Everyone wants to find extra cash. There is no shortage of articles, webcasts, and conferences discussing investments, the market and how to get the best return. There is also a myriad of tools and calculators available to show people what that extra percentage point can mean 20 years down the road. Bank customers may spend hours searching for the best rate and have been known to switch institutions in order to gain (or save) an extra quarter point. We all know the importance of building and preserving wealth; now, let’s help our clients put this in perspective.
Consider the big picture
The quarter-point return needs to be a part of a holistic, integrated plan. We can’t ignore that in the absence of a well-planned and well-executed strategy for transferring wealth, the results of that extra quarter point, and much more, can quickly disappear. It’s like spending a great deal of time and money to insulate your home while leaving the back door wide open.
For instance, dying intestate (without a valid will) can be costly, yet approximately 50% of Canadians fall in that category each year. In addition to forfeiting tax and probate planning opportunities, an estate may be exposed to higher legal and administration fees.
A poorly drafted will, or otherwise-deficient estate plan, may be no better. An inadequate will can result in a full or partial intestacy, disgruntled beneficiaries, court challenges, family conflict, and so on. An effective estate plan can eliminate or greatly reduce the likelihood of such difficulties and provide additional benefits.
As advisors, we can help our clients develop an effective plan that:
- 1. Maximizes wealth for clients and their heirs;
- 2. Minimizes the impact of liabilities, especially taxes;
- 3. Reduces the burden on a client’s family;
- 4. Assures continuation of a client’s interests and values;
- 5. Includes a plan for the unexpected; and
- 6. Provides peace of mind.
Items 3 to 6 are just as important as the financial considerations. In fact, my estate planning mantra is “start at the end.”
Start at the end
Determine whom and/or what the client wishes to benefit, and then work backward to find the best method of so doing. This means taking into account beneficiary considerations (special needs, age, financial acumen, etc.) and overall costs (income tax, probate fees, executor compensation, legal fees and so on). For the purposes of this article, I’ll limit my focus to the items that can be measured in dollar terms. The soft, or less tangible, issues will be explored in a future article.
Comprehensive wealth management should incorporate strategies to build, preserve and transfer a client’s wealth. The classic transfer approach is by way of a will. However, depending on the circumstances, we should consider ancillary strategies such as beneficiary designations, nature of ownership and inter vivos trusts.
Minimizing the associated costs can maximize wealth, particularly in the context of a transfer. Canada does not impose gift taxes, succession duties or inheritance taxes; however, death can result in significant income tax liability and, depending on the province, consequential probate fees. Yet planning opportunities are available.
Let’s start with probate fees. Ontario, by way of example, levies an Estate Administration Tax equal to 1.5% of the value of the estate flowing under the will. Structuring the estate so that assets pass outside the will can minimize these fees. As such, where it works in the context of the overall plan, it makes sense to designate the beneficiary directly, rather than name the estate, on assets such as RRSPs, RRIFs and life insurance policies.
Joint ownership is a little trickier. Joint ownership with right of survivorship (not applicable in Quebec) generally makes sense between spouses in first marriage situations. Beyond that, exercise extreme caution. Where joint ownership is viable, the time and costs inherent in administering an estate can be significantly reduced. In Ontario, where the nature of the assets allows, consideration should also be given to the use of multiple wills to minimize probate fees.
Planning for income tax liability also affords a number of options, both pre- and post-mortem. Virtually every estate can achieve income tax saving with proper planning and execution. Comprehensive income tax planning will take three different taxpayers into account: the deceased, the estate (or trust) and the beneficiaries.
Let’s begin with the deceased and taxation in the year of death. Depending on the nature of the assets owned and income received by the deceased, a number of tax-saving opportunities may be available. First, if possible, defer the realization of capital gains by taking advantage of the spousal rollover provisions. In Canada, a taxpayer is deemed to have disposed of their capital property for proceeds equal to fair market value immediately before death. In other words, death triggers the realization of accrued capital gains. In addition, the full value of RRSPs/RRIFs must be reported as income on the terminal T1 return. When viable in terms of the overall estate plan, it makes sense to defer the resulting tax liability. By taking advantage of the spousal rollover, taxes on capital assets can be deferred until the death of the surviving spouse.
Second, make judicious use of the principal residence exemption where there is more than one eligible property. Third, ensure the estate takes advantage of any unused RRSP contribution room (on the deceased’s terminal return and/or that of his or her spouse). A fourth possibility may be to file up to four separate returns for the year of death to take advantage of the graduated rates in order to reduce the overall tax liability. The best piece of advice you can give your clients is to appoint a knowledgeable executor who knows the rules and will take full advantage of all planning opportunities.
Going forward, further tax savings are available via testamentary trusts. This is where the other two taxpayers — the estate and the beneficiary — come into play.
Testamentary trusts fall into two categories: trusts you need and trusts you might want.
The first category includes trusts for minors, special needs beneficiaries, spouses in subsequent marriage situations and spendthrifts. A trust is necessary in these situations either because the beneficiary is unable to take ownership of the property (they are under the age of majority, for example) or because the well-being of the beneficiary may be impacted. An example of the latter is the transfer of estate funds to a trustee to be used for the benefit of a family member with a gambling or other addiction.
An example of optional trusts is the establishment of a trust for an adult, competent beneficiary. Although capable of receiving an outright distribution, where the beneficiary is in a high marginal tax bracket, establishing a trust can mean significant annual income tax savings. This is because testamentary trusts are taxed as individuals and enjoy the same graduated rates. You then tax the trust income in the trust (at a lower marginal rate) rather than in the hands of the beneficiary (at a higher marginal rate). These savings can be multiplied by the number of beneficiaries.
Where a testator has charitable intentions, proper planning can result in decreased income tax liability and increased benefit to the charity. Such options will be explored in future articles.
Consider administration costs
An experienced estate planner can help identify ways to satisfy your clients’ wishes with respect to the disposition of their estate in the most cost-effective way. Most people express some concern over what it will cost to prepare and ultimately execute the estate plan. However, only when the expenses are weighed against the potential savings can the true cost and benefit to the estate be determined.
So, next time you’re checking the rate of return on your client’s investment portfolios, take a moment to consider whether your client’s estate plan is up to the challenge of effectively preserving and transferring the wealth you’re helping them build.
Originally published in Advisor's Edge Report
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