When contemplating how you want your estate to be divided, care should be taken when it comes to making use of beneficiary designations for registered investments (RRSPs, RRIFs) and life insurance.
Beneficiary designations allow you to bypass your estate and have certain assets (RRIF or life insurance) paid directly to your chosen beneficiary. This is generally a very positive aspect of estate planning as it allows you to avoid probate fees (currently 1.4% in BC) and enables the asset in question to pass quickly and efficiently in most cases.
However, without sufficient thought some unintended consequences can arise when it comes to distributing assets byway of beneficiary designations.
Beneficiary Pitfalls
Suppose Jim is the father to three adult children, Sam (48), Julie (46) & Heather (41). Jim is a widower and has never remarried. Now 78, Jim’s health is a growing concern. While Sam and Julie live in other provinces, Heather lives nearby and has played a huge role over the past number of years in helping her father maintain the house. If it weren’t for Heather, Jim would have likely been forced to sell this sentimental home long ago. Jim is ever thankful for her support and as he reviews his estate plans he wants to make sure that he provides for his three children fairly.
Jim has two major assets; his house and his RRIF. His house is worth $500,000 and his RRIF is worth $1,000,000. Both Sam and Julie are doing well financially and they each own their own home. Heather, has struggled financially since her divorce and she currently does not own a home. As Jim reviews his estate plan he decides that he will name Sam and Julie as the equal beneficiaries of his RRIF. Jim recognizes that approximately half of his RRIF balance will be lost to tax at death and he estimates that Sam and Julie will each receive $250,000 from his RRIF after-tax. To recognize Heather’s ongoing help around the house and to assist her in getting back on her feet, he decides that he’ll leave his house to Heather alone. Given that his principal residence will not be subject to tax, Heather should receive an asset valued at $500,000.
Even though Heather stands to receive a larger inheritance than her siblings, Jim feels that this is the most equitable solution and addresses each of their needs. Jim is happy to be taking care of the people he loves most.
Unfortunately for Heather, while Jim has done a good job of approximating the amount of taxes owing upon death, he has failed to account for how the tax treatment of his assets will ultimately work. Upon death, Jim’s RRIF ($1,000,000) will be distributed to Sam & Julie byway of the beneficiary designation of his RRIF. They will each receive $500,000 without any tax consequence to them. Meanwhile, Jim’s house will be transferred to Heather once his estate is settled. However, before Jim’s estate can be distributed according to his wishes, Jim’s executor will first have to pay any income tax or debts owing. This will include the resulting tax liability on his RRIF balance, roughly $500,000. Assuming Jim has no other assets of significance, his executor will be forced to sell the house that was intended for Heather simply to fund the tax owing on his RRIF. Sam and Julie will each receive $500,000 and Heather will be left with nothing.
Within short order and legal dispute will certainly ensue. This is certainly not the legacy that Jim intended to leave his three children.
While grim, this fictional example highlights the importance of a carefully crafted estate plan that provides sufficient cash at the moment it is needed to deal with the tax problems that result as a consequence of death.