SWPs – Systematic withdrawal plans

Tax treatment of non-registered account decumulation

During accumulation, investors enjoy a tax deferral when the price of their holdings increases. In tax terms, this is known as an unrealized capital gain, and works whether securities are held directly or within a mutual fund. In this article, we’ll use mutual fund examples and terminology.

Later, if the money is not needed all at once, it will usually be taken as a series of annual draws, known as a systematic withdrawal plan (SWP). This spreads the tax by allowing continuing deferral on the remaining investment.

Tax deferral with unrealized capital gains

In registered accounts such as Registered Retirement Savings Plans (RRSPs) and Registered Retirement Income Funds (RRIFs), investors are entitled to tax-sheltered growth regardless of the type of income that is earned. There is also no tax as the investment value varies, but when withdrawals are taken, each dollar is fully taxable.

For non-registered accounts, interest and dividends are taxable in the year earned, as are capital gains that a mutual fund realizes and distributes to investors. Changes in the price of underlying securities will cause a mutual fund’s value to change, but no tax arises out of such fluctuations. But when there is a redemption/sale of the fund by the investor, that is a taxable event. And if the fund’s value has increased in the interim then the investor will realize a capital gain at that time. That capital gain is equal to the fund’s fair market value (FMV) minus the investor’s adjusted cost (ACB), the latter being discussed in greater detail under the next heading.

Fortunately, only a portion of the capital gain is taxable. The “taxable capital gain” is derived by applying what is known as the income inclusion rate. That rate has ranged between 1/2 and 3/4 since 1971, but has remained stable at 1/2 since 2000. Now, in accordance with the 2024 Budget, the rate has again risen to 2/3, but the 1/2 rate remains available for individuals on the first $250,000 of capital gains in any year. (For trusts and corporations, the 2/3 rate applies to all capital gains.) The 1/2 rate is used in the examples to follow, on the assumption that the investor is an individual with less than $250,000 of annual capital gains.

Adjusted cost base

An investor’s ACB begins with the amount invested, averaged across multiple purchases. For example, if one mutual fund unit was purchased last year for $4, and one unit this year for $6, the total ACB is $10, which works out to $5 average per unit. The total value as of the second purchase is $12, including an unrealized capital gain of $2.

The “adjusted” part of ACB includes such things as acquisition costs on each transaction, and income that is not distributed but instead reinvested. Notably, the investor is still taxed on reinvested income as if it had been distributed, with the ACB increase ensuring that the investor is not taxed a second time on a later disposition.

Redemption, portion, proportion

As a capital gain is an addition to invested capital, you could think of it as a chocolate-dipped soft ice cream cone. When it comes time to consume it, you could be taxed as if you licked off all the chocolate first (that’s the added portion), or each bite could be treated as some ice cream and some chocolate.

Eating preferences aside, it is the latter biting version that more closely resembles a mutual fund redemption. Each redemption has two portions: ice cream in the form of a non-taxable return of capital (ROC), and chocolate dip that is treated as a realized capital gain. The proportion of each on a given redemption is based on the size of the redemption in relation to the ACB and the current market value. This is best illustrated by looking at a few scenarios.

SWP scenarios

Suppose you inherit $100,000 from a great aunt and decide to use it to supplement your monthly income by $500, or $6,000 annually. You choose a mutual fund you expect to earn a consistent 6% annual return, all in unrealized capital gains. To keep the focus on the SWP effect, we’ll simplify the arithmetic by having you take your withdrawal at year-end rather than monthly. Your marginal tax rate is 40%.

Scenario 1 – Equal withdrawals, maintaining principal

In this first scenario you intend on preserving that $100,000 for your children, so you’ll take withdrawals equal to the investment return. Here’s what it looks like in the first year, with figures rounded to the nearest dollar:

After that first-year withdrawal, the ACB is reduced to $94,340 to account for the $5,660 ROC, but you still have $100,000 invested. The second year’s withdrawal will net to $5,868, for an effective tax rate of 2.2%. It will take over 100 years for the effective tax rate to round to the actual 20.0% rate on taxable capital gains.

Though you will have maintained the principal amount invested, the continuing reduction in the ACB means that an increasing portion of your investment will be taxable. If you never sell, there will still be a deemed disposition at your death (though this could be deferred by rolling it at ACB to your spouse), before passing on to your children as desired.

Scenario 2 – Equal spendable withdrawals, depleting principal

Instead of allowing the net withdrawal to be reduced each year, you may prefer to have a consistent after-tax spendable amount. If you want $6,000 in your hands, you would need to withdraw/redeem more than that in order to account for taxes. That would only be another $69 in year 1, but the extra amount would increase each year.

While this slowly depletes the principal, even at year 25 you will still have about $70,000 invested.

Scenario 3 – Indexed withdrawals, eventually exhausting principal

As the years roll on, the flat amount of withdrawals under either of the preceding scenarios will lose purchasing power due to inflation. Rather than passing on the principal to your children, your priority may be to use this money to take care of your own living expenses. To do so, you could index the withdrawals each year.

The current inflation rate recommended in the 2024 FP Canada Projection Assumption Guidelines is 2.1%. At that rate, you could sustain an indexed $6,000 spendable withdrawal from $100,000 of principal for about 25 years.

US estate tax & estate returns – For Canadians

Exposure when owning American property at death

As Canadians, we may expect (though not look forward to) tax being imposed on us by our government at death. In particular, the value of tax-sheltered retirement accounts is brought into income at death, as are the capital gains on the deemed disposition of capital assets – both of which may be deferred by transfer/rollover to a spouse or common law partner (CLP).

For those owning property in the United States at death – ranging from real estate to financial assets to personal belongings – there may be US Estate Tax due (capitalized in this article to distinguish from generic tax references), and US estate filing obligations even if no such tax is owed. The tax is based on gross value, not just the capital gain that Canada targets, and even when there is a rollover to a Canadian spouse/CLP. As well, US financial assets are counted whether in non-registered form or in tax-sheltered accounts like RRSP/RRIFs and TFSAs.

Whether you are pre-planning against your own future exposure, or acting post-mortem as an executor, professional advice is imperative in this extremely complex area. This article outlines the key terms and major steps involved, to help prepare for that professional engagement.

Who is exposed to the Estate Tax?

This article focuses on the tax and estate implications for Canadians who own US property at death, with emphasis on the Estate Tax. To lay the groundwork, we begin with an overview of how that regime applies to Americans domestically, paving the way for the discussion of its application to Canadians that follows.

US citizens and domicilliaries

The Estate Tax applies to the worldwide estate at death of US citizens wherever they may be living, and of
non-citizens domiciled in the US. Domicile is like residence, though technically based on a person’s country ties.

If the fair market value (FMV) of a deceased’s worldwide estate exceeds the year’s asset exclusion amount – US$13.16 million in 2024 – tax may be due on the amount over that threshold. Historical exclusion amounts are shown in Table 1 on the last page of this article. Though the table shows increasing amounts year-to-year, it is slated to return to its pre-2018 indexation formula in 2026 (roughly halved to about US$7 million), absent further legislative changes.

Credits and deductions are then applied to reduce this preliminary figure to the amount upon which the tax is calculated, applying graduated rates ranging from 18% to 40% as shown in Table 2 on the last page of this article.

In addition, the US has a gift tax and generation-skipping transfer tax (GSTT). The gift tax applies to lifetime transfers above an annual exclusion amount per donee, currently US$18,000 in 2024. The GSTT limits transfers to beneficiaries at least two generations younger than the donor/giver. Without getting into the arithmetic, to the extent that the gift tax and/or GSTT apply during lifetime, this can erode the asset exclusion amount for the Estate Tax.

One important note before continuing: Though the rules and figures are expressed on an individual basis, there are plenty of ways to defer, deduct and double-up when planning with a spouse. Professional advice is recommended.

US non-residents, including Canadians

Relevant to this article, the Estate Tax can also apply to a deceased Canadian who is a non-resident of the US, if:

1. FMV of the deceased’s US-situs assets (detailed following) exceeds US$60,000, and
2. FMV of the deceased’s worldwide estate exceeds the current year’s exclusion, again US$13.16 million in 2024.

However, whereas US citizens and domiciliaries pay based on the full FMV above the exclusion, the calculation for a non-resident Canadian is a proration of US-situs assets to the worldwide estate (again, above the exclusion).

Threshold and deadlines for filing a US estate return, and paying Estate Tax

The executor of a deceased Canadian must be careful not to confuse the test for the Estate Tax with the test for the requirement to file a US estate return. If a deceased Canadian owned US-situs assets in excess of US$60,000 at death, an estate return must be filed with the US Internal Revenue Service (IRS), regardless of the size of the estate. Generally, the executor must include a certified copy of the Will or court order when filing.

The IRS clearance certificate facilitates the executor’s ability to deal with estate assets. Without that proof, financial institutions may refuse to take instructions from the executor, and US real estate transfer agents may be unwilling to register an intended transaction. As well, the estate’s reporting provides the tax cost basis for heirs’ future real estate dealings, without which they may face higher tax on a later sale, or may not be able to sell the property at all.

Important deadlines for executors:

- A US estate return is due within nine months of death, along with payment of the Estate Tax. A six-month filing extension is generally granted if application is made before the due date.
- Extension of the Estate Tax payment due date is distinct from an estate return extension. Executors must be aware that while this will avoid late payment penalties, interest will accrue from the original due date.

Categorizing assets

US-situs assets

The IRS defines “situs” as “The place to which, for purposes of legal jurisdiction or taxation, a property belongs.” Though a non-exhaustive list, here are some examples of the most common US-situs assets, also phrased as “US-situated assets” in some IRS publications:

- Real estate (including time-shares), generally being the full value even if held jointly with right of survivorship
- Tangible personal property (furnishings, vehicles, boats, art, collectibles) owned and located in the US
- Shares of US corporations (public or private), even in a Canadian brokerage account or registered account
- Bonds and debt issued/owing from a US individual, corporation or government
- US retirement plans, common types being 401K and 403B plans, and individual retirement accounts (IRAs)
- Contents of a safety deposit box in the US, including cash, regardless of currency/country of denomination
- US property held in a trust if the deceased had power of appointment, including an alter ego or joint partner trust

NOT US-situs assets

Some financial assets may have US elements, but due to their underlying structure or the way that ownership is held, they are not considered to be US-situs assets. Some examples, again non-exhaustive:

- US securities in a Canadian mutual fund trust or corporation, segregated fund or exchange-traded fund (ETF)
- Personal property that is merely in-transit, for example jewellery worn by a Canadian who dies while travelling
- US marketable securities or investment real estate held in a Canadian corporation, noting however that vacation property may come under IRS scrutiny for avoidance, especially if it is the corporation’s only asset
- American depository receipts (ADRs), as they do not hold US securities
- Deposits in a US bank account (but not US brokerage account), as long as it’s not part of a US business activity
- Excepted US government and corporate bonds under the “portfolio interest exemption”
- US-denominated bonds of a Canadian issuer providing US exposure without holding US securities
- Life insurance on a Canadian who is a US non-citizen/non-resident

Worldwide estate

A deceased’s worldwide estate is determined according to US rules, whether the property is in the US, Canada or elsewhere. This may include assets of significant value, about which careful decisions and actions may have been taken to alleviate or circumvent Canadian income tax or provincial succession issues, but which nonetheless remain countable for the Estate Tax, including:

- Canadian registered plans, including RESPs, RDSPs, TFSAs, RRSPs, RRIFs, and survivor pension benefits
- Life insurance owned by the deceased (or sometimes a deceased’s corporation), even with a named beneficiary
- FMV of private corporation shares, after payment of a death benefit from corporate-owned life insurance
- Gross value of real estate and non-registered accounts, even when held jointly with right of survivorship
  (with limited exception if the survivor is a spouse with a proven contribution to the asset acquisition)
- Property in a trust considered to be a US grantor trust, likely capturing a Canadian alter ego or joint partner trust

Tax calculation

Once it is determined that a deceased Canadian meets the threshold of both US-situs assets and worldwide estate, attention may turn to calculating the tax liability. The calculation begins with the gross value of the US-situs assets.

Deductions

A variety of deductions and credits may be taken, most of which must be prorated based on the proportion of US-situs assets to worldwide assets. The main deductions are:

- Funeral and estate administration expenses
- Liabilities of the deceased at or as a result of death, including foreign (i.e., Canadian) income tax
- Death taxes paid to a US state
- Charitable donations (generally must be made to a US entity, with payment made in the US)
- Non-recourse debt on US property (i.e., lender’s claim is limited to the pledged asset) – Fully deductible.

Taxable estate

The deductions are applied against the gross US-situs assets to arrive at the taxable estate. This figure is then used to calculate the preliminary Estate Tax amount by applying the graduated rates in Table 2.

Unified credit

Any deceased who is a non-resident and non-citizen of the US may apply the unified credit against the calculated preliminary Estate Tax. The minimum unified credit is US$13,000, which is equivalent to the Estate Tax on an estate of exactly US$60,000, as can be verified by viewing columns [A] and [C] on Table 2.

Alternatively, the executor may claim the unified credit under the Canada-US Tax Convention (the “Treaty”), which allows Canadian residents to claim the same as is available to a US citizen or domiciliary – US$5,389,800 in 2024, equal to the tax on a US$13.16 million estate – as can be verified by viewing the first row on Table 1. This is then prorated based on the proportion of US-situs assets to worldwide assets.

Thus, the formula for a Canadian resident is:

Marital credit

The Treaty allows a marital credit for property passing to a Canadian or US resident spouse who is a non-US citizen. It is restricted to legally married spouses as defined under US law. The credit is equal to the lesser of the prorated unified credit and the Estate Tax payable on US-situs assets transferred to the spouse. The net result is that it can effectively double the prorated unified credit.

Canadian federal tax credit for US Estate Tax paid

As noted in the introductory paragraph of this article, Canadian tax law deems capital property to be disposed upon death. This applies to the worldwide assets of a Canadian resident, including US-situs property. As of June 25, 2024, a 1/2 capital gains inclusion rate applies to the first CA$250,000 of capital gains in a year, with 2/3 inclusion applying to capital gains above that threshold. The included amount, or “taxable capital gain” is added to the taxpayer’s income for the year. When a person dies, the terminal taxation year is January 1^st to the date of death.

Under the Treaty, a foreign tax credit may be claimed against Canadian federal tax related to US-situs property.
The credit is limited to the Canadian tax liability on that property, noting that there is no terminal year tax on RRSP/RRIF accounts (including any US-situs investments therein) rolled to a surviving spouse.

At present, no province or territory allows a foreign tax credit for the Estate Tax.

Planning options to limit Estate Tax

There are both simple steps and complex strategies that can be taken to reduce Estate Tax exposure. Each has its costs, benefits and drawbacks, with some able to be used in combination, and some mutually exclusive of others. Following here are some approaches that can be explored more deeply with a qualified cross-border professional.

Lifetime gifting or selling

If a given property is not owned at death, then the Estate Tax will not apply, at least not directly. Depending on when and to whom assets are transferred, gifting could affect the eventual exclusion amount available at death. The other immediate consequence to consider is early realization of capital gains that would otherwise be deferred until death.

Relocating property out of the US

Vehicles, jewellery, artwork, collectibles and other personal belongings are considered US-situs property if housed in the US. It may be preferable to transport any such property back to Canada if not required for current living needs.

Choosing/changing form of investments

While US securities are US-situs property, there are ways to have US market exposure that still shields against Estate Tax. One of the simplest ways is to own US mandates in Canadian mutual funds, segregated funds or ETFs. Large accounts can command fees comparable to individual security portfolios, so cost is not a material issue.

Life insurance, with or without an ILIT

Assuming an adequately healthy person, life insurance can provide liquidity to pay the Estate Tax. Unfortunately, the death benefit will be included in the worldwide estate if owned by that person. Alternative owners could be another person or an irrevocable life insurance trust (ILIT). In the latter case, it is best to have the ILIT acquire the policy from the outset, as there is a lookback attribution to that person if transferred within three years of death.

Non-recourse mortgage financing

Non-recourse debt is fully deductible against US-situs assets without proration based on one’s worldwide estate.
As enforcement is limited to the property being mortgaged, it may be difficult to source a willing lender. Additionally, such arrangements inevitably have higher interest charges and other potentially onerous covenants.

Canadian holding corporation

Assets held in a Canadian corporation will not be subject to the Estate Tax. While beneficial on its own, this must be balanced with the Canadian corporate tax treatment, particularly in light of the increased 2/3 capital gains inclusion rate for corporations as of June 25, 2024. As well, if residential/vacation property is held in a corporation, its use by a shareholder or other non-arm’s length individuals will likely be treated as a taxable shareholder benefit.

Canadian discretionary trust

A trust may be preferable to a corporation for either or both investment holdings and vacation property. Though trusts are taxed at the highest bracket rate (including that they too now face the 2/3 inclusion rate on capital gains), they can often be drafted such that income is allocated to one or more beneficiaries. For vacation property, the terms can allow for its use by a wide range of beneficiaries, and there is no corresponding concern like shareholder benefits with corporations. As trusts are subject to deemed disposition of capital assets every 21 years, periodic monitoring and occasional adjustment or distributions may be necessary.

Distinguishing US and non-US gift recipients

Whether giving in life or at death, it may make things more manageable for the next generation if you isolate or skew the allocation of US-situs property to US persons only. They will have to grapple with US succession rules on all their assets anyway, whereas non-residents will only be exposed if they hold US-situs assets.

US dynasty trust

If you expect one or more of your beneficiaries to remain permanently in the US, an irrevocable dynasty trust may be worth considering. If drafted in accordance with US law, it can minimize the impact of the Estate Tax, gift tax and GSTT, and as a US resident trust it is not subject to the 21-year deemed disposition of capital property.

Reference tables

RESP withdrawal rules and strategies

What, how much and when it’s available

The basic structure of the Registered Education Savings Plan (RESP) has been around since the 1970s. They allow for tax-free savings and investment growth to help pay for post-secondary education, and since the 1990s have been supplemented by a range of government support programs.

This article looks beyond how RESPs are funded and grow, to what ultimately matters most to parents and students – which is how they are put to work paying for that education once it is underway.

Knowing what’s inside, to explain how it comes out

In order to follow the different ways that money comes out of an RESP, it helps to first identify the source of that money. Here are the three main money components, along with a brief point about the tax consequences of each:

Personal contributions

An RESP subscriber (commonly parents) may enter into a contract with an RESP promoter to save for one or more student beneficiaries. The contributions made by the subscriber are not tax-deductible; however, they are also not taxable when withdrawn. The current lifetime contribution maximum is $50,000 per beneficiary.

Government assistance

No tax is due when government assistance is paid to an RESP, whether from the Canada Education Savings Grant (CESG), the Canada Learning Bond (CLB) or a provincial government program. Amounts are taxable when later paid to a student as part of an educational assistance payment or EAP (discussed below).

Accumulated income

Earnings on both contributions and government assistance are tax-free while within an RESP. That accumulated income is taxable in the year of a withdrawal, either to the student when paid as part of an EAP, or to the subscriber when paid in the form of an accumulated income payment or AIP (discussed below).

Withdrawals for education purposes – Educational Assistance Payment (EAP)

An RESP is designed to assist with education expenses once a beneficiary is enrolled in post-secondary schooling. Most often that will be a full-time program leading to a degree, diploma or certificate, but part-time and distance learning may also qualify, including apprenticeships for skilled trades. The government maintains a list of all eligible programs and institutions.

Most of the RESP withdrawal rules relate to the conditions and tax treatment of EAPs, which are comprised of the latter two of the three components described above: government assistance and accumulated income. Whether paid to the student or to an educational institution on his or her behalf, the student is taxed on all EAPs taken in the January-December taxation year, regardless of the school year in which they are enrolled.

Though the entire EAP is taxable, the RESP promoter tracks the proportion drawn from each of government assistance and accumulated income. The relevance of this distinction will become clearer below when we look at the treatment of a refund of contributions after a student completes (or chooses not to continue with) schooling.

What kind of educational expenses qualify?

There is no fixed list of qualifying expenses. Instead, according to the RESP Provider User Guide: “An RESP promoter is not required to obtain receipts from a beneficiary as proof of expenses before making an EAP. The RESP promoter determines whether the EAP helps further the beneficiary’s education, whether it is reasonable, and whether the payment complies with requirements of the Income Tax Act and the terms of the plan.”

The 13-week limit and 6-month horizon

The EAP limit during the first 13 consecutive weeks of enrollment is $8,000 for full-time studies, or $4,000 if studying part-time. (These amounts are as of 2023, with the 2023 Federal Budget having announced the increase from the previous $5,000 and $2,500 respectively.) If tuition and related payments are higher, the RESP promoter must obtain approval from the government on a case-by-case basis before approving a higher EAP amount.

After 13 weeks, there is technically no annual limit on the amount of EAPs that can be paid, though the 13-week rule is re-applied if the student is out of school for 52 weeks or more. As an outer boundary, a student can receive payments for up to six months after a program has been completed, so long as the expenses would have qualified as EAPs if they had been paid before the student’s enrollment ended.

Reviewing large EAP requests

Despite there being no annual EAP maximum, it doesn’t mean the floodgates are wide open. To reduce the administrative burden on RESP promoters, the Canada Revenue Agency (CRA) has a yearly EAP threshold below which it will not question the reasonableness of EAPs. It was set at $20,000 in 2008, indexed thereafter in line with the Consumer Price Index. The figure for 2024 is $28,122.

Below this amount, the RESP promoter is not expected to assess the reasonableness of each expense, but more scrutiny will be applied above the threshold. Also, bear in mind that CRA may later inquire into those expenses, so receipts should be retained as proof should the need arise.

Refund of contributions

A subscriber may, at any time, request a refund of contributions. A refund is not taxable, whether paid to the subscriber or directed to the student. Either way, RESP contribution room is not restored when there is a refund.

However, if a student is not qualified for an EAP when a refund is taken, a portion of the CESG and CLB may have to be repaid. The repayment is based on the proportion of refunded contributions that previously attracted that assistance. When this happens, any repaid CESG entitlement is lost, but repaid CLB entitlement is restored.

To avoid this effect, a subscriber could withdraw all contributions once a student is qualified for EAPs, leaving all remaining government assistance to continue to grow tax-shelterd within the RESP. One option for the refunded amounts would be to invest within the the tax-free savings account of the parent-subscriber and/or student.

Withdrawals when not enrolled – Accumulated Income Payment (AIP)

In limited circumstances where it is clear that it will not be possible for the RESP to pay an EAP, the accumulated income may be paid as an AIP. This payment is made to the subscriber and is subject to regular income tax plus an additional tax of 20%. The additional tax can be avoided if an equivalent contribution is made to the subscriber’s Registered Retirement Savings Plan, provided the subscriber has available RRSP room.

Payment to a designated educational institution

In situations where neither an EAP nor an AIP can be made, the plan income must be paid to a Canadian educational institution which would otherwise qualify for EAP purposes. This is basically a forfeiture of the income as the subscriber does not receive a tax slip or a donation receipt.