If you are considering a direct beneficiary designation for either a Registered Retirement Savings Plan (RRSP) or a Registered Retirement Income Fund (RRIF), you should be aware of some negative consequences that can occur.
A direct beneficiary designation can result in unintended tax consequences to the estate, the inequitable treatment of heirs or the distribution of your estate in a manner different from your intentions. But a little advance planning could help avoid these problems.
Unintended Tax Consequences
If you have designated a beneficiary on your RRSP or RRIF, the entire value of it will be paid directly to that designated beneficiary. No tax will be withheld on the funds transferred. However, you or your estate will be deemed to have disposed of all your assets at fair market value.
This means that the entire fair market value of your registered investment will be included on your terminal personal tax return and your estate will be responsible for paying any resulting taxes owing even though the cash is now in the hands of your beneficiary.
If your RRSP or RRIF is paid to a qualified beneficiary, the tax can be deferred if your beneficiary transfers the funds to another registered investment but if they do not qualify then significant taxes can result. Qualified beneficiaries include your spouse, common-law spouse or a financially dependent child or grandchild.
Treatment of Heirs
Depending on the assets you hold when you die, designating a beneficiary to your RRSP or RRIF can also result in the inequitable treatment of your heirs. For example, John has three children, Jack, Jill and Tom, and no surviving spouse. He wants each child to inherit an equal portion of his estate. When John dies, his assets are comprised of a $100,000 RRSP and $200,000 of non-registered investments with a $100,000 capital gain. John designated Jack under the direct beneficiary designation of the RRSP and Jill and Tom will receive the rest of his estate.
In his designation of Jack as the beneficiary of the RRSP, John overlooked that there would be no tax withheld on the payment of the RRSP to Jack and also that his estate would be responsible for the tax liability on the RRSP as well as on the capital gain on the non-registered investment.
The tax on the $100,000 of income from John’s RRSP and the $50,000 of taxable capital gain on the non-registered investment will be reported as income on John’s terminal personal tax return. Assuming a marginal tax rate of 40%, the taxes owing will be $60,000. Jill and Tom will receive a net amount of $140,000 to split between the two of them or $70,000 each while Jack will inherit $100,000.
Distribution of Assets
If you have a blended family, then designating your RRSP or RRIF directly to your spouse may not achieve the result you want. If you would like to provide an ongoing income to your surviving spouse for the remainder of their lifetime, but prefer to leave the underlying assets to your children upon your spouse’s death, then you should consider paying the RRSP or RRIF to your estate rather than designating your spouse under the direct beneficiary designation. If your spouse inherits the RRSP or RRIF by direct beneficiary designation you lose the ability to impose your wishes on when and how it is used.
There are many instances when the direct beneficiary designation on your RRSP or RRIF will not result in the outcome you desire. Use discretion when making this decision and talk to your financial advisor and accountant for further information and advice.
If you would like more information or have any questions, feel free to contact us at 780.466.6204, or click here to send us an email.
Thanks to Shannon Warawa of KWB Chartered Professional Accountants for providing this content.