Minimize your final tax bill
If you think you pay a lot of tax while you’re alive, consider the amount your estate will have to pay Canada Customs and Revenue Agency (CCRA), formerly Revenue Canada, upon your death.
While we have no succession duties in Canada, death can trigger a final tax bill that looks and feels a lot like an inheritance tax. Upon death, the profits you’ve earned on your assets can be taxed immediately as capital gains and the total value of your RRSP or RRIF treated as if you had cashed it in. There is some good news, though: your home is exempt from tax under the principal residence exemption.
Taxable capital gains
Fifty per cent of your profits, or capital gains, are taxable when they are sold or deemed to have been sold. On death, this tax bill can be deferred if the assets are left to a spouse or a common-law partner, which now includes a same-sex partner.
Suppose your investment portfolio was worth $160,000 at the time of your death and the adjusted cost base for tax purposes was $60,000, for a profit of $100,000. (Adjusted cost base normally includes what you paid for the investment – or its value when you received it if it was a gift – pl any expenses to acquire it, such as commissions or legal fees and the cost of any improvements or capital expenditures.) Of this, 50 per cent, or $50,000, would be taxed at your marginal tax rate. If you were in the 45 per cent tax bracket, the tax bill for these profits on your final return would be about $22,500.
RRSPs and RRIFs
When you contributed to your RRSP or a spousal RRSP, you reduced your tax bill in the year you claimed these contributions. While it was understood that tax would have been paid on amounts withdrawn from your RRSP or RRIF, few people anticipate the size of the potential tax bill on death.
If the beneficiary of your RRSP or RRIF is not your spouse, common-law partner, young child or certain dependent children, the value of the registered plan is treated as if you had cashed it in on death. For example, if the RRSP is valued at $150,000 at the time of death and you’re in the 45 per cent tax bracket, the tax bill would be about $67,500.
Minimize the cost of dying
How much you’re willing to do to reduce the cost of dying depends on your personal philosophy. Some people will plan extensively to minimize the tax bill at death and maximize the inheritance they leave to their beneficiaries. Others consider any inheritance to be a gift and are willing to pay whatever is required.
At the same time, some strategies undertaken to minimize the cost of dying could have adverse consequences if premature – such as giving away too much too soon to your children or done for the wrong reasons – such as setting up joint ownership of assets.
Let’s consider some techniques you might put in place while you’re alive to reduce your tax bill as well as some procedures your executor may undertake after your death and ways to reduce the taxes your beneficiaries pay on income earned after receiving their inheritances.
Next page: How to reduce your final tax bill
How to reduce your final tax bill
Tax planning is completely legal. Tax avoidance is not. Here are some common and not-so-common techniques to reduce the final tax bill.
1. Leave your RRSP or RRIF to your spouse or common-law partner, which now includes a partner of the same sex. The value of your RRSP or RRIF can be transferred effectively tax free (under what is called a “refund of premiums”) to an RRSP or RRIF in your spouse’s name.
2. Leave assets with taxable capital gains to your spouse or common-law partner as a spousal rollover, either outright or in a spousal trust. This would allow the tax on the profits to be deferred until your spouse or partner sold the assets or died.
3. Do year-by-year tax planning as well as final tax planning. One of the key goals of tax planning before retirement is to defer your tax bill for as long as possible. But if you expect to be in a much higher tax bracket at death than currently, consider increasing your current taxable income slightly each year over a number of years to take advantage of your lower tax rate. This might mean withdrawing a little more from your RRSP or RRIF, or selling some investments so you can include the taxable capital gain on your tax return and pay tax at a lower rate now rather than paying more tax at death.
But you need to consider more than just your tax bracket in your plan. You don’t want to inadvertently trigger the clawback of any income or deductions that are tied to income, such as Old Age Security benefits.
4. Business owners can consider triggering an estate freeze on assets they expect to increase even more in value in the future. This could be done by creating a new class of shares or by transferring assets to a living trust, which would allow the current value of the company to be locked in and all future growth passed to the next generation.
5. Keep your tax records up to date. It’s important to report capital losses on your tax return in the year you incurred them, even if you cannot use them to reduce the tax on any capital gains for that year. That’s because, by reporting them, you make these losses available for reducing your taxes in future years and, ultimately, on death. Upon death, losses can be applied against capital gains as well as other types of income.
6. Keep all pertinent paperwork. One of your executor’s jobs is to recreate your financial life to complete your final tax return and settle up with CCRA. He or she will need to find your most current tax returns and the corresponding assessment notice.
Next page: More ways
While it seems like a long time since the $100,000 capital gains exemption was eliminated, a number of Canadians filed the special $100,000 capital gains declaration in 1994 although they may not yet have taken advantage of the declaration for their cottage or other assets. But if your executor doesn’t know you made this declaration, he or she may overlook using it to reduce your final tax bill. Keep a copy of the declaration with your current tax papers.
7. If you make a gift to a registered charity in your will or by naming the charity as beneficiary on your RRSP, RRIF or life insurance policy, the charitable receipt can be used to claim the non-refundable tax credit and reduce your final tax bill.
If you want to donate to a charity in your will, consider leaving assets with taxable capital gains, such as stocks, bonds and mutual funds, rather than cash. You then get the benefit of effectively paying tax on only 25 per cent of the profits rather than on half of them
8. Spend your assets. Retirees often have difficulty spending the nest egg they have built up even although the reason they saved and were prudent with their money was to ensure a comfortable retirement. Very few made their sacrifices to leave as much as possible to their children. So remember why you saved this money in the first place — and plan accordingly. Only you can determine if your priority is to ensure your adult children benefit after you’re gone or to live the life you planned.
How your executor may reduce your final tax bill
Your executor or personal representative may make some last-minute elections that may minimize your final tax bill after your death. Some of these options require that he or she have the power to make them, according to the instructions in your will — as long as they’re in the best interest of your estate and your beneficiaries. For instance:
1. If you have unused RRSP contribution room and are survived by a spouse or partner who is under 70, your executor could make a contribution to a spousal RRSP and use the deduction on your final tax return.
2. Rather than transfer assets to your spouse or common-law partner at the adjusted cost base (and triggering no taxable capital gains), an executor may elect to transfer some of the assets at higher cost base to maximize the value of other tax items, such as any capital losses or charitable donations.
3. If the amount of a charitable receipt is more than the maximum limit your executor can claim on your final tax return, he or she could re-file your tax return for the previous year and claim as much of the receipt as possible.
Next page: More examples
4. There are up to three optional tax returns your executor can file on your behalf. These returns could allow you to use some of the personal tax exemptions and tax credits more than once, thus reducing the overall final tax bill:
- a) a return for amounts due at the time of death that had not been paid, such as bond interest that had matured but not yet been cashed, or salary that had been earned but not yet paid.
b) a return for income from a sole proprietorship or partnership.
c) a return for income earned from a testamentary trust.
Setting up a testamentary trust
As well as minimizing the final tax bill, you may want to consider how to reduce the taxes your beneficiaries might have to pay after they receive their inheritances. Just for the record, because your estate is responsible for paying your final tax bill, your beneficiaries receive their inheritances tax-free.
But any income they then earn on the inheritance — interest, dividends or capital gains income — is taxed in their hands. Suppose a beneficiary inherits $100,000 outright and tucks it away in a money market fund until figuring out how best to use it. If the money earns three per cent, there would be $3,000 in interest income after 12 months. Added to all other income for the year, your beneficiary could end up losing almost half of it in tax if he or she were in the top tax bracket.
But if you left the inheritance in a testamentary trust rather than gifting it outright, the income would be taxed as a completely separate taxpayer according to the graduated tax rates. So, for example, if the $3,000 were the only income earned by the trust for the year, the tax bill would be much less.
Setting a up testamentary trust requires additional wording in your will, and you must also consider what plans your beneficiary might have for the money. If it’s likely to be spent on a house or to pay off the mortgage, then setting up a testamentary trust may not be worth the added expense and administration.
Tax clearance certificate
If your executor distributes assets out of your estate to your beneficiaries before settling up with the CCRA, your executor will be personally on the hook for any outstanding balance. Therefore, after the final assessment notices have been received for all your tax returns, it’s prudent for your executor to request a tax clearance certificate from CCRA. Once the certificate has been issued, your executor is off the hook for any further tax liability.
While many executors never bother to request this certificate, they should. In one case, a husband died and the final tax return was filed. Since the details seemed simple enough, the executor didn’t bother to request a tax clearance certificate. However, a year later, the wife was audited and her income increased, denying the married tax credit. Because the tax clearance certificate had not been requested for the husband’s final tax return, his tax return for the year of death is still in the process of being reassessed.
Estimate your final tax bill
So how big a tax bill will your estate face? While you don’t know exactly how much your estate will be worth at the time of your death, you can estimate the amount of tax your estate may face on death. Use the guide “Preparing Returns for Deceased Persons,” which you can find at www.ccra-adrc.gc.ca, to prepare a pro forma calculation using tax software (just be sure not to e-file it!).
The key to dealing with the tax bill on death is to make sure that you pay no more than you are required to and that your estate has enough liquidity to be able to pay the taxes without selling assets you want to keep in the family, such as the family business or the cottage. If your estate won’t be able to come up with enough cash to cover the taxes without selling these assets, consider life insurance (see “Life Insurance Covers Your Assets,” page xx).
Estimate your potential tax liability periodically so that you don’t end up paying any more tax than necessary any sooner than necessary. The tax rules and rates are always changing – as is the value of your estate. Seek professional tax advice to help you achieve your goals.