The article “How To Ensure Your Inheritance Goes To Your Children And Not The Taxman” was originally published on Financial Post on March 2, 2020.
With a little planning, retirees can reduce their lifetime tax payable and minimize the potential tax payable by their estate.
Benjamin Franklin once said that “in this world nothing can be said to be certain, except death and taxes.” For many retirees, there is an inflection point when both those certainties intersect, and concerns about having saved enough for retirement turn to protecting an estate from tax and other costs.
Some of the main drains on an estate are income tax, probate and estate settlement. This article will focus on the first of those, income tax, and the most common estate assets that come into play: registered retirement accounts, Tax Free Savings Accounts and non-registered assets.
The good news is that for married and common-law couples, income tax can be largely deferred on the death of the first spouse. And with proper planning in advance of death or even afterwards, taxation can be mitigated and potentially even eliminated.
Registered accounts such as RRSPs, RRIFs, defined contribution pensions, LIRAs, and LRIFs can be transferred tax-deferred from one spouse to another on death simply by naming them as successor annuitant or beneficiary.
Only a spouse can be named as a successor annuitant. A successor annuitant takes over an existing registered account upon the death of their spouse and the account is not collapsed. Only RRIFs, LRIFs and similar income fund accounts that have been converted prior to or upon turning 71 can have successor annuitants (not RRSPs).
If a spouse is named as a beneficiary, a registered account still passes over to them tax-deferred, but the account is collapsed and transferred into the RRSP or RRIF of the surviving spouse.
Even if a registered account does not have a spouse named as beneficiary, and the beneficiary is instead the estate of the deceased, the executor of the estate — often the spouse — may be able to transfer some or all of the account to the survivor’s RRSP or RRIF to maintain tax deferral. This is easy to facilitate when the surviving spouse is the sole beneficiary of the estate, as is often the case.
If a child or other non-spouse beneficiary is named to receive the registered account proceeds, the amount is fully taxable to the deceased on their final tax return. An exception may apply for a child or grandchild who is financially dependent. The fair market value of the account on the date of death is included as income on that last tax filing. RRSP/RRIF beneficiaries may be personally liable for the tax owing if there is not enough cash remaining in the estate of the deceased to pay the tax.
While engaging in retirement income planning, it is important to consider what happens on death to a RRSP or RRIF. Even if tax is initially averted by passing an account tax-deferred to a surviving spouse, that survivor’s future annual retirement income and tax payable will increase as they take withdrawals from a larger account in retirement. Furthermore, upon their own death, their RRIF account will be fully taxable to them. This reinforces the benefit of considering early RRSP and higher than minimum RRIF withdrawals to pay less lifetime tax, even if it means paying a little more tax today. This strategy can not only increase potential spending in retirement but may also increase a potential estate for a retiree’s beneficiaries.
My mother passed away last year after a two-year terminal illness. We drew down her RRIF account in tranches that far exceeded the RRIF minimums, primarily in anticipation of funding long-term care costs as opposed to maximizing her estate. My advice comes sometimes from personal experience as much as from professional expertise.
A TFSA holds true to its name and is tax-free during life and upon death. A spouse can be named as a successor holder or a beneficiary of a TFSA account. Naming a spouse as a successor holder ensures that income earned in the TFSA from the date of death onwards remains tax-free, as the spouse takes over the account. Naming a spouse as just a beneficiary may result in taxation of income earned after death, but a TFSA may still be eligible to transfer to the survivor’s TFSA if the transfer is completed by Dec. 31 of the year following the year of death.
Children and other non-spouse beneficiaries can only be named as beneficiaries, and TFSA income earned after the deceased has passed away is taxable.
An important planning strategy for a TFSA is to maximize it — or minimize withdrawals from it — to the extent possible. This includes using non-registered funds when available to contribute annually and reinforces the benefit of early RRIF withdrawals to avoid drawing down a TFSA in retirement.
TFSA contributions should be made in January to maximize growth over the year. Asset allocation within an investment portfolio should ideally be tilted towards growth in a TFSA, and potentially as much as 100 per cent in stocks, assuming withdrawals can come primarily or exclusively from non-registered and RRIF accounts instead. This strategy can help maximize TFSA assets for both spouses, including the survivor’s future tax-free assets after the first death.
Non-registered investments, vacation properties, rental real estate, private company shares, and other taxable capital assets can generally be left to a surviving spouse upon death with no capital gains tax immediately payable. Instead, an asset is transferred at its adjusted cost base (or undepreciated capital cost for real estate) from the deceased spouse to the survivor.
A recipient spouse can elect to have an asset pass over at a value other than the cost if it makes sense, such as if the deceased has a low income in the year they die, or if they have unused capital losses they are carrying forward from previous years. This requires the filing of an election with the Canada Revenue Agency in the year of death, so the default is that a capital asset is made over to a surviving spouse at cost with no tax payable.
The same does not apply for children or other non-spouse beneficiaries, even if an asset is held jointly. To be clear, joint ownership does not exempt the deceased from capital gains tax. The deceased is deemed to dispose of their share, including part ownership in the case of a joint asset, at the fair market value at death with tax payable accordingly on the final tax return of the deceased.
Retirees with significant non-registered assets can consider proactive strategies like gifting to family or charities during their lives instead of upon their death. Non-registered assets can also be a good source to fund TFSA contributions for children or grandchildren over the age of 18, but these would be considered outright gifts to the recipients. Registered Education Savings Plan (RESP) contributions for grandchildren can be another way to reduce taxable non-registered assets and tax payable and begin to transition family wealth to the next generation.
Discretionary family trusts can be a tool to have non-registered investment income and capital gains taxed to other lower income family members such as children or grandchildren to reduce annual taxation, as well as tax on death.
Private corporations can have complicated tax implications, but strategies such as ensuring a corporation qualifies for the lifetime capital gains exemption, implementing an estate freeze, purchasing corporately held life insurance, or post-mortem pipeline transactions — amongst others — can help mitigate income tax payable on death in certain situations.
Talking about dying can be uncomfortable, but as I prepare to file my late mother’s final tax return, it is a stark reminder that death is a part of life. So, too, is income tax, and with a little planning, retirees can reduce their lifetime tax payable and minimize the potential tax payable by their estate.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.