The purpose of this blog is not to get existential, so if you were expecting a discussion of lights at the ends of tunnels or a visit from a Morgan Freeman-like God, we are unfortunately going to disappoint. Rather, after having a discussion with a client about their mother, and some of the steps that could be taken in preparing her estate, which led to a discussion about tax. While I think most folks have a working understanding of the fact that tax will be due on their estate when they pass away, I think understanding the nature of this tax and what, if anything, can be done to offset it, makes for good blog fodder. With that in mind, let's do a quick run through.
We will begin with the assumption that there is no surviving spouse. If there is a surviving spouse, most of your estate (if not all) will pass tax-free to your spouse and unless there are circumstances that dictate otherwise (second marriage for example), one should strongly consider naming his/her spouse where possible to avail themselves of this tax-free rollover treatment. We will also add that we are going to simplify this and ultimately there is more "meat on the bone" with much of this and thus one should talk to their accountant/lawyer before embarking on any changes. With that in mind, let's get to it:
Principal Residence: One's principal residence will not be subject to tax upon death; however, it will be subject to probate. Probate fees vary by province and in Ontario it is ~1.5%. So, if one has a home worth $2 million, the estate will not owe tax on this amount, but there will be probate costs of ~$30k. Can anything be done to avoid this? Not really, short of selling the property before you pass away and renting.
Secondary Residences: Cottages or rental properties are going to be subject to both capital gains tax and probate fees. So, if one owns a cottage worth $1 million with a cost base of $500k, one's estate is going to owe capital gains tax of ~$125k (~25% of the $500k capital gain). In addition, there would be probate fees on the cottage of ~$15k. Can anything be done to avoid this? The capital gain is pretty much locked in - in other words, even if one sold the property before death or tried to add their beneficiaries to the title on the property, a capital gain is going to be triggered. Adding the beneficiaries to title, however, could potentially avoid probate on the property; although, as mentioned, it would trigger a tax bill that would need to be funded.
RRSP/RIF: RRSP's and RIFs are subject to income tax upon death. So, if you have $1 million in a RRSP/RIF upon passing, you would be assumed to earn $1 million in the year of your death, which would be taxed mostly at the highest marginal tax rate. In Ontario, for example, your $1 million would be reduced to $500k as this would be the average tax rate on a $1 million "salary". The good news, as it were, if one names a beneficiary on his/her RRSP/RIF, there is no probate fee as the RRSP/RIF would not have to be probated. Can anything be done to avoid this? Not really; although, one could accelerate RIF payments while still alive to smooth out the tax burden over time. This is, perhaps, best illustrated by an example:
Example 1: Let's say one is turning 80 and decides to make the minimum mandated annual RIF withdrawals. Further, let's assume this person has a $1 million RIF and this person has no other income and used 100% of the after-tax value of the RIF payment to support themselves. Further, let's assume this person lived for exactly 10-years and earned a 4% rate of return on his/her RIF - what would that look like?
So, in our example, we would withdraw ~$700k from our RIF over the 10-years, pay ~$173k of tax on these payments (for after-tax income of ~$528k) and would have a portfolio worth ~$606k on death. This portfolio would "owe" tax of ~$290k, bringing the total tax bill to ~$463k and leaving ~$315k after-tax to the beneficiaries of the estate.
Example 2: Okay, now let's take the exact same situation, except let's assume we take $100k from the RIF every year as opposed to the mandated minimum. Further, since our expenses will not change (aside from a higher tax bill as we are taking out more money), let's assume that the additional money (after tax) we are taking from the RIF is invested in a non-registered portfolio that also grows at 4% per year. Would would this look like?
Okay, so the total tax paid on the RIF over the 10-years and at death would now be ~$365k. However, because we also have a non-registered account, we are also going to owe some tax on that; although, this will be taxed at ~25% of the capital gain, which works out to ~$12k. Further, because this is a non-registered account, it would be subject to probate (more on this shortly), which would cost us an additional ~$3,600. Our beneficiaries would be left with a RIF worth ~$141k and an investment portfolio worth ~$230k for a combined estate value after all taxes have been paid of ~$372k.
Comparison: In case you did not do the math yourself, under Example 2, we ended up paying about $82k less in taxes and probate over the 10-years (including on death) than we did in Example 1 (~$381k vs. ~$463k). Further, our beneficiaries are left with ~$57k more in Example 2 than they are in Example 1 (~$372k vs. ~$315k). The main reason for these differences is that we end up paying significantly less tax at higher marginal rates in Example 1 than we did in Example 2.
Caveats: We would caution that there are a lot of things to think about before committing to something like the above. These include OAS claw-back, the potential for tax rates to change (although tax rates are only likely to go higher in upper brackets, so this would likely make our example more compelling) and some other factors. Also, we are assuming in the above that we live for exactly 10-years, which we obviously would not know at the age of 80 (although, whether we live for 5, 10, 15 or 20-years, the math would still favour the accelerated approach). The bottom line would be one would want to discuss with his/her advisor/tax professional before considering the above.
Tax-Free Savings Accounts (TFSAs): TFSAs are truly one of the better inventions Canada has come up with in the past two-decades. TFSAs are not subject to taxation upon death and as long as beneficiaries are named, TFSAs are not subject to probate. In other words, one should maximize his/her contributions to a TFSA as the money is always accessible tax-free and the TFSA has no tax impact on the estate. We would caution that the government could always change the rules as it relates to TFSAs (but when have they ever done something like this?).
Non-Registered Accounts: Non-reg accounts are going to be subject to capital gains tax on death as well as probate fees. So, if one has a non-reg account worth $1 million and a cost base of $500k, upon death, the estate is going to owe ~$125k of capital gains (~25% of $500k) and probate of ~$15k. Can anything be done to avoid this? Yes - one could realize capital gains while still alive and gift the proceeds to his/her would-be beneficiaries. While this would not avoid the capital gains tax, it would avoid probate. Of course, one would also lose the income provided by the disposed of securities, as well as the "safety net" the assets provide, so this should only be done with careful consideration. The other option would be to "convert" the account to what is known as a Joint Gift of Beneficial Rights of Survivorship (JGBRS) account.
JGBRS: Without getting too far into the weeds, a JGBRS essentially enables one to name irrevocable beneficiaries to one's non-registered account. By doing so, one gives the non-reg account similar properties to a RIF account in that, upon death, the account would no longer be subject to probate (although capital gains would still be owed). As mentioned, probate is ~1.5% in Ontario, so if one had say a $5 million non-registered account, ~$75k of probate could be saved by the conversion. Converting the account does not trigger any tax; however, there are some important considerations:
- Once named, the beneficiaries cannot be changed, so one needs to be sure (i.e. if you are iffy on someone, the JGBRS is not a good option);
- The beneficiaries must be named equally on the account (so 50/50 for two, 1/3rd each for three, etcetera);
- While the owner of the account retains full control, one is likely in the process of setting up the account going to have to disclose how much money is in the account, so some privacy will likely be lost (so, if you do not want your heirs to know how much money you have, a JGBRS is likely not a good option).
Bank Accounts: Bank accounts may be subject to probate. Where possible, naming one or more beneficiaries as joint account holder on a bank account can save some probate headaches. While banks are likely to allow small accounts to avoid probate, once we start getting into bank accounts with $15k to $20k or more, there is a higher likelihood that the bank is going to require probate before releasing the funds. This not only would trigger probate fees on the money in the account, but it would also "lock-up" the money in the account until the will has been probated, which can take a year or more. By putting someone jointly on the account, there would be no need for probate (upon death, your name would simply be removed from the account). However, once someone is put jointly on the account, he/she essentially co-owns the account, so this should be done only in cases of extreme trust.
Life Insurance: Life insurance is not subject to taxation and if beneficiaries are named on the policy, it is not subject to probate. Thus, in a sense, life insurance has similar properties upon death to a TFSA. There are lots of different kinds and aspects to life insurance, which go well beyond the scope of this blog. That said - if one is potentially going to be faced with a large estate tax bill and one cares about this (I often tell clients that it is 100% okay not to care - in other words, saying "let my beneficiaries pay the tax, they will still be left with a lot" is a perfectly fine answer), then permanent life insurance makes a lot of sense.
One good way to think of permanent insurance is essentially as a part of one's fixed income portfolio. In other words, if one has a portfolio that is 50% equity/50% fixed income, consider $50%/45%/5% with the 5% allocated to permanent insurance. While the insurance will not pay any income while one is alive (although one can borrow tax-free against the policy's cash value in a pinch), it would have a pay-off upon death significantly higher than would a fixed income portfolio (assuming rates stay sub-8%, which seems very likely), especially if one considers the tax-free treatment of insurance. Thus, structuring a policy such that it covers all the taxes owed on an estate can be a great long-term planning solution.