Death and Taxes – Estate Planning Mistake #3
There’s a lot of misinformation floating around about how certain assets are taxed when the owner dies. I’ve heard that RRSPs are not taxed if beneficiaries are named on the RRSP application. This is only partially true and if you think you’ll be able to leave RRSPs to your adult child with no tax consequences, they are in for an unpleasant surprise.
I’ve also heard that the principal residence passes free and clear to the named beneficiary. This is also only partially true. The principal residence isn’t taxed at death but it is still part of the estate and thus subject to probate fees. There will very likely be some price to pay on the principal home.
Let’s start with RRSPs. RRSPs aren’t just passed to the beneficiary tax-free unless they qualify as one of the following:
Your spouse
Your financially dependent child or grandchild under 18 years of age
Your financially dependent child or grandchild, of any age, who is physically/mentally disabled
We’ll call the people in this category “qualifying beneficiaries.”
When you pass away your RRSP assets are deemed disposed, meaning that you have sold all of your RRSP assets at their Fair Market Value (FMV). The entire amount of your RRSP savings is then added to your income for the final tax return. Your estate is then responsible for paying the taxes on that RRSP. If you have been a diligent saver and have a large amount of RRSPs to pass on, they will likely be taxed at a high marginal tax rate (MTR). One of two things will happen:
The other savings/investment assets in the estate will have to be used to pay the tax bill first, before being passed on to your non-qualifying beneficiaries; or
The tax bill will be subtracted from the RRSP assets
Either way, Canada Revenue Agency will get its share.
Next, your principal residence. This situation gets messed up when people try to avoid paying a bill. Your principal residence is not taxed when you pass away. If you leave your principal residence to your children, they will not get a tax bill. However, the residence is part of the estate, so there will be probate fees. In Ontario, those fees are 0.5% on the first $50,000 of estate assets and then 1.5% on any amount over $50,000.
Example: if your entire estate is valued at $500,000, you can expect to pay $7000 in probate fees.
In order to avoid paying the probate fees, it has become popular to name children and other beneficiaries as joint tenants. This is where people often get burned. When you name a non-spouse as a joint owner on your property, they are now a 50% owner of that property, meaning that you have just given away half the ownership rights of that property. If you sell the property and your adult child doesn’t live in the home with you, they are on the hook for the taxable capital gains resulting from the sale. Normally, a principal residence exemption would apply on capital gains resulting from the sale of the home. However, that exemption becomes totally non-existent for your joint owner’s half of the interest in the home for every year the joint owner does not live in the home with you.
Additionally, if they have outstanding debts, their creditors can now come after their interest in the property. Your property. Worst of all, if your adult child gets taken to the cleaners in a divorce case, their 50% interest in the home is fair game for the ex’s lawyers.
And all of that doesn’t even consider the cost of the legal paperwork to put their name on your home. Ask yourself if all of this risk is worth avoiding the probate fees.
Here’s an example of how an “equal” share of assets in a will can quickly become unequal:
Jim, a resident of Ontario, passes away. He owns a mortgage-free home worth $500,000, a mutual fund portfolio worth $500,000 and an RRSP portfolio worth $500,000. The adjusted cost base (ACB – the net cost of building that portfolio, including contributions) of his portfolio is $250,000. He sets up joint ownership on the house with his son Jack, leaves his RRSP portfolio to his daughter Jill, and his non-registered mutual fund portfolio to his other son Jesse. Here is a basic rundown of what will happen (not including deductions, credits, etc.):
Probate fees on $1,000,000 estate: $14,500
Tax payable on $500,000 RRSP portfolio (46.41% MTR): $232,050
Tax on $250,000 capital gain in the mutual fund portfolio (46.41% MTR): $58,012.50
The taxes and fees payable ($304,562.50) will be subtracted from the non-registered mutual fund portfolio.
So Jack will receive the $500,000 home, Jill receives the $500,000 RRSP portfolio, and Jesse receives only $195,437.50. Granted, it’s nearly two hundred thousand more than he started out with, but this kind of unequal distribution is what leads to nasty estate disputes (and even lawsuits) between family members. Is that really what Jim wanted for his children?
Is that what you would want for yours?
Many Blessings,
Andray Domise
Independent Financial Advisor
Change your life one dollar at a time, with REAL help for building wealth and reducing debt: http://www.andraydomise.com
Estate Planning FAQ:
Question: What do you think about this type of estate planning?
My grandfather says that houses can only stay in the family for so long because once a family gets too big, it’s hard to share it… (like a summer house). So, can you keep a house in a family for more than 2 generations? Of course it depends on how big the family is; ours is really big! The descendants become like strangers I guess because they are far removed from the original owners (grandparents). So, it there a way to improve/fix this dilemma so the house can stay in the family indefinitely?
Answer: Most likely your grandfather is alluding to the fact that it is difficult to have a house in which everyone owns a piece as the family grows from one generation to the next. Sooner or later there will be family members who aren’t interested in the house and wish their share in cash. Someone has to inherit the property. If it goes to one child then the others usually get money instead or something of equal value. If all children get a share then the problem starts as they pass their share on to their children until it becomes impossible.
Question: Financial Planning versus Estate Planning, which is the higher priority?
If you had an extra $1000 and all things being equal, which is more important at this moment, meeting with a financial planner or getting your estate planning documents in order (trust-we have one child, will, durable power of attorney and HCPA/AMD) for my wife and I? The idea being that on average a good fee-only financial planner or attorney to do either thing will cost $250-$300/hour (in the Washington DC area).
As far as financial background, we have life insurance, we contribute monthly to a 401K and Roth IRA and I have a defined benefit pension (yes they still exist). We are paying down debt, but I still feel that we could use a good financial review (not to sure about our allocations in the Roth and IRA’s). We DO NOT HAVE A WILL or other estate planning documents… and this is beginning to concern me… should it?
Answer: All the financial planning in the world isn’t going to be worth squat if you don’t have the legal power to protect it.
You need a will, living will, power of attorney etc. If you are seriously hurt in a automobile accident and are not able to communicate, your spouse has very few choices without the power of attorney and the living will. You may end up as a “turnip” in a nursing home spending all that money you have worked to save, just to care for you.
Or, if you and your spouse somehow are both killed, what will happen to the child? Think about your family and your spouses family and image that there could be conflicts over who should be in charge, and who will control the finances. Who will be the legal guardians? Who will help your child decide what happens to all the money you have amassed? Who will control that child’s future? Without a will, living will, and power of attorney, there will be problems.
Take care of this planning. Once this is done, then continue your progress on financial planning.
Question: Will and estate planning with a baby?
Did you have a will or other estate planning documents done after your baby was born? Did you see a lawyer, and if so, what documents did you have done? I am most concerned about choosing someone to take care of my son if we both die; can you offer any advice?
Answer: You should definitely meet with an attorney and get your affairs in order. Talk to your husband about who you would want to name as guardian in the event that something were to happen to you, and find time to sit down and speak with the person or couple and make sure that they are willing to be your child’s guardian.
Decide what you want to do with your assets, including any property, life insurance, investments, and retirement funds. You can set up a trust that will help your guardians with the expenses of raising your child, provide for college expenses when the time comes, and the rest can remain in the trust until your child reaches a designated age (usually 25 or 20, depending on your wishes). If you have several children, you may want to provide a sum of money up front for the guardians, because the expansion of their family might require a move to a larger home to accommodate everyone. And then you can set up the trust to provide a monthly payment to the guardians while your child is still living in their home.
Keep in mind that you can name a separate person (or more than one person) as the trustee, which is often advised, so that there is no conflict of interest. So you may also want to give some thought as to who you would want to control the funds in the trust. If there is nobody in your family you would want to name, you can designate your attorney.
You can set up an initial meeting with an estate planner to determine what your options are, and he can also advise you as to whether you have sufficient insurance and investments to provide for your children.
Question: How to deal with a Borderline Personality with regards to Estate planning?
One of my siblings is unfortunately a Borderline Personality,what is the best way for my parents to plan their Estate (Will) with this situation in mind. My parents reside in Quebec, the sibling in question resides in the USA.
Answer: There is no simple answer to this question. A lot depends on how much assistance this sibling needs now in his/her financial affairs, and if the parents believe this person can handle finances on their own. Perhaps your parents could require that the BP sibling get good financial counseling upon receiving the bequest at the least, and if they are not confident of this sibling’s ability to handle the money, set up a trust.
Question: Can you suggest a good book or website for estate planning?
I hear that if a grown (adult) child lives at home with the parents for 2 or more yrs that the parents can quitclaim the house to the child. This would be to avoid (legally avoid) estate taxes on the house if it were willed to the kid.
Answer: I would speak with an estate planning attorney. Most good attorneys will do a free consultation, and give a recommendation depending on your specific needs. Each state has slightly different laws and each scenario is different so it is not a good idea to take advice from people on tv/the internet.
Question: Where on line can I find some useful information on estate planning and tax avoidance?
Answer: Schwab has some good free info on its site. However, you get what you pay for. I would suggest a consultation with a good estate planning lawyer. The best advice is usually proprietary.
Question: How is tax burden minimized when using Trusts in estate planning?
Answer: A trust doesn’t reduce the tax issue. The IRS sees revocable/grantor trusts as continuing to belong to the person who set them up. The savings occur with fewer costs at probate and the ensurance that the titles of the assets go to the intended parties. This is good when a husband and wife have, say, 2.5 million assets and the estate would normally go to the other spouse. With proper trusts in place, if the 2nd spouse dies soon after the first, the same asset isn’t subject to tax in both estates.
Question: What is meant by the term “estate planning?”
Does it mean that, with proper planning, with the help of an expert, a person not rich, and not poor but somewhere in the middle, can insure his savings and other assets for his children after his death? In other words, can he “protect” his assets so that his children will be sure to inherent his money?
Answer: You are correct. It is the a plan that protects your assets from probate and inheritance taxes if done correctly. It also ensures your heirs receive what you wish. Eliminates fighting among your children.
The professionals also encourage you to tell your children your decisions once the plan is complete. At any time you can change, alter or eliminate any part of the plan.