Death, taxes and your RRSP: What you need to know to minimize the tax hit to your estate
Jamie Golombek: Here's a look at how the tax works along with what happens when someone dies with a significant RRSP or RRIF
For millions of Canadians, the RRSP, and it’s common successor, the RRIF, provide a lifelong tax deferral which allows a taxpayer to set aside a portion of their income while working for use later in life, often in retirement.
Mechanically, it’s quite simple: you generally can claim a deduction on your income tax return for RRSP contributions up to 18 per cent of your “earned income” for the prior year, to a maximum of $27,830 for 2021. Down the road, you will pay tax on funds you withdraw from an RRSP (or a RRIF) at federal/provincial combined marginal tax rates that currently range from about 20 per cent to 54 per cent, depending on your level of income and province or territory of residence.
If your tax rate in the year of withdrawal is exactly the same as it was in the year of contribution, the RRSP has provided you with a tax-free rate of return on the investment income earned therein, mathematically equivalent to saving in a TFSA. If your tax rate is lower in the year of withdrawal than it was when you contributed (and claimed that deduction), you’ll be even further ahead. But what if you die with a significant RRSP or RRIF — how does the tax work?
A technical interpretation from the Canada Revenue Agency released this week sheds some light on the somewhat complex tax rules that arise when someone dies owning a RRIF and what can happen if action isn’t taken fast enough after death. But before reviewing the CRA’s comments, let’s go over the basics.
Under the Income Tax Act, fair market value (FMV) of your RRSP or RRIF as of the date of death must be included in income on your terminal tax return for the year of death, with tax payable at your marginal tax rate for the year.
There are exceptions, however, which may allow a tax-deferred rollover to certain beneficiaries. The income inclusion can be removed from your terminal return and possibly deferred if the RRSP or RRIF is left to your surviving spouse or common-law partner. If certain steps are taken within certain time limits, including that your spouse or partner receives the proceeds and puts them into their own RRSP (if 71 or under) or RRIF, the potentially large tax hit on death can be deferred, and tax will be payable by your surviving spouse or partner at their marginal tax rate in the year in which funds are withdrawn from their RRSP or RRIF.Alternatively, an RRSP or RRIF may be left to your financially dependent child or grandchild and used to purchase a registered annuity that must end by the time your (grand)child reaches age 18.
The benefit of doing this is to spread the tax on the RRSP or RRIF proceeds over several years, allowing the (grand)child to take advantage of personal tax credits as well as graduated marginal tax rates each year until they reach the age of 18.
If the financially dependent grandchild or child (of any age) was dependent on you because of physical or mental disability, then the RRSP or RRIF proceeds can instead be rolled to their own RRSP and effectively only taxed when withdrawn.
While these tax-deferred rollover options may be available whether you designate eligible family members as beneficiaries in your will or in the RRSP or RRIF contract, using a direct beneficiary designation on the RRSP or RRIF itself may avoid provincial probate fees (where applicable).
When dealing with an estate, it’s important to understand the rules, otherwise an opportunity for tax savings may be missed, as was the case in a scenario discussed in the recent CRA technical interpretation letter.
The CRA was asked for its views on the tax consequences arising from the death of a RRIF annuitant where the sole beneficiary under the RRIF, their spouse, died before having received the RRIF proceeds. The RRIF annuitant died in 2018, the surviving spouse died in 2019, and the RRIF proceeds weren’t distributed to the spouse’s estate until 2020.
The person asking the question of the CRA wanted to know who was responsible for paying the income tax on the FMV of the RRIF as of the date of death and on the subsequent appreciation in value of the RRIF from the date of death to the date the proceeds were paid to the surviving spouse’s estate.
The CRA confirmed the general rule that when the annuitant of a RRIF dies, they are deemed to have received, immediately before death, an amount equal to the FMV of the RRIF at the time of death, which is included in their income on their terminal tax return for the year of death. This income inclusion may be reduced, however, if the RRIF proceeds are paid to a “qualifying survivor,” being the spouse, common-law partner or qualifying (grand)child, as discussed above. This is known as a “designated benefit” and is included in the income of the qualifying survivor, rather than the deceased, which may be tax advantageous depending on what other income the deceased had in the year of death. Most importantly, however, the CRA noted that the qualifying survivor must be alive at the time the amount is paid.
In the example above, since the RRIF proceeds were paid out after the surviving spouse’s death, the payment cannot be considered a designated benefit, meaning that the FMV of the RRIF at the time of the annuitant’s death had to be included in their terminal tax return for 2018. It could not be included in the spouse’s estate. Only the amount equal to the increase in value of the RRIF between the date of the annuitant’s death and the date the property was distributed to the spouse’s estate in 2020 would be included in income for the spouse’s estate.
While we don’t know all the facts of this specific case, presumably this result may not have been ideal as there was no opportunity to have the date of death value of the RRIF, or at least some of it, potentially taxed in the hands of the surviving spouse, versus in the deceased’s terminal return.
Jamie Golombek, CPA, CA, CFP, CLU, TEP is the Managing Director, Tax & Estate Planning with CIBC Private Wealth Management in Toronto.