Saturday, January 6, 2007

Guess Who Pays the Tax On Death

When it comes to estate planning, parents often wish to distribute their assets equally among their children. Without proper planning, the actions taken could have the opposite effect and result in unequal distributions.

For example, assume the rapper “50 Cent” is widowed and has two children, Nickel and Dime. Assume also that 50 Cent's last few albums did not do so well on the charts, so 50 Cent is left with an RRSP worth $150,000 and remaining assets worth $150,000, for a total of $300,000 in assets.

50 Cent wants to benefit his children equally but he also wants to save a bit of tax. He decides to name Nickel as the sole beneficiary of his RRSP and name Dime as the sole beneficiary under his will. 50 Cent believes that this method will allow him to save on probate tax by excluding the RRSP from the estate and split his assets equally between Nickel and Dime. Unfortunately, 50 Cent's plan will not have the desired effect. Nickel will end up receiving the whole $150,000 in the RRSP free and clear of any tax, whereas Dime’s share of the estate will end up absorbing all the tax.

When 50 Cent passes away, income tax will be payable on the $150,000 held in the RRSP because this amount is being transferred to a child (rather than a surviving spouse). However, the RRSP will be included as the income of 50 Cent on his final tax return. This means that the estate – not Dime – will be liable to pay $66,000 of tax on the value of the RRSP. After the estate pays the tax, the estate will have only $84,000 left.

While the RRSP will not be subject to probate tax, the assets passing under the will are subject to probate tax. The probate tax of $2,100 has to be paid by the estate, leaving the estate with only $81,900.

After all taxes are paid, and assuming no other debt, Nickel (as sole beneficiary of the RRSP) is left with $150,000 while Dime (as sole beneficiary under the will) is left with $81,900. The end result is an unequal distribution and Nickel receives an unintentional windfall. Due to the application of the tax rules, 50 Cent's desire for equal distribution of his assets between his two children is not met and Dime feels he’s been “nickel and dimed” out of his fair share.

One simple way around this would have been for 50 Cent to name both Nickel and Dime as equal beneficiaries of both his RRSP and his will. This way, the $231,900 remaining after taxes would have been split equally between them.

Without careful planning and advice, the application of the tax rules may result in unintended consequences. It is important to keep in mind who is paying the tax.

-- Devinder Sidhu

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.