Many Canadians save and invest not just to build a better future for themselves but also to leave a financial legacy for their children or grandchildren. Without proper planning, however, much of that legacy could wind up going to the government in the form of taxes.
For example, suppose you own a vacation property (that is not your principal residence) worth $300,000 and you have $400,000 in your Registered Retirement Income Fund (RRIF). You’re planning to leave the property plus $50,000 to your son and $350,000 cash to your daughter.
Unfortunately, it’s not that simple. Here’s why:
Capital gains tax
Any increase in the value of your vacation property since you purchased it would be treated as a capital gain, half of which would be taxed at your marginal tax rate. So if you originally purchased it for $60,000, you’d be looking at a capital gain of $240,000 ($300,000 – $60,000 = $240,000), half of which would be taxable ($120,000). At a marginal tax rate of 48%, the taxes would come to $57,600.Income tax
The tax bite on registered assets is even bigger. Unless you leave them to your spouse (which defers the tax), the entire amount is taxed as income on your final tax return. At a marginal tax rate of 48%, the tax bill would be $192,000.Your estate would wind up with a total tax bill of almost $250,000, leaving far less for your kids.
Preserving your estate
So what can you do to leave more for the people you care about? The first step is to estimate the future tax bill. This means estimating what your taxable assets might be worth when they enter your estate and the tax they’ll attract. The figure won’t be precise, but it will give a general idea of the amount you’re dealing with.There are a number of strategies you may be able to use to minimize the taxes owing. Here are a few you can explore with a qualified tax advisor.
Deplete your RRIF
Ordinarily, if you don’t need your RRIF to live on, you’d withdraw only the minimum required by the government to allow it to continue to grow tax-deferred. But remember, what’s left will eventually be subject to tax at the highest rate. By withdrawing more than the minimum each year, there’s less left to be taxed at the end. Of course, you want to keep the withdrawals small enough so they’ll be taxed at a lower rate than they would as part of your estate.Keep a record of the cost of capital improvements to vacation property
When you make capital improvements to a property (other than your principal residence), the amount is added to your original cost, which decreases the capital gain. Capital improvements are structural changes or restoration that enhances the value of a property. Examples include adding a wrap-around deck or new metal roof.Sell during your lifetime
If you’re thinking of leaving vacation property to your children or grandchildren, you might instead sell it to them now. While you’ll have to pay tax on any capital gain, it will relieve your estate of the tax burden.Paying the piper
While there are steps you can take to reduce the taxes on your estate, chances are there will still be a balance owing. The simplest way to cover that amount is to leave sufficient cash or liquid assets in the estate, such as your own and your spouse’s Tax-Free Savings Accounts (TFSAs).A convenient and cost-effective alternative is to purchase permanent life insurance to offset the tax liability. The tax-free benefit can cover the tax bill, preserving the rest of your estate for your beneficiaries. You might also make a large charitable bequest in your will or leave your Registered Retirement Savings Plan (RRSP) or RRIF assets to charity. The resulting tax credit can help offset the tax payable.
Talk to your advisor when you’re ready to think about leaving a legacy for your loved ones. They can help you estimate what your estate’s tax bill might be and outline specific strategies for discussion with a tax advisor.
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