Plan Ahead: Will Your Estate Be Subject to a High Marginal Tax Rate?

When we reach retirement, it is common for many individuals to have a marginal tax rate that is lower than during their prime working years. However, at death, this may change substantially. This is because our property is deemed to have been disposed of at fair market value at death and subject to taxation. In some cases, individuals will join the top one percent of taxpayers as the estate will be subject to a high marginal tax rate.

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For couples, the taxes that are incurred on death may be deferred by using the spousal rollover — the transfer of certain registered funds (such as the Registered Retirement Savings Plan (RRSP) and Registered Retirement Income Fund (RRIF)) and/or capital property to the spouse (common-law partner) upon the death of the other. With this transfer, there will be no immediate tax consequences to the surviving spouse. However, once the surviving spouse passes away, the transfer of these assets may result in the estate being subject to the highest marginal tax rate, potentially leaving a tax bill that may significantly reduce the value of an estate.

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As many of us wish to pass along as much of our hard-earned wealth to our beneficiaries, are there ways to better plan for the eventual tax liability?

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Here are three considerations that may require forward planning:

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The RRSP exit strategy. While postponing withdrawals from the RRSP until retirement by using the RRIF takes advantage of the tax-deferral opportunities, waiting too long to draw down significant savings may have consequences. If you have other taxable income streams in retirement, you may be pushed into a higher marginal tax bracket. This may also result in a clawback of OAS benefits. As you approach retirement, and if you are in a lower marginal tax bracket, it may make sense to slowly draw down RRSP/RRIF funds. If you aren’t in need of these funds, a potential opportunity may be to use these withdrawals to fund a Tax-Free Savings Account to benefit from the future growth opportunity of the investments, as well as their eventual tax-free withdrawal.

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Converting a portion of the RRSP to fund insurance. Often, for high-net-worth investors who have contributed significantly to their RRSPs over their working years, there will still be funds available within the RRIF accounts at death. A partial drawdown to fund insurance can help to minimize the overall lifetime tax bill, especially when withdrawals occur in years in which the marginal tax rate is not at its highest. Funding a life insurance policy may be a way to provide an inheritance on a tax-free basis to the beneficiary(ies). Joint last-to-die life insurance is commonly used for this purpose by spouses, as insurance proceeds are paid out only upon the death of the surviving spouse.

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Electing to not use the spousal rollover. There may be reasons to elect out of a spousal rollover for certain assets upon the death of the first spouse when there are opportunities to offset the potential tax liability. This can be done on a property-by-property basis. One common reason may be to use the deceased taxpayer’s lifetime capital gains exemption. It may also make sense when the deceased’s marginal tax rate is low on the date-of-death return. Finally, the first spouse may have unused capital losses carried forward that can be used to offset the resulting capital gains. A tax professional can help explore the options.

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Seek Assistance. These are just some of the potential tax-planning opportunities to consider as you plan ahead. Please seek the advice of a tax planning professional as it relates to your particular situation.