Who pays the tax on mom’s RRIF at death?

Sibling stressors, legal rules, moral dilemmas

Some of the largest dollar value estate planning decisions we make are the naming of beneficiaries on registered plans.

With this in place, the plan proceeds will go directly to the named beneficiary/ies, rather than falling into the estate of the deceased. This bypasses exposure to estate creditors and probate tax, and reduces any delays obtaining the net funds if they had to pass through the estate.

But while making a beneficiary designation on a RRSP/RRIF may streamline both time and cost of distribution, the tax result could present an unexpected dilemma for the recipients.

Why is there tax on registered plans at death?

A registered retirement income fund (RRIF) is the payout form of what originated as a registered retirement savings plan (RRSP). Together they are legally-authorized income deferral arrangements. When a person dies, there is no more future deferral time, so the arrangement is generally terminated and the remaining balance taxed.

The main exception is a tax-deferred rollover to a spouse (or possibly to a dependent child), but otherwise the account value is brought into the deceased’s income in the terminal year.

Who is responsible for paying the tax?

Absent a rollover, and assuming for the moment no named beneficiary, a deceased’s RRSP or RRIF will be paid to the estate.

It is the executor’s job to deal with the deceased’s debts, with tax liabilities and creditors being top of the list. The registered plan proceeds are applied to those obligations, including paying the tax associated with the terminal income inclusion. After the tax obligation and creditors have been satisfied, the net remaining funds can then be distributed to estate beneficiaries along with other estate assets.

Does a beneficiary designation avoid income tax?

If the deceased had named a beneficiary on the plan, the gross proceeds would be paid in accordance with that designation. However, despite that no money flowed into the estate, the value of the RRSP or RRIF would still have been included in the deceased’s terminal year income, the tax on which remains the estate’s responsibility.

But who actually bears the tax?

If the estate has insufficient assets to pay tax, the Canada Revenue Agency (CRA) can force plan beneficiaries to pay a proportionate share of the deceased’s tax on the amount each received. Otherwise with a solvent estate, if the RRSP/RRIF beneficiary/ies and the residual estate beneficiary/ies are different, then the latter effectively bear the tax on the former’s RRSP/RRIF receipt. Notably, this Income Tax Act rule only applies to CRA; other estate creditors cannot pursue registered plan beneficiaries if there are insufficient estate assets to meet the deceased’s debts.

Is it the same for beneficiaries of registered pension plans?

When a named beneficiary of a registered pension plan (RPP) is entitled to a lump sum payment on death of the plan annuitant, the plan administrator withholds tax at source, and pays the net amount to the beneficiary. The administrator then issues a T4A slip to the beneficiary indicating the gross amount and the withheld tax, which the beneficiary then uses to report the income in the year of receipt. The withheld amount may be more or less than the actual tax due on the lump sum, which will either increase or reduce the recipient/beneficiary’s ultimate tax bill.

In sum, both the payment and tax liability land with the beneficiary on a lump sum RPP payment.

What did mom know, and what did she want? – Jeffrey’s dilemma

Jeffrey and his brother were named as beneficiaries of their mom’s RRIF, while they and their sister were the three estate beneficiaries. It was openly known that mom intended the brothers to get the RRIF, but it was unclear if she was aware of the tax rules.

While everyone got along fine, the sister could potentially have questioned mom’s knowledge and intention at the time of making the beneficiary designation. Whether that would be successful before a judge would depend on the facts and available evidence, but it would be certain to hurt family relations and cost money if they were to end up in court together.

The brothers, who were also the executors, looked into whether there was an accepted practice in such cases. Ultimately, it came down to a moral decision, and they decided that they two would bear the tax.

In all, it’s a reminder that even apparently simple decisions could have unexpected effects. While it’s impractical for you to have each RRSP or RRIF designation legally reviewed as made, the topic should be on the agenda next time you’re with your estate planning lawyer, to be sure all beneficiary designations properly reflect your intentions and expectations.

Commuting a registered pension plan

The why, when and how to your decision

Whether you are headed into retirement or changing jobs at an earlier stage of your life, one of the largest financial decisions you face when you leave an employer is what to do with your retirement savings.

If you have been saving in your own registered retirement savings plan (RRSP), there’s not much more to say as it already belongs to you. Even when it is a group RRSP arranged through your workplace, generally the accumulated amount is yours to keep, though you’ll likely have to transfer to other investment choices.

If instead your work has a registered pension plan (RPP), there’s more involved.

Distinguishing registered pension plan types

You may be allowed to stay in your employer’s RPP, move to a new employer’s plan, or transfer into a locked-in retirement account. Depending on the type of RPP, that last option can be relatively straightforward, or it can be a multi-part process to arrive at the pension value, including potential immediate tax fallout.

Pensions come in two main varieties: defined contribution (DC) plans and defined benefit (DB) plans. Some plans are hybrid arrangements that have elements of both.

Defined contribution plans

Under a DC plan (also called a ‘money purchase plan’), the employer’s obligation is the amount to be contributed.

The employer as the pension sponsor must contribute a certain amount to the plan each year. Sometimes there may also be employee contributions. You will be able to choose among the investment options within the plan, with all income and growth tax-sheltered. The accumulated value is what is available to provide your retirement pension, which by default is paid as an annual annuity.

If you leave prior to retirement, the plan may be transferred dollar-for-dollar into a locked-in retirement account, where your investments may continue to grow tax-sheltered. The main feature of being ‘locked-in’ is that there is a maximum amount you can draw from it each year, which is intended to limit depletion so that it is sustainable through your retirement years.

Defined benefit plans

By contrast, under a DB plan the employer’s obligation is the pension benefit to be paid in future.

The employer must provide a retirement pension as determined by a formula. An actuary calculates the employer’s required contributions, based on the number of plan members and their respective rights. Those contribution amounts are adjusted from time to time according to past investment experience and future economic expectations.

You will be entitled to a retirement pension according to a formula in the plan (more on that below). If you leave before retirement and want to take your funds with you, once again an actuary is needed to determine the value. That’s where the complications really set in.

The remainder of this article focuses on commutation of a DB plan, first in terms of valuation and tax effects, and then on to how to approach this decision based on your particular needs.

Between you & your employer: Gross commuted value

A DB plan annual retirement pension is determined by multiplying a base income times a credit rate times years of employment. The base income and credit rate are negotiated between employer and employees. The base could be (for example) the average of your last five years of employment income, or better yet your best three years’ income. The credit rate generally ranges from 1% to 2% per year of employment.

If you leave prior to retirement, an actuary has to determine the value of your entitlement in the accumulating pension fund. On the face of it, it’s that annual pension discussed above multiplied by a present value (PV) factor. The PV factor is essentially an interest rate, but one requiring numerous inputs to derive, the main ones being current age, assumed commencement date (less any reduction for starting early), continuation provisions (e.g., to spouse), any guarantee period and any annual indexation.

The result is the lump sum current amount that would be required to pay the projected annual pension to you over your expected lifetime. For the sake of the calculation, it is assumed that the lump sum will be invested at long-term interest rates. Accordingly, commuted values tend to be higher when prevailing interest rates are low, and lower when interest rates are high.

Between you & the CRA: Maximum tax-free transfer to a locked-in plan

The commuted value from the actuary’s report should not be confused with the amount that can be transferred into a locked-in retirement account.

In structure, the tax rule is similar to the commuted value calculation above. In tax terms, it multiplies your “lifetime retirement benefits” by a PV factor. In this case though, the PV factor is less generous than the commuted-value PV factor outlined above. For example, it doesn’t account for any indexing or early retirement benefits. As a result, the tax transfer value is often less than the commuted pension value. In a sense (though not literally), you might think of the tax calculation as what you would have accumulated under the RRSP rules, and therefore that’s the amount that you are allowed to transfer into a locked-in retirement account.

The excess amount will be taxable in the current year. While this is obviously not a pleasant prospect, it is applying tax to the more generous terms of the DB RPP, but you still get to keep the after-tax amount. The impact of this may be deferred if you have unused RRSP contribution room and choose to make a corresponding contribution.

Considerations before deciding to commute

Apart from the value of the commuted plan and tax transfer, here are some surrounding issues to review before committing to a course of action:

1. Investment of the commuted value may ultimately deliver a larger retirement income, but this should be balanced against downside investment risk. Some people like to make investment decisions, while others shy away. A conversation with your financial advisor can help you decide.
2. Are you comfortable leaving behind indexing and guarantees that may have been part of the original pension?
3. Do you want to be able to adjust income from year to year, or ever make a lump-sum withdrawal? As locked-in plans put a cap on annual withdrawals, a commuted pension may be needed for this kind of flexibility.
4. Some pension plans allow continued health and dental coverage (at least for some period of time), which can relieve your budgetary costs in retirement.
5. On the other hand, if you have health concerns that may affect your life expectancy, you may prefer to take the commuted pension as a sure thing to be able to pass on the remaining value to your beneficiaries, especially if you have no spouse.
6. Spousal pension income splitting is available under age 65 from a registered pension plan, but generally only from age 65 for an individual life income fund. Does this affect your income plans?
7. Beyond a spouse, you may wish to leave a legacy to family or charity. Managing a commuted pension amount may provide an avenue for that kind of planning.

Corporate investment portfolios – Opportunities and obstacles

Informing your returns by understanding passive tax rules

The taxation of passive income in corporations is a very complex topic. The intention here is to provide a general overview to help you discuss with your accountant and your investment advisor how this may apply in your circumstances.

As the owner of a corporation, you know your active business income is taxed at a rate that is usually well below your personal rate. Presumably, that’s part of the reason you are using a corporation in the first place.

Top personal tax rates are near or beyond the 50% mark, but general corporate rates are in the area of 26% to 31%, and small business corporate rates (on active business income up to $500,000 in most provinces) range from 9% to 15%. The variance depends on the provincial rates where a corporation is resident, with federal rates being consistent across the country.

Is passive income tax-preferred in a corporation?

In a single word, the answer is “no”, but it’s much more complicated than that.

For active business income, those lower corporate rates allow more after-tax cash to be reinvested in a business that is run through a corporation. The public policy purpose is to help businesses grow.

However, those low rates do not extend to non-business income earned in a portfolio – known as passive income – such as interest, dividends (Canadian or foreign) and capital gains. So, if passive income isn’t entitled to reduced tax rates, why invest in a portfolio within a corporation?

There’s more investible money if it stays in the corporation

When you use a corporation, income tax is charged first at the corporate level, with the net-of-tax amount added to the corporation’s retained earnings. Those retained earnings are eventually distributed as taxable dividends to shareholders. To protect taxpayers from double-taxation, the arithmetic is designed so that a shareholder’s personal tax on a dividend is reduced by the amount that the corporation has already paid.

Note though that a corporation is not required to immediately distribute its retained earnings. Apart from reinvesting in the business as noted above, those funds could go into a passive investment portfolio. As compared to paying a dividend (reduced by the associated tax) and investing in a personal portfolio, there will be more dollars to invest if the portfolio is at the corporate level.

But … the public policy response

As more can be invested at the corporate level, proportionately more passive income could be earned there. While this is understandably appealing to a shareholder and corporation, from the policymaker’s perspective it is an unintended consequence of this two-stage system: The use of the corporation as a more efficient form for business growth has arguably led to an extra benefit for earning passive income.

Emulating top personal tax rates

In response, additional corporate tax is imposed, making it less appealing to invest corporately. The additional tax takes the corporation approximately to the top personal tax bracket rate. Much of that extra tax is refunded to the corporation (see RDTOH following) when later dividends are paid – but not necessarily all of it. Again, it varies by province, and also by the type of income earned. For example, the combined corporate and personal tax can be 4% to 8% higher on interest earned through a corporation, as compared to earning interest in a personal portfolio.

The (intended) equalizer: Refundable-dividend-tax-on-hand

Historically, that extra tax has been tracked in the corporation’s refundable dividend tax on hand (RDTOH) account. In truth there are two RDTOH accounts, depending on whether the original income was charged the general corporate rate or the small business rate, but for simplicity in this article we’ll refer to it in the singular. Either way, RDTOH is effectively a deposit with the Canada Revenue Agency (CRA) that earns no income. Most taxpayers aren’t so generous to make such interest-free loans to the CRA, and that’s why it’s usually a priority to get that money back – refunded – so that it can be put back to work in the corporation, whether that’s as a business reinvestment or an addition to a passive portfolio.

When a taxable dividend is paid to a shareholder, a portion of the RDTOH balance is refunded to the corporation. The current refundable rate for present purposes is 38 1/3%, but a simpler way to express it (as a rough estimate) is that for every $5 dividend paid from the corporation to a shareholder, about $2 comes back to the corporation from its RDTOH.

Previously, any taxable dividend could recover refundable tax. As of 2019, refunds are generally only paid on dividends where the original corporate income was charged the small business rate (non-eligible dividends) or where it arises out of the corporation’s passive investment income.

Reduction in small business deduction threshold

A further implication of earning passive corporate income is the potential reduction in how much active business income (ABI) is entitled to the small business deduction (SBD) or rate. The SBD is available on income up to $500,000, but for every $1 of annual passive income, that threshold is reduced by $5. That means that if passive income exceeds $150,000 in a year, all active business income will be charged the general corporate rate.

What’s a shareholder to do?

As much of a challenge as all this presents, all is not lost for corporations and their shareholders.

First, your corporation pays no tax on Canadian dividends that are passed through to you as shareholder. Those dividends maintain their preferred tax treatment, the same as if the security had been in a personal portfolio. And as more dollars are available to be invested at the corporate portfolio level, as discussed above, more of those Canadian dividends can be generated.

Second, a corporate portfolio that grows through unrealized capital gains defers income realization. This in turn delays application of the passive rules. Ideally the portfolio would remain intact until there is a personal need for the funds. By cashing out the investment at the same time as an intended dividend, there will be minimal, if any, inefficient refundable tax balance.

Third, only a portion of capital gains are taxable, with the non-taxed portion able to be paid as a tax-free dividend. The current income inclusion rate is 1/2, with the corollary that the non-taxed portion is also 1/2.

And finally, a shareholder is likely to be at a lower tax bracket in later years. By consciously leaving an appropriate amount in a corporate portfolio, tax can be both deferred and reduced.

As always, tax should not be the primary consideration when investing. It can however have an especially large impact when income is originally earned in a corporation. With awareness of the passive tax rules, you can have a more informed conversation with your accountant and your investment advisor about how to manage your corporate portfolio.