How taxes can eliminate an inheritance

The situation

Alex was a 68-year old retiree living in Toronto and the father of two adult sons: Carl, owner of a successful computer business in Guelph; and Pete, who worked for a landscaping company in Toronto.

When he was diagnosed with a rare heart disease, Alex decided to review his estate plan, to ensure his assets would pass on to his two sons with a minimum of hassle.

Alex’s estate was fairly simple. When his wife died several years ago, Alex sold the family home and assumed a modest lifestyle. The bulk of his assets consisted of an RRSP worth $410,000 and a non-registered investment account worth $105,000. Alex also had some personal effects of sentimental value.

During his illness, Pete acted as Alex’s primary caregiver, helping his father with groceries, bills, and other day-to-day needs. Alex’s older son Carl would have been more involved, but the fact he lived in Guelph and owned a rapidly expanding business made that difficult.

The plan

Alex decided to name Pete the sole beneficiary of his $410,000 RRSP. This was partially in recognition of Pete’s ongoing role as caregiver, and partially in recognition of Pete’s personal financial situation — Pete made a good deal less money than his brother, and had past financial problems.

Alex didn’t want to disinherit Carl, however, so he named him executor and sole beneficiary of his estate; leaving him the non-registered investment account. The two sons were to split Alex’s personal effects as they saw fit.

The result

Less than a year after revising his estate plan, Alex passed away. And, his beneficiary designations created unexpected consequences.

Because Pete was not a “qualified beneficiary” (i.e., a spouse, a common-law partner or a financially dependent child/grandchild), there was no opportunity for a tax-deferred rollover of Alex’s RRSP to his son. Instead, Alex was legally deemed to have sold his RRSP just before death, resulting in taxable income on his terminal (year of death) tax return.

Since the RRSP had a value of $410,000 when Alex died, there was an income inclusion of $410,000 on Alex’s final tax return. At a tax rate of 46%, the total tax bill was just over $188,000.

Because the value of Alex’s estate at the time of death was only $105,000 (the total in Alex’s non-registered account), and since all taxes and debts must be paid before the heirs get anything, the full value of the estate was used to pay the tax liability on the RRSP and other income in the year of death. Net result: Carl’s inheritance was reduced to zero.

What’s more, under federal law, RRSP beneficiaries are “jointly and severally liable” for the excess liability in proportion to the amount attributable to the benefits received. That means the shortfall of $88,000 ($188,000 – $100,000; assuming a $5,000 tax on Alex’s non-RRSP income) became Pete’s liability, reducing his inheritance to $322,000.

Worst of all, the grossly unequal distribution created a legacy of bad blood. Alex’s mementos and personal effects became a battleground, as Carl and Pete used them as a proxy to settle financial scores.

A better solution

In the end, Alex’s failure to consider the consequences of his beneficiary designations led to an estate planning disaster. All of his estate intentions were frustrated.

What could Alex have done differently? One possibility would have been to name both his sons as beneficiaries of his RRSP (such an allocation need not be equal). This would create a more equitable sharing of the tax burden.

Alternatively, a portion of the RRSP could have been allocated to his estate to improve Carl’s opportunity for an inheritance. In such a case, estate administration fees would usually apply.

Wilmot George, CFP, TEP, CHS, is vice-president of vice-president, Wealth Planning at CI Investments.