Why naming the wrong beneficiary on your RRSP can be costly
Tax implications are at the top of the list, writes Sabrina DiFederico
Have you named the right beneficiary on your RRSP? For many people, the answer is no.
Some assets, such as life insurance policies, segregated funds and Registered Retirement Savings Plans (RRSPs) can have beneficiaries designated directly on the plan. This means that in the event of your death, these assets will pass directly to the named beneficiary without flowing through your estate.
In general, it is a good idea to name beneficiaries when possible. There are numerous reasons, but chief among them is that named beneficiaries receive the proceeds much faster than if the assets must flow through the estate. This is especially important if the beneficiaries need to cover funeral costs, lawyers, travel costs, etc. The other advantage is that the assets go directly to the named beneficiaries and don’t attract any estate administration tax.
So with all these benefits, why am I saying you’ve named the wrong beneficiary on your RRSP? It’s not that you shouldn’t name a beneficiary; instead, you should consider the income tax implications that may result from your choice of beneficiary.
Money that goes into an RRSP is income tax-deferred: when you put money into the RRSP, you get a refund on the income tax you paid on those earnings.
On the flip side, when you take the money out, you must pay income tax on the funds you withdraw. In this way, you defer paying income tax from your peak earning years to your retirement when your income is lower. In theory, following this plan means you pay less income tax.
If you die before you’ve had an opportunity to withdraw all the funds from your RRSP, the money will pass on to your named beneficiaries. If the beneficiary you name is your spouse, they will get the money as an RRSP. An RRSP gives them some flexibility to control the withdrawal of funds and, in this way, manage the income tax liability.
But what if you name your adult, non-dependent son Joe as the beneficiary of your $100,000 RRSP? Joe will get a cheque for the full value of the RRSP. No tax? Lottery win, right? Nope.
You will be deemed to have withdrawn the funds from your RRSP, in full, at the moment of your death. Depending on your income, your estate could owe as much as $50,000 in income tax.
Canada Revenue Agency will look to your estate to pay your income tax bill. Remember that Joe already got his money and it is not part of the estate.
Now let’s say you left your cottage to your adult daughter, Mary, figuring both the cottage and the RRSP were worth about $100,000. You may be surprised to learn that the estate might have to sell the cottage to pay your income tax bill. Mary will get whatever is left, but it will be far less than Joe got.
If the RRSP was your only asset, it actually gets worse instead of better. Since the RRSP went directly to Joe and you have nothing else, your estate will have no cash with which to pay that tax bill. Seems OK, right?
Not really. CRA will look first to the estate, then the estate beneficiaries, then to your executor, and eventually they will track down to whom the RRSP was paid.
The process won’t be instantaneous. In fact, it might take a few years. Long enough that those funds are long spent and life has moved on.
But CRA will still come to Joe with your $50,000 tax bill and demand payment.
Don’t let your legacy be a hidden income tax bill. How can you avoid this? 1) If you are married, leave the RRSP to your spouse.
2) Warn your children in advance to file your final tax return before spending any of their inheritance.
3) Leave a portion of the RRSP, say 30 per cent, to the estate so you know there are some liquid funds in the estate to cover some, if not all, of the income tax.
The views and opinions expressed in this article are those of the author, Sabrina DiFederico, CFA, CPA, CA, MBA, an independent financial adviser with her own wealth management practice in Hamilton. She can be reached at email@example.com. Examples are for illustrative purposes only. Calculations are based on a number of simplifying assumptions. Seek professional advice and consider your unique circumstances in estate planning.