Registered retirement savings plans (RRSPs) are increasingly popular. 59 percent of Canadians say they have contributed to one of these plans, which offer a more tax-efficient way to put money towards retirement. While many people plan how they intend to use their money during retirement, some savers overlook what happens to their plans when they die, a move which can greatly diminish the investment's value. If you pay into an RRSP, learn more about what happens to the plan when you die, and find out how you should set up these plans to offer the best return on your investment.
Why people choose to invest in RRSPs
RRSPs help thousands of Canadians plan for retirement. With one of these plans, you can save money in a way that lowers the amount of tax you pay. You can deduct the total annual contribution you make to your RRSP from your gross income, which lowers the amount of tax payable through your tax return.
You don't pay any tax on money invested in an RRSP, either. You only pay tax when you decide to withdraw money from the plan, by which time you are normally in a lower tax bracket. As such, RRSPs are particularly attractive to investors who need to support themselves during retirement. For example, single people (through divorce, death or choice) won't have a dual income to rely on and are likely to need a bigger income to get through retirement.
What the Income Tax Act says about RRSPs
When you die, the Income Tax Act (ITA) says that your estate must dispose of your assets at the fair market value. The government calculates this value based on events immediately prior to your death, but many people fail to realise that ITA also treats your RRSP as an asset. As such, unless you make alternative arrangements, your lawyer must record the full value of your RRSP as an asset, which means the amount becomes taxable.
The good news is that you can plan your estate in a way that can avoid this tax liability on your RRSP. ITA rules also say that you can defer the tax liability if you appoint a qualified beneficiary for your RRSP. This rule applies if you have started to draw an income from the RRSP or if the plan has not yet matured.
In these circumstances, a qualified beneficiary can include:
- Your spouse or common-law partner (including same-sex couples)
- A child or grandchild, if he or she is still financially dependent on you at the time of your death
The authorities will accept that a child was financially dependent if he or she was a minor (under the age of 18), or the child was physically or mentally impaired.
In the case of your spouse, the rules allow you to rollover the value of your RRSP into the spouse's RRSP, without paying any tax.
In the case of a dependent child, you can roll the RRSP into an annuity that will pay the child until he or she is 18. This will spread the tax liability over several years, as the authorities will treat the payment as an income.
Where the beneficiary is a dependent and mentally or physically impaired, you can roll the funds over into a new RRSP for the child. In this case, the tax liability will not start until the RRSP matures.
If you don't have a spouse or dependent child, you can also opt to list a charity as your beneficiary. In this case, you will receive a tax credit of up to 100 percent against the value of donations. Ultimately, you can choose to leave the full value of your RRSP to a charity, without paying any tax.
Why you should not list the estate as your beneficiary
It is unwise to ask your lawyer to list the estate as your beneficiary. In this case, the fair market value of the RRSP becomes fully taxable. The estate is also subject to probate fees, which means your estate will lose a further share of your RRSP. If you have no spouse, you can avoid probate fees by appointing your children as the beneficiaries, but this will still not avoid the income tax liability on the RRSP.
Why you should consider other investments
Your accountant and estate lawyer may recommend that you limit the money you invest in an RRSP because of these tax issues, particularly if you don't have a spouse to act as the beneficiary. Indeed, in some case, investors never really feel the benefit of these plans, which sometimes only really defer the tax liability until the person dies.
Non-RRSP assets do not create the same tax liability in your estate. For example, a systematic withdrawal plan can help you generate a healthy retirement income, without delaying the tax liability. Nonetheless, as well as talking to your financial advisor, you should consult your estate lawyer for expert advice about how to make sure you maximize the investment that your beneficiaries inherit.
Registered retirement savings plans help Canadians invest for the future, but it's important to consider how to set up beneficiaries to these plans. To avoid a significant tax liability later in life, get advice from your estate lawyer and a financial advisor.