How to integrate RDSPs, Henson trusts and annuities

With the Registered Disability Savings Plan (RDSP) expected to launch late this year, financial advisors need to make sure all relevant aspects of planning for people with disabilities are properly coordinated.

Based on the RESP model, the RDSP offers incentives to friends and families to provide higher income for people with severe disabilities and encourage those with disabilities, who are able to work, to accumulate funds. For minors, the government’s matching contribution formula will be determined by the parents’ incomes. Those over 18 will be eligible for government contributions based on their (and their spouses’) incomes.

To appreciate the benefits from the matching grants, advisors must understand each contribution consists of two parts—the Canada Disability Savings Grant (CDSG) and the Canada Disability Savings Bond (CDSB).

For families earning less than $74,357, the CDSG is 300% of the first $500 and 200% of the next $1,000 contributed in a taxation year; to a maximum of $3,500. That equates to a personal contribution of $1,500 resulting in $3,500 in grants, for a total of $5,000 in the RDSP in any given year. The maximum CDSB grant is $1,000 for eligible individuals with income below $20,883; this grant is indexed with no CDSB available for incomes over $37,178.

Advisors need to make clients aware there can only be one RDSP per beneficiary and it must be set up by the beneficiary, custodial parent, legal guardian or provincial public trustee/official guardian’s office. Anyone can contribute to the plan, and there’s no annual limit, but there is a lifetime contribution ceiling of $200,000. Advisors must also know the maximum lifetime grant limit is $70,000 for the CDSG and $20,000 for the CDSB. Investments that can be held in the RDSP are the same as those allowed in an RESP.

The plan may provide for an ad hoc payment from the RDSP in any amount for things like the replacement of a wheelchair or similar equipment.

To qualify for an RDSP, the beneficiary must receive the federal Disability Tax Credit, and to claim the disability amount the impairment has to be prolonged. The person with a disability must be blind, require life-sustaining therapy, or be markedly restricted in one of the following basic activities of daily living due to the impairment: speaking, hearing, walking, dressing, feeding, mental functions necessary for everyday life, or bowel and bladder functions.

Critical Considerations If, down the road, the disabled person no longer qualifies for the tax credit, the federal grants, as well as all income accumulated on that portion of the RDSP, become repayable to the government and the balance of the income becomes taxable to the beneficiary.

This is something to consider carefully when advising clients about whether an RDSP makes sense for their children, because there’s a very real possibility a beneficiary could cease to qualify due to improved medical and pharmaceutical treatments. For example, a young child who is profoundly deaf may not meet the Disability Tax Credit impairment criteria if he or she obtains cochlear implants. Similarly, stroke and spinal paralyses are being treated successfully with Functional Electrical Stimulation; and Aspergers and Autism therapies are improving. To help a parent decide whether or not to contribute (or wait), consider several issues: • If the parent’s income is over $75,000, any contribution to the RDSP will not qualify for matching CDSG and CDSB. Using another vehicle to accumulate funds, or paying down debt, may make more sense. • Parents who earn less than $37,000 a year (the CDSB threshold) will probably be unable to afford RDSP contributions, but an RDSP may be an option if family and friends can also contribute to the plan. • Adult children with disabilities often have an income below the $20,883 grant threshold, so it’s important to consider the age at which an RDSP should be created. If the RDSP is created before the child turns 18, the parents’ income is used to determine grant eligibility. If a child is 18 or older, their own income is used to determine eligibility. • Federal government grant contributions (CDSG and CDSB) are not made after the beneficiary turns 49. • Contributions can be made to the RDSP up until the end of the year the beneficiary turns 59. Then, under current legislation, the total RDSP must be used to purchase an annuity for the beneficiary. The monthly amount, from this annuity, would be dependent on life expectancy, sex and amount of accumulation in the plan. Life expectancy varies tremendously for different disabilities and with improvements in medical treatment, many are living much longer. • An RDSP may be turned into an income stream earlier than age 60. Regardless of when a beneficiary converts the RDSP into income, your client should know that this revenue will be considered a combination of return of capital, CDSG and CDSB payments, and accrued income on the investments. The portion related to the CDSG and CDSB (plus all the income earned in the plan) is taxable, similar to an RESP. • There’s less value in contributing to an RDSP for beneficiaries over the age of 49 as no CDSG or CDSB will be payable. But there are other benefits. An RDSP beneficiary cannot be pressured into giving or lending money to friends and other family members as the beneficiary designation is irrevocable, and the right to receive payments from the plan cannot be assigned or surrendered. Also, tax-free compounding and the ability to continue receiving provincial benefits mean there may be a benefit to contributing to an RDSP. • In order to maximize CDSG and CDSB payments, contributions to the RDSP should be made as soon as it’s available for all people with disabilities aged 29 or older.

RDSP: Impact on Benefits The Federal Government wants the RDSP to be excluded as both an asset and an income for purposes of calculating provincial disability benefits. Only British Columbia, Saskatchewan, Yukon, Newfoundland, and Manitoba have agreed to exempt RDSP assets and income from social assistance calculations. There is a private member’s bill before the Ontario Legislature and the provincial government is saying it will make a decision before the plan comes into effect. The Government of Quebec, in its most recent budget, announced RDSP payments would be exempted “up to certain limits.”

While provincial concessions are important, the fact remains all provinces need to get on board if the RDSP is going to work as a method of elevating the socio-economic status of people living with disabilities. And the provinces need to be clear as to whether housing subsidies will be affected.

While people receiving income from sources other than provincial disability benefits (or the equivalent) don’t need to be concerned about provincial decisions in this regard, they do need to consider whether generating an income stream may pose a problem to disability benefits.

Other factors to consider include: • Lack of provincial benefits doesn’t necessarily mean no prescription drug coverage before age 65. The Ontario Trillium Drug Plan works on an income basis, so coverage would likely be available. Advisors should help people concerned about future coverage to contact their case workers. • Safeguards ensure the beneficiary’s financial interests are protected as the funds inside the RDSP cannot be used as collateral for loans. If a lump sum withdrawal is made, then the CDSB and CDSG contributions are immediately repayable with interest. • Unlike an RESP, there’s no option for the RDSP to be rolled into an RRSP or any other vehicle. • Anyone, related or not, can contribute to an RDSP. • Topping up the contributions with a lump sum (not to exceed total contributions of $200,000) could be achieved through a will.

The Inheritance Trust In a few provinces, including Ontario, people receiving provincial disability support are allowed to receive an inheritance (and other types of settlements), without losing benefits, as long as the lump sum does not exceed $100,000.

While there are stipulations associated with these types of trusts (they cannot grow above $100,000 and income up to $5,000 must be paid out during the year), they do give the beneficiary control because they are inter vivos trusts created by the beneficiary and not testamentary trusts set up in the will. However, clients need to know that any amount over the yearly $5,000 will be deducted dollar for dollar from benefit cheques.

Henson Trusts The Henson Trust is an Absolute Discretionary Trust, which sprinkles income to a beneficiary with a disability. Such a trust is of value only to beneficiaries who receive ODSP (or another provincial benefit program for people with disabilities), because it allows receipt of occasional benefits, but not an income stream.

As there’s no right to income or capital in the trust document, and the trustees can withhold income and assets from the beneficiary, it’s not considered an asset or income under provincial benefits definitions.

A Henson Trust may be testamentary or inter vivos. However, not all provinces recognize Henson Trusts and their status is fragile—regulations can change and Henson Trusts are continually being challenged. The following provinces allow Henson Trusts: Ontario, British Columbia, Manitoba, New Brunswick, Nova Scotia, and Saskatchewan. The provinces that have challenged the Henson Trust include: Newfoundland & Labrador, Nunavut, and Northwest Territories. The status of Henson Trusts in Alberta is defunct.

There are pros and cons depending on the individual situation: • As long as the beneficiary is under age 65, he or she can continue receiving provincial benefits with the occasional payment of monies from the trust. At age 65, provincial payments stop and payments begin under the federal system and include CPP, OAS and GIS. While GIS (Guaranteed Income Supplement) is income tested, it isn’t asset tested, and the reduction is not dollar for dollar. • A trust, Henson or otherwise, could use the preferred beneficiary election to enable the tax to be paid in the trust and not affect GIS. • A major benefit with Henson Trusts is the person with the disability is not required to be eligible for the Disability Tax Credit. • The cost of setting up a Henson Trust is an issue for amounts of $100,000 or less. In these cases, an inheritance trust may make more sense. • Trustees are entitled to an annual fee, which is a percentage of assets. This is typically 2% to 2.5%. A T-3 trust return must be filed by the trustee. • All trusts are required to maintain records and to abide by any terms in the trust documents (typically spelled out in the will). These may include instructions on how to invest and acceptable investment vehicles. • Trustees who are family members may have a conflict of interest when they or their immediate family are residual beneficiaries of a Henson Trust. Decisions to invest more for long-term growth and less for current income, and to withhold payments of income and capital, may not be in the interest of the beneficiary but rather in the interest of the trustee-beneficiary or other family members. • A Henson Trust beneficiary capable of handling his or her own affairs may resent the structure, as it creates or increases dependency on others. • The Income Tax Act has a provision that allows an RRSP or RRIF to roll over on death to a disabled child or grandchild financially dependent on the deceased. If that person is a minor, the funds are used to purchase an annuity which pays out by age 18. But in the case of an older dependant with a disability, the RRSP or RRIF can roll over tax-free into a beneficiary’s own RRSP. The person, however, must be financially dependent on the parent or grandparent, and eligible for the Disability Tax Credit. Financially dependent is usually defined as the deceased being able to claim the beneficiary as a dependant, and the beneficiary’s income being below the sum of the basic personal tax credit and the disability tax credit. This amount was $16,490 in 2007. • RRSPs and RRIFs can also be rolled over to Henson Trusts—the advantage is that none of the money will be lost to tax. If there’s no surviving spouse or the spouse will not need the money, putting it directly into a Henson Trust may make sense. • Some public service pension plans pay survivor benefits, first to a spouse and then to a dependant survivor. The dependant survivor would be an adult child who receives provincial benefits. It will likely have negative consequences for the dependant’s provincial benefits, although if the end result is a significantly higher income, it’s more beneficial.

Annuities Parents wishing to provide a stable income stream for a disabled but employed adult child, who is not eligible for provincial benefits because his or her income (earned income, maximum CPP disability benefit, worker’s compensation, minimal company or private disability payments) exceeds a set threshold, may want to consider an annuity. They can be structured in a variety of ways: • Used in conjunction with the RDSP, a term certain annuity can be used to top up or replace other income for a period of 10 to 30 years, providing a regular and secure level of income. Once that fixed term is over, the annuity stops and the RDSP starts generating income, replacing the original annuity. Since the RDSP is a new program, it will likely take at least 20 to 30 years before an income stream can be regularly generated this way. • An annuity could be purchased by the parents for themselves, paying the income to the beneficiary child. Rather than a term certain annuity, a prescribed life annuity with a guarantee period of 20 years could be chosen (with the child as beneficiary in case the parent dies before the guarantee period). The annuity would continue to pay the beneficiary until the guarantee period is up. The advantage is that if the parent lives longer than the 20-year guarantee period, the annuity carries on for as long as the parent lives. • The annuity payments are made up of a return of capital and an income (interest) payment. On a term certain annuity providing $24,000 per year in income for a 30-year-old male, the taxable portion would be about $6,400. • Advisors need to ensure income from an annuity in the beneficiary’s name will not affect income from another source such as a disability pension or worker’s compensation. • Indexing is technically feasible for annuities. However, it comes at a price and most companies are averse to even issuing indexed annuities. A way around this is to keep the initial payments at a level that is reasonable and add a second annuity 10 years later. Staggering will achieve a similar result and the beneficiary will be older, so payments will be higher per dollar invested (on a life annuity).

Each new government program adds both opportunities and complexities for advisors and their clients. In such a climate, looking at all the options and advising clients appropriately becomes ever more critical.