the full RRSP assets and the tax bill would have to be paid by the estate, reducing the amount your children would receive.
Every individual situation is different and we encourage individuals to obtain professional advice. Below we have listed a few general ideas and techniques that you may want to consider in your attempt to reduce a large tax bill:
- Pension credit — you should determine if you are able to utilize the pension tax credit of $2,000. If you are 65 or older, then certain withdrawals from registered accounts may qualify for this credit. Rolling a portion of your RRSP into RRIF would allow you to create qualifying income. For couples this credit may be claimed twice – effectively allowing some couples to withdraw up to $4,000 per year from their RRIF account(s) tax-free (provided they do not have other qualifying pension income).
- Single or widowed — single and widowed individuals will incur more risk with respect to the likelihood of paying a large tax bill. Single and widowed individuals should understand the tax consequences of them dying as no tax deferrals are available.
- Charitable giving — one of the most effective ways to reduce taxes in your year of death is through charitable giving. Those with charitable intentions should meet with their professional advisors to assess the overall tax bill after planned charitable donations are taken into account.
- Life insurance — one commonly used strategy is for individuals to purchase life insurance to cover this future tax liability. The tax liability created upon death coincides conveniently with the life insurance proceeds. This would enable individuals to name specific beneficiaries on their registered account without the other beneficiaries of the estate having to cover the tax liability.
- Estate as beneficiary — if you name your estate the beneficiary of your registered account then probate fees will apply. An up-to-date will provides guidance on the distribution of your estate.
- Life expectancy — Individuals who live a long healthy life will likely be able to diminish their registered accounts over time as planned. Ensuring your lifestyle is suitable to a longer life expectancy is the easiest way to defer and minimize tax.
A wealth adviser should be able to generate a financial plan to review with you and your accountant. The financial plan should outline the tax your estate would have to pay if you were to die today. This will begin a conversation that may allow you to create a strategy that reduces the impact of final taxes on your estate and throughout your lifetime.
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the Times Colonist. Call 250-389-2138. greenardgroup.com