Death and Taxes: Estate Planning Mistake #3
Estate Planning Mistake #3: Not Doing the Math
There’s a lot of misinformation floating around about how certain assets are taxed when the owner dies. I’ve heard tell that RRSPs are not taxed if beneficiaries are named on the RRSP application. This is only partially true and if you think you’ll be able to leave RRSPs to your adult child with no tax consequences, they are in for an unpleasant surprise.
I’ve also heard tell that the principal residence passes free and clear to the named beneficiary. This is also only partially true. The principal residence isn’t taxed at death but it is still part of the estate and thus subject to probate fees. There will very likely be some price to pay on the principal home.
Let’s start with RRSPs. RRSPs aren’t just passed to the beneficiary tax-free unless they qualify as one of the following:
- Your spouse
- Your financially dependent child or grandchild under 18 years of age
- Your financially dependent child or grandchild, of any age, who is physically/mentally disabled
We’ll call the people in this category “qualifying beneficiaries.”
When you pass away your RRSP assets are deemed disposed, meaning that you have sold all of your RRSP assets at their Fair Market Value (FMV). The entire amount of your RRSP savings is then added to your income for the final tax return. Your estate is then responsible for paying the taxes on that RRSP. If you have been a diligent saver and have a large amount of RRSPs to pass on, they will likely be taxed at a high marginal tax rate (MTR). One of two things will happen:
- The other savings/investment assets in the estate will have to be used to pay the tax bill first, before being passed on to your non-qualifying beneficiaries; or
- The tax bill will be subtracted from the RRSP assets
Either way, Canada Revenue Agency will get its share.
Next, your principal residence. This situation gets messed up when people try to avoid paying a bill. Your principal residence is not taxed when you pass away. If you leave your principal residence to your children, they will not get a tax bill. However, the residence is part of the estate, so there will be probate fees. In Ontario, those fees are 0.5% on the first $50,000 of estate assets and then 1.5% on any amount over $50,000.
Example: if your entire estate is valued at $500,000, you can expect to pay $7000 in probate fees.
In order to avoid paying the probate fees, it has become popular to name children and other beneficiaries as joint tenants. This is where people often get burned. When you name a non-spouse as a joint owner on your property, they are now a 50% owner of that property, meaning that you have just given away half the ownership rights of that property. If you sell the property and your adult child doesn’t live in the home with you, they are on the hook for the taxable capital gains resulting from the sale. Normally, a principal residence exemption would apply on capital gains resulting from the sale of the home. However, that exemption becomes totally non-existent for your joint owner’s half of the interest in the home for every year the joint owner does not live in the home with you.
Additionally, if they have outstanding debts, their creditors can now come after their interest in the property. Your property. Worst of all, if your adult child gets taken to the cleaners in a divorce case, their 50% interest in the home is fair game for the ex’s lawyers.
And all of that doesn’t even consider the cost of the legal paperwork to put their name on your home. Ask yourself if all of this risk is worth avoiding the probate fees.
Here’s an example of how an “equal” share of assets in a will can quickly become unequal:
Jim, a resident of Ontario, passes away. He owns a mortgage-free home worth $500,000, a mutual fund portfolio worth $500,000 and an RRSP portfolio worth $500,000. The adjusted cost base (ACB – the net cost of building that portfolio, including contributions) of his portfolio is $250,000. He sets up joint ownership on the house with his son Jack, leaves his RRSP portfolio to his daughter Jill, and his non-registered mutual fund portfolio to his other son Jesse. Here is a basic rundown of what will happen (not including deductions, credits, etc.):
Probate fees on $1,000,000 estate: $14,500
Tax payable on $500,000 RRSP portfolio (46.41% MTR): $232,050
Tax on $250,000 capital gain in the mutual fund portfolio (46.41% MTR): $58,012.50
The taxes and fees payable ($304,562.50) will be subtracted from the non-registered mutual fund portfolio.
So Jack will receive the $500,000 home, Jill receives the $500,000 RRSP portfolio, and Jesse receives only $195,437.50. Granted, it’s nearly two hundred thousand more than he started out with, but this kind of unequal distribution is what leads to nasty estate disputes (and even lawsuits) between family members. Is that really what Jim wanted for his children?
Is that what you would want for yours?
Tags: Estate, Estate Planning, joint tenant, Mutual Funds, principal residence, principal residence exemption, probate, RRSP, Tax Planning, will
This entry was posted on Thursday, October 8th, 2009 at 6:23 am and is filed under Estate Planning, Investments, Tax Planning. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.
