Please note: This article is not applicable in Quebec.
Do you have a Registered Retirement Savings Plans (RRSP) or a Registered
Retirement Income Funds (RRIF)? Designating a beneficiary to your RRSP or RRIF is often presented as sound financial planning, since doing so can avoid probate and probate fees. However, a direct beneficiary designation can result in some negative consequences such as inequitable treatment of heirs, unintended elimination of heirs and unexpected tax consequences to the designated beneficiary.
Taxation at death
If you designated a beneficiary to your RRSP or RRIF with your financial institution, then the entire value of the RRSP or RRIF will be paid directly to your designated beneficiary, with no withholding for tax. However, when you die, you will be deemed to have disposed of all your assets immediately before your death, which means that the full value of your registered investments will be included in your tax return in the year of death. Regardless of who you designate as your beneficiary, your estate will be responsible for paying any resulting tax liability.
However, if your estate does not have sufficient funds to cover the taxes owing, the Canada Revenue Agency (CRA) can collect the taxes owing from your RRSP or RRIF beneficiary. If your beneficiary is unaware of this potential tax liability, he or she could be in for an unpleasant surprise when a tax bill arrives. As the settlement of the estate can take some time, there have been cases in which the beneficiary has already spent the inheritance before being notified of
the tax liability.
If your RRSP or RRIF is paid to a “qualified beneficiary”, then the tax can be deferred if your beneficiary chooses to transfer the funds to another registered investment. A “qualified beneficiary” can be either your spouse or common-law partner or your financially dependent child or grandchild.
Inequitable treatment of heirs due to taxation
Because your estate is initially responsible for the tax liability on your RRSPs and RRIFs, designating a beneficiary could result in the inequitable treatment of your heirs.
Example:
Alice was a resident of Ontario, and had three children (Sam, Jamie, and Susan) and no surviving spouse. She wanted each child to inherit an equal portion of her assets.
When Alice died, her assets were comprised of $400,000 of non-registered assets with a $200,000 capital gain and a $200,000 RRSP. Alice made Sam the direct beneficiary of the RRSP, and her will divided the rest of her estate (the non-registered assets) equally between Jamie and Susan.
Alice thought that this would leave each child with an equal portion of her assets. What Alice did not take into account was the fact that there would be no withholding tax on the payment of the RRSPs assets to Sam, and her estate would be responsible for paying the income tax on the RRSP and the capital gain from the non-registered investments, as well as any probate fees.
Alice’s executor will have to add $300,000 of income to Alice’s terminal tax return – i.e. $200,000 of income from her RRSP and $100,000 of income from the taxable capital gain on the non-registered investment. Assuming a marginal tax rate of 46%, the taxes owing would be $138,000. In addition, Ontario probate fees on her $400,000 investment would come to at least $5,500. Thus, between them James and Susan will only have $256,500 to split, or $128,250 each, while Sam has an inheritance of $200,000.
Planning for a blended family
Do you have a “blended family”? Would you like to provide an income for your surviving spouse for the remainder of your spouse’s lifetime, but ensure that any remaining capital goes to your children, and not your spouse’s family? If that’s what you want to do, then you should not designate your spouse as the direct beneficiary of your RRSP or RRIF, but pay the RRSP or RRIF to your estate.
If your spouse inherits by direct beneficiary designation, then you lose the ability to impose any “strings” on that inheritance. You can instead indicate in your will that the RRSP or RRIF is to be payable to a trust for your spouse – but recognise that any “rollover” will be lost in that case, and taxes will be owing when you die.
Alternatively, you could use life insurance or other assets to provide your children with an inheritance and leave the RRSP or RRIF to your spouse, or you can indicate that your spouse will inherit the value of the RRSP or RRIF, but on condition that he or she will transfer the amounts to another registered investment so that the estate is not liable for any taxes in respect of the RRSP or RRIF. If your spouse chooses to take a payment in cash from the estate, then you can direct your executor to only pay the after-tax value of the RRSP or RRIF to your spouse.
Locked-in plans
Do you have a locked-in plan (including a LIRA, LIF, LRIF, or PRIF)? Your ability to name a beneficiary on a locked-in plan is restricted by the pension legislation that governs the plan. If you are the annuitant of a locked-in plan and you have a “spouse” as defined in the particular pension legislation at the time of your death, your “spouse” will almost always be automatically entitled to the proceeds of the plan.
Your “spouse” can waive his or her right to the death benefits from a locked-in plan in Alberta, British Columbia, Newfoundland and Labrador, Ontario, Quebec and Saskatchewan, allowing you to designate a non-spouse beneficiary, but your spouse can also revoke his or her waiver at any time prior to your death.
Example:
Ken is divorced, has an adult child (Kate) and lives in British Columbia. He has a locked-in plan subject to British Columbia pension legislation, and designates Kate as his beneficiary. Ten years later, Ken gets married to Gail, and 2 weeks after that, Ken dies. Gail did not sign a prescribed waiver form, so the proceeds of the locked-in plan will be paid to Gail, even if Ken might have preferred to have them paid to Kate. Because Ken had assumed that Kate would receive his locked-in plan, he did not make alternate provisions for her in his will.
Summary
In some cases, it may be appropriate for you to designate a beneficiary on your RRSP or RRIF, but there are many cases when you might prefer to have your RRSP or RRIF payable to your estate and distributed in accordance with the terms of your will. While probate avoidance could result in some savings, it can also create many problems and potentially strained relations amongst your heirs. Be very careful before making a direct beneficiary designation on your RRSP or RRIF. For further information and advice, please contact your Investors Group Consultant.
Written by Mohamad Sawwaf, CFP, CPCA
Financial Consultant and Division Director
IGM Financial Inc.
He can be reached at Mohamad.Sawwaf@investorsgroup.com.
Please note: this article is not a substitute for legal advice. This article only provides general information which you may find helpful. You may wish to consult with a qualified professional financial or legal advisor, as appropriate.