How to destroy an inheritance

It is said that there are two certainties in life – death and taxes. Unfortunately, many are not aware how the two can come together at the same time to create unintended distributions (and a legacy of conflict) in the absence of a well-structured estate plan. Financial advisors can help clients as they navigate their way through situations like the following.

Alex, age 68, was recently diagnosed with a rare heart disease which doctors predicted would shorten his life. Upon hearing the news, Alex decided it was time to review his estate plan with a view towards transitioning his assets to his kids, Carl (42) and Pete (38). Since becoming a widower several years ago, Alex has lived a modest life, accumulating the bulk of his assets in an RRSP worth approximately $410,000. Alex’s only other asset was a non-registered mutual fund account totaling $105,000.

Carl runs a successful computer programming business. Pete works for a landscaping company. Over the years, Pete has had some challenges financially, but has been able to support his family.

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Throughout the years, Pete has spent a considerable amount of time with his father helping with day-to-day needs. While Carl would have loved to do the same, proximity did not allow it – Carl lived in Guelph, while Alex and Pete lived in Toronto.

In reviewing his estate plan, recognizing Pete’s financial challenges, Alex decided that he wanted to leave his $410,000 RRSP to Pete and took the necessary steps to ensure that Pete was named sole beneficiary on his RRSP contract.

(Note: In Quebec, it is generally not possible to name beneficiaries on RRSP or RRIF applications. RRSP and RRIF assets generally flow through the estate of the deceased and are governed by the terms of the deceased’s will.)

Wanting to leave assets for Carl as well, Alex named Carl executor and sole beneficiary of his estate with the intention of leaving his non-registered investment account to Carl at death.

Shortly after revising his estate plan, Alex died. Did Alex achieve his objective of leaving the bulk of his assets to Pete while, at the same time, ensuring the availability of an inheritance for Carl?

Let’s review the tax implications that resulted from Alex’s death. When an RRSP annuitant dies, unless the RRSP beneficiary is a “qualified beneficiary” (ie. spouse, common-law partner or financially dependent child or grandchild), the RRSP annuitant is deemed to have sold his/her RRSP just before death, resulting in a taxable income inclusion for the deceased for the year of death.

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The income inclusion generally equals the fair market value (FMV) of the RRSP at the time of death. Similar rules apply for RRIFs. Tax resulting from this event would be a liability of the deceased’s estate to be funded by assets of the estate. This can present challenges for beneficiaries of the deceased’s estate as their inheritances would be reduced to account for this debt even though the full value of the RRSP would be paid directly to beneficiaries named on the RRSP contract.

In Alex’s case, since his RRSP had a value of $410,000 at the time of his death, there was an income inclusion of $410,000 on Alex’s final tax return. Because his RRSP beneficiary (Pete) was not a qualified beneficiary, there was no opportunity for a tax-deferred rollover. As the majority of Alex’s income inclusion was subject to tax at 46%, a tax liability of approximately $188,000 in respect of the RRSP resulted. Alex’s estate was responsible for funding this liability to the fullest extent possible – even though it meant the elimination of Carl’s inheritance. Because the value of Alex’s estate at the time of death was $105,000, and because all debts (including income tax) must be paid before any excess is paid to beneficiaries of a deceased’s estate, the full value of Alex’s estate ($105,000) was used to fund the tax liability of his RRSP and other income in the year of death, reducing Carl’s inheritance to zero.

But, that’s not all. As indicated, where a deceased’s estate is liable for tax on the distribution of an RRSP, the full value of the RRSP is normally paid to beneficiaries named on the RRSP contract without withholdings for income tax. So, in the above case, ignoring RRSP administration fees, Pete received $410,000 from Alex’s RRSP. But, does Pete get to keep the full amount?

As per section 160.2(1) of the Income Tax Act (ITA), when a deceased RRSP annuitant’s estate does not have enough assets to fund the tax liability created by the RRSP at death, RRSP beneficiaries are “jointly and severally liable” for the excess liability in proportion to the amount attributable to the benefits received. Subject to proposed legislation, interest on the unpaid debt might also apply. Although Pete received $410,000 from Alex’s RRSP, the tax liability resulting from this distribution ($188,000) was only partially funded by Alex’s estate. Since Alex’s estate did not have sufficient assets to fund the entire liability, the shortfall of $88,000 ($188,000 – $100,000; assumes $5,000 tax on non-RRSP income), became Pete’s liability, thus reducing his inheritance to $322,000.

Read: Estate plans are for everyone

In the end, because of his failure to seek assistance in defining his estate plan, Alex’s testamentary intentions were frustrated. Not only did his desire to provide an inheritance for Carl not materialize, but the amount Pete received fell short of Alex’s expectations. Had Alex worked with a financial advisor in this situation, he likely would have considered the tax implications of his plan and devised a strategy that would have allowed a better result. This might have involved naming both Carl and Pete beneficiaries of his RRSP to allow for a more appropriate sharing of the tax debt (unequal allocations are possible when naming beneficiaries), or, a portion of the RRSP could have been allocated to his estate to improve Carl’s opportunity for an inheritance (estate administration fees apply where applicable).

Situations like these have the potential to result in long-term conflict amongst family members. In the absence of a well-structured estate plan, it is not unusual to see beneficiaries (siblings in this case) arguing over their respective shares of a deceased’s assets based on what they believe the deceased “intended” for them to receive. Furthermore, where a parent wishes to leave inheritances of unequal shares to children at death, it is critically important to seek the assistance of legal professionals. Unless there is a reason for the unequal distribution (e.g. to compensate a caregiver, or due to illness, disability, etc.), children may attempt to bring claims against a deceased parent’s estate.

When speaking with your clients about RRSP and RRIF beneficiary designations, be sure to discuss tax implications at death. Doing so would help shed light on a topic that many Canadians are not familiar with, and would go a long way in ensuring that your client’s intentions are carried out.

Wilmot George, CFP, TEP, CLU, CHS, is vice-president, Tax, Retirement and Estate Planning, at CI Investments. Wilmot can be contacted at wgeorge@ci.com.

Wilmot George

Tax & Estate

Wilmot George, CFP, TEP, CLU, CHS, is vice-president, Tax, Retirement and Estate Planning at CI Global Asset Management. Wilmot can be contacted at wgeorge@ci.com.