Live rich, die poor
One way to avoid taxes on death would be to rid yourself of all assets (including your RRSP or RRIF) before you die. This strategy, however, is full of potential pitfalls. One pitfall is, even if you give something away, you are deemed to have disposed it at fair market value and tax will be payable on any capital gains. Your estate plan should permit you to live comfortably for the rest of your life and provide access to the assets you enjoy – again, the example of the family cottage. You don’t want to get involved with the children’s squabbles over your property and you don’t want to face a significant tax liability now. What to do?
Estate planning tools
Early inheritances to children/grandchildren
If an objective of your estate is to pass property to children, why not do it now? The kids may prefer the money now rather than later–especially if they have a mortgage. Where cash is given to an adult child there are no income tax implications to you–regardless of how the money is used. If you liquidate a portfolio of securities you may incur capital gains, which are taxed in the year of liquidation. However, this tax may be less than it would be on your death, plus you have the cash to pay the tax. Moreover, your current tax rate may be substantially lower than your tax rate in the year of death, which is typically the highest marginal rate.
Consider opening an investment account in trust for your grandchild. Any interest or dividends continue to be taxed in your hands but any capital gains are taxed in the grandchild’s hands. This is a great way to provide for a grandchild’s education plus reduce your current tax load.
A family trust is typically used where a parent or grandparent desires to avoid family squabbles or is not at ease with providing access to money now for fear it will be be used inappropriately.
A cottage, for instance, can be transferred to a family trust. The parents become trustees of the trust and, therefore, control the use of the property on behalf of the beneficiaries (the kids). The trust permits the parents to continue the use of the cottage until their deaths. The net result is that the parents no longer own the cottage and consequently on their death, it does not form part of their estate. The cost? The transfer of the cottage to a trust could trigger a tax liability.
This liability may not be significant compared to the future tax liability and a potentially higher tax rate at death.
This concept is not for everyone as there is investment risk involved. But for an individual with many assets including a large RRSP/RRIF and who is concerned about a significant tax liability on death, this may be an excellent way taking money from a registered plan and offset100% of the tax.
Let’s say you have a $1,000,000 RRSP/RRIF and a ten-year time horizon. Also, for simplicity assume a constant interest rate of 10%:
- Borrow $1,000,000 and invest it. As the purpose of the loan is investment, interest paid on the loan is tax deductible.
- Withdraw $100,000 from your RRSP each year. Some tax will be withheld on the withdrawal; however, this will be refunded when your return is processed.
- Use the $100,000 from the RRSP withdrawal to pay the interest cost on the loan.
The result: the yearly RRSP/RRIF withdrawals are net tax-free as they are offset by the interest expense deduction. It may appear that at the end of the ten years the RRSP/RRIF has been removed completely tax-free. However, this assumes no growth in the RRSP/RRIF during the meltdown period – quite unrealistic. To counter this, the RRSP withdrawals are increased, which means your loan interest must be higher to offset the increased RRSP/RRIF withdrawal.
In addition, investing outside an RRSP removes a number of constraints. Full international investing is available. As well, you can take advantage of capital gains being taxed on only 50% of the gain and as well, when applicable, the dividend tax credit.
In the end, you have a $1,000,000 or greater loan outstanding that can be paid off by liquidating the portfolio built up on the borrowed funds. What you have left is the after-tax growth of the portfolio from the original $1,000,000 (or greater) invested.
Another risk to consider is that the investment portfolio must really “work” for you. The return must be great enough to ensure the after-tax return on the portfolio is greater than the tax that would have been paid on the RRSP/RRIF on death. Investing in Segregated funds which have certain guarantees attached to them might be a good way to invest in this strategy.
Tax-free RRSP/RRIF withdrawals are available to individuals who have significant tax write-offs in excess of their income. For example, an investor in a real estate project may already be incurring significant interest expense in excess of pension and investment income. Here an RRSP / RRIF withdrawal can be made to offset this deduction. In effect, the tax deduction is not being “wasted”.
As your estate grows so does the tax liability. A good estate plan might provide a way to stop this growth from accruing in your hands. This is accomplished by exchanging a “growth asset” for a “non-growth” asset. This will “freeze” the growth of the asset in your hands and also freeze the tax liability. The growth after the freeze accrues to someone else–your heir(s). As the growth is frozen so too is the tax liability. This liability can then be calculated and steps can be taken to plan for it. Often life insurance will be purchased. On death the insurance proceeds are used to pay the tax liability and the estate remains intact.
An estate freeze is a common technique used by family businesses. It is often coupled with passing the business to a second generation. The common shares (the growth asset) owned by the parents, are exchanged on a tax-free basis for preferred shares. The sons and daughters of the second generation then purchase new common shares. The parents’ tax liability is frozen and steps are undertaken to provide the funds to pay this liability at death. The children, who, upon the parent’s death, become the sole owners of the business, inherit the preferred shares. The procedure repeats itself when time comes to pass the business to a third generation.
There are a number of ways one can leave funds to a charity. Many of these ideas provide a tax break during your lifetime as well as at death. Contact the “planned giving” department of your favourite charity.
In designing an estate plan, U.S. assets (stocks, vacation properties, etc.) cannot be forgotten. Many are under the impression that recent changes to the US/Canada Tax Treaty have made U.S. estate taxes a moot point. While the changes to U.S. estate taxes are welcome to all Canadians, the taxes cannot be ignored. The changes are favourable and will never result in a taxpayer being in a worse tax position than previously. The new rules have different impacts on different taxpayers. Speak to your tax specialist for more information on this important topic.
This is one of the last steps in an estate plan. After you have decided on your estate’s objectives and design and have begun to enact a plan, your will needs to be prepared (or amended). Like all financial planning estate planning is continuous and needs periodic revisions and changes, as does your will.