Wednesday, 15 July 2009

RRSPs and the Government's Secret Tax Weapon

Jonathan Chevreau posted today on a BMO Retirement Institute survey finding that boomers expect to receive huge amounts of inheritance money to pay for their retirement.

A quick skim of the Passing it on study reminded me that in the case of inheritances "what you see is not what you will get". The example box on page four of the report shows how an estate worth $350,000 at death can be chopped in no time down to $223,500. That's even before lawyer and executor fees, or probate fees (taxes) get taken out. The reason is that instead of inheritance taxes Canada has a nifty little tax rule called deemed disposition, whereby upon death a person is considered to have sold all property at fair market value and to have cashed in all registered plans like RRSPs, RRIFs, LIRAs, LRIFs etc. There is an exception that a spouse can transfer the registered plans into his or her name without tax being triggered, but eventually the spouse too will die. Sooner or later there will tax to pay and since everything enters the person's income all in the same year, for almost everyone that will mean falling into a much higher, if not the highest, tax bracket.

Think about it, how many people die penniless, their registered plans depleted to nothing? You and I may withdraw RRSP money during retirement at lower marginal tax rates than while we were working but it is pretty sure that come death, our estate will be paying top rates. The government will end not only recouping its tax deductions but may well end up with more tax! That's the secret weapon. If you are dead, you may not care about paying unfairly high taxes on your estate and it is certainly difficult to complain at that point, or to vote against the government.

I've tried getting stats out of Stats Can and the Canada Revenue Agency about the extent of the issue - e.g. what is the average size of registered plans at death - but none seem to be readily available. (An indicator that this issue is real is suggested by Stats Can's table Private Pension Assets of Family Units, which shows that elderly families in 2005 had a median of $186,000 in private pension assets. Another table shows that the net worth of families 65 and older was a median $303,000, of which maybe half might be a tax-exempt principal residence, but the rest would mostly be in some form of taxable savings.) Better it not be too well known, I guess. People might get upset. The problem may get worse over the years as the decline of defined benefit plans means RRSP-type savings become more and more important.

This issue is one reason I am using my TFSA first since that account is "tax pre-paid" for contributions and any gains are tax free, even at death. It is also a reason to take money out of the RRSP when my tax rates are low.

Finally it is a good reason to donate money to charity since the tax credit effectively would mean no tax to pay even at the top marginal rate on the donated amount. Maybe that's why significant numbers of seniors are planning to donate parts of their estate to charity, not to bequeath it all to family.


Neil said...

Why is it that people get upset about stuff like this. You're doesn't matter anymore. And yes, when my parents pass on - hopefully many years from now - there will be a sizable tax bill to pay. But whatever's left over is still money that I didn't earn, and the people who did work for it will be very, very, very relaxed about the situation.

Donating to charity is fine, but if you are doing this to avoid taxes, make sure you ask the question "are the services that this charity provides of higher value to me than the services the government provides."

Frankly, I'd be a happy camper if dead people paid even more tax - it means that I get to pay less while I'm alive.

CanadianInvestor said...

Hi Niel, Thanks for the comment. The upset stems from a few things. First is the unspoken sleight of hand that could result in paying more rather than less taxes. The constant, seemingly universal description of RRSPs as a tax saving vehicle may be misleading.

Second is the fact that RRSP savings belong to the the individual, not the government. Granted, the government gave a tax deferment at the time of contribution but once that deferred tax is given back at death, taking anything more isn't playing very fair.

From the perspective of the inheritor, yes, you're right, an inheritance was (most often) not earned. But from the perspective of the deceased, it was earned and saved. When I pass away I would like to choose who gets my money, not to see a much bigger chunk of it appropriated by government. The fact that I have been responsible during retirement and not used up all my RRSP/RRIF money, and thus not let myself become dependent on the state to support me, should not result in the state taking a much bigger slice at death. In my whole working career, I have never been in the top tax bracket, yet my RRSP is big enough that if I died tomorrow, that's how it would be taxed.

Inevitably, I would maintain that donating to charity will be higher value because it will support something that is 100% what I want. When paying taxes, there are lots of wasteful, stupid programs that get supported, or ones I simply don't agree with, but I pay all my taxes because it is part of living in society. With a donation I can choose only the good.

Neil said...

As I said, fair enough on giving to charity. But it really does have to be of substantially more valuable to you, since you have to give all or almost all of the contents of your registered plans in order to avoid taxes. Conversely, only a portion needs to be paid in taxes. Also remember that the first $126k of your deemed income at death will not be taxed in the highest bracket...only the marginal amounts over $126k.

If the combined value of leaving money for your children and the portion of government services that you value meets or exceeds the value you place on the charitable donation, you are making a bad bargain just to spite the tax man.

Maybe it's the accountant in me, but I was never under the impression that RRSPs were a tax savings vehicle. They are and always have been a tax deferment vehicle - at best tax neutral, but often you do pay for this privilege. This is true even while you're alive, since - particularly if you grew your savings using Canadian dividends and capital gains - you may end up paying more in taxes during retirement than you would have if you'd taken the pay-as-you-go route of a non-registered plan.

CanadianInvestor said...

Neil, as with investing, I would agree that donating to charity merely to avoid taxes is not a good idea.

Rather than trying to spite the government, I only want the government not to spite me!

Your last sentence reminds me that when people do the RRSP vs non-Registered account comparison, the time frame only extends to retirement but not including death.

Anonymous said...

I have 1.2 mill i n my rrsp contributed at 29 t0 45% tax rate all coming out at max rate of 50%. No sympathy needed. Just MR. TAXMAN wins again!

Rob in Madrid said...

I just forward this to my Sister in Law, she has no idea how lucky she is, she inherited 700,000 dollars when her Dad died, and he had it all in non registered accounts. She thought that because he had 'transferred' the money before he died that she got it free of taxes.

Neil, regarding inheritances, for many people the amount isn't significant but it makes a huge difference in your kids lives. It may not mean a Rolls Royce but can made a paid off mortgage, or car or college for the grand kids.

And yes I'd rather get my Dad's money than the government

Anonymous said...

Neil needs to be educated .

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