Friday, 21 June 2013

Saving Taxes on Investments at Death

Death is bad enough for the person involved without the potential for taxes on investments to add pain for the inheritors of whatever legacy is left behind. Fortunately there are a few choices that an investor can make in a Will or that an Executor can make after death to minimize the damage of the grim tax reaper. We'll say in advance that the following is meant to give readers an awareness of some worthwhile options. Due to the complexities of tax law inter-acting with the details of individual situations, this is one area of investing where consulting professionals like lawyers and accountants is advisable especially where large sums are at stake. You only die once and there is no second chance to do it right.

The Law: No inheritance tax, capital gains on deemed disposition instead
Canada has no inheritance tax on assets. Instead, tax law dictates that all assets are deemed to have been sold on the day of death at fair market value. As a result, capital gains calculations must be done for the deceased taxpayer and the income reported on the return for the year of death. It's the day of reckoning - no more deferral of capital gains.

In addition, tax-deferred (RRSP, RRIF, LIRA, LRIF etc) and tax-exempt TFSAs of the taxpayer are forced to end and everything is considered to have been withdrawn in the year of death. For example, someone with a $250,000 RRIF balance will have that much income on their year of death final return, putting them into the highest tax bracket. RRSP contributions that years before may have received a refund based on much lower marginal tax rate suddenly are reclaimed at the top marginal rate. Ouch! Considering that a taxpayer may have other assets like a family cottage that has accumulated a large capital gain but which the children do not want to sell to pay the tax, the sudden large tax hit may cause cash flow problems. Big financial worries are not welcome at a time that is already emotionally stressful. What can be done?

Transfer RRSP / registered plan or TFSA to spouse
If there is a surviving spouse (or common law partner or financially dependent children and grandchildren), the deemed disposition of such plans can be avoided by naming the spouse as beneficiary to the plan issuer / administrator (e.g. the online brokerage like BMO InvestorLine etc). The Income Tax Act allows this. The surviving spouse in effect steps into the deceased's shoes and continues on. There is no effect or dependence on the survivor's contribution limits or room. See's Death of a TFSA holder and Canada Revenue Agency's TFSA Guide and Death of an RRSP Annuitant for details. Estate Planning for RRSPs at the CGA website explains some of the mechanics how all this is accomplished and gives an informative example.

An added benefit is that such direct transfers avoid the registered plan assets being taken into the Estate of the deceased and being subject to another tax, the provincial probate fees. In some provinces probate fees/taxes are minimal, while in others like Ontario and Nova Scotia, they can be substantial for larger estates (see tables for each province).

Implement a Spousal Rollover
The law allows the Executor to decide, after death and presuming it is also in accord with provisions of the Will about who inherits pieces of the estate, to rollover assets to the spouse (or the same qualified beneficiaries as above) in order to avoid deemed disposition. The spouse takes over the assets at the same Adjusted Cost Base the deceased had.

The rollover is a more general case of the RRSP rules i.e. it also can apply to non-registered accounts and assets. That can be very beneficial in avoiding a large immediate tax hit if there is a large accumulated unrealized capital gain in an unregistered portfolio. Lawyer John Mill in his Succession [Tax Counsel] blog article Spousal Rollover - the most valuable tax plan? provides more detail on how rollovers work and when there are or are not useful.

One situation where they might not help is if the deceased taxpayer has accumulated capital losses of previous years to offset potential gains from deemed disposition.

The Executor is allowed to decide to rollover, which is the default, or opt out of it. Deciding exactly what to do can get quite involved as the rollover is allowed on a property by property basis (see Tax Specialist Group's Electing Out of a Spousal Rollover on Death) e.g. one stock with no unrealized gain might not be rolled over while another with a large gain might be to avoid triggering immediate tax in the final return. When a Will divides an Estate amongst a spouse and children for example, the spouse could receive assets with gains to rollover while children get assets with no unrealized gains. If the deceased taxpayer pays less, everyone gets more. However, if the Will gets too specific about who gets what assets, that may not be possible - a Will drafted with good professional tax advice and properly written with good legal advice becomes ever more important the more investments there are and the more complicated the situation.

Consider a post-death contribution to a spousal RRSP
To obtain a RRSP deduction and reduce taxable income in the year of death on the final return of the deceased taxpayer, the Executor can make a contribution to a spousal RRSP within 60 days of the date of death. Death and Taxes in the CGA magazine discusses this option amongst others.

Set up a Testamentary Trust(s) in the Will
Testamentary Trusts, most commonly created by a Will, begin when a person dies. They hold assets on behalf of one or more beneficiaries. The key benefit is that they are treated as a separate taxpayer under tax law. That means that income splitting between spouses can continue. The trust is taxed at graduated rates just like an individual. Two income streams, one from the trust containing the deceased taxpayer's assets and one from the surviving spouse can each pay at a lower rate than the combined larger income would. Properly written, the Trustee (often set up to be the surviving spouse) can decide whether and how much of the income to have taxed in the Trust or to be distributed to the beneficiary for taxation in his/her hands year by year. RRSP money can go into a Testamentary Trust.

The biggest limitation is that the Trust is not allowed to distribute capital losses to the beneficiary. Losses can only be used to offset capital gains within the Trust. Capital gains on the other hand, may be distributed to the beneficiary.

There's another benefit. Rollover rules apply, so assets can be rolled over into a Spousal Testamentary Trust, avoiding deemed disposition and deferring the realization and taxation of capital gains.

Though a non-Spousal Testamentary Trust, e.g. a Testamentary Trust for non-financially dependent children, cannot benefit from rollover, it can still provide income-splitting tax advantages for them. A high-earning top tax bracket adult child might benefit from receiving an inheritance from a parent not directly but indirectly in a Trust, which they could control if named as trustee with full discretion, since the income could be taxed in the Trust at a lower rate. See McEwan & Co Law Corp's Estate Planning page for more detail on ins and outs of Testamentary Trusts in amongst other topics.

A separate account to manage a Testamentary Trust can be set up at most online brokers. It should also not add much to lawyer's fees for writing a Will.

Check out the possible tax benefit of carryback of Capital Losses
Special unique tax rules apply upon and just after death, when the deceased's investments pass temporarily into the Estate, pending distribution to the people named in the Will. The Estate is a separate taxpayer from the deceased person and from the subsequent inheritors or Trusts such as those discussed above. In fact, the Estate itself is a Trust.

After death, the financial world doesn't stop. Interest on bonds is received, dividends too. When the Executor takes control after the Will has been approved by a court through probate (cautious financial institutions won't let Executors trade until probate is done) there may be buying and selling of securities within the Estate. Normally, as a separate taxpayer the Estate would have to compute and report its own taxes. The special rules of Subsection 164(6) allow the Executor to carryback capital losses in the Estate, incurred up to a year after death, to the final return of the deceased taxpayer.

Another special rule allows capital losses, normally deductible only against capital gains, incurred during the year up to the date of death to be deducted against any type of income in the final return and in the return of the year preceding death (which if already filed would be done with an adjustment form - see CRA's T-4011 Preparing Returns for Deceased Persons 2012 and the T-4013 T3 Trust Guide). However, the Estate carryback can only be applied to the final return, not also to the preceding year.

As we said at the outset, if you are not already convinced of the usefulness of professional advice when it comes to carrying out these strategies, please consider it. The words of Albert Einstein, one of history's most brilliant thinkers, merit reflection: "The hardest thing in the world to understand is the income tax." That he said this talking to his accountant shows he was also smart enough to know the limits of his own skills.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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