Prompted by the recent death of a friend, a client asked what they could do to avoid a large tax bill from their registered savings when they died.
First, a brief summary of registered savings plans. Contributions to registered retirement savings plans (RRSPs) are tax deductible and any investment returns are not taxed until withdrawn. In the year a retiree turns 71 the RRSP is converted to a Registered Retirement Income Fund (RRIF) and minimum withdrawals are mandated in the following year. A minimum withdrawal is prescribed by the government but actual withdrawals may exceed the minimum. RRSP or RRIF withdrawals are treated as taxable income.
The value of the RRIF (or RRSP)1 must be included as income in the year of death, and is fully taxable as regular income. There are exceptions when there is a qualified beneficiary, often a surviving spouse, but without qualified beneficiaries there is the prospect of a large tax bill on death. The RRIF of a last surviving spouse may have increased from the rollover of the RRIF from their spouse when they died. Depending on other income and estate assets, a RRIF with a value of $150,000 could be taxed at 48% or higher upon death2 .
Withdrawing more than the RRIF minimum, either regularly or intermittently, reduces the tax burden on the estate. The downside is a higher taxable income in the year of withdrawal, and the loss of the RRIF tax shelter for the portion of the withdrawal that is unspent and saved. While any unused TFSA room may provide some relief, any investment return on the unspent RRIF withdrawal would be subject to taxation.
Individual circumstances will vary; relevant factors include average and marginal tax rates, tax credits, investment returns, age, expected longevity and other sources of income. However, the most important question is one not so easily quantified: the value the retiree attaches to passing assets to beneficiaries. At one extreme, if retirement assets are considered exclusively for the purpose of retirement income, what happens to any residual should be irrelevant. In such circumstances, accelerating RRIF withdrawals for the purpose of reducing taxes on death offers no advantage. Conversely, someone with poor health prospects may want to enjoy more income earlier in retirement. Some of that enjoyment may be donating to beneficiaries while the retiree is still alive. We accommodate this different utility for estate income by introducing a weighting factor where a weight of zero indicates no interest in the estate value and a value of one indicates that a tax dollar (accounting for inflation) has the same value whether paid while alive or dead.
As an illustration, we consider the situation of Michelle. Michelle is age 65 with $500,000 in a RRIF. She pays a marginal tax of 30% on income and her estate would pay a marginal tax rate of 50%. She earns an investment return of 5%. Inflation is 1.6%. Michelle withdraws the RRIF minimum at the start of each year.
Michelle wants to know if increasing the withdrawals from her RRIF would reduce her overall taxes paid, including the taxes paid by her estate. Initially, we assume that Michelle attaches equal weight to a dollar of tax paid when she is alive to one paid when she is dead, so we can simply add the taxes paid while she is alive to the tax paid by her estate to arrive at the total tax paid.
To address Michelle’s question, we consider the tax consequences of when she dies. If she dies at age 70, for example, then she will have paid tax on the RRIF income she received since age 65, plus the estate income tax3 on the value of RRIF. We can then compare with an accelerated withdrawal strategy. In Michelle’s case she spends the RRIF minimums but saves any additional withdrawals in a taxable investment account for future use.
The chart below shows how the minimum withdrawal for a RRIF changes with age. For our accelerated strategy, we use the maximum withdrawal from a Life Income Fund (LIF)4. A LIF is a type of RRIF used to hold pension assets that typically arises from participation in company pension plans. In addition to a minimum withdrawal there is also a specified maximum withdrawal. If Michelle held her retirement assets solely in a LIF then this would be the maximum she could withdraw, otherwise she could choose her own accelerated withdrawal schedule. Using the LIF maximum withdrawals almost doubles the rate of withdrawal for the first fifteen years and then increases more rapidly.
We show the tax paid using the RRIF withdrawal minimum as a function of age of death for Michelle in the figure below. The total tax (solid line) is the sum of the tax paid on the withdrawals (dashed line) and the tax on the remaining RRIF paid by Michelle’s estate (dotted line). As expected, the estate tax declines as the RRIF is depleted while the total tax paid on withdrawals increases with age. All calculations are in real dollars.
In the figure below we compare the total tax paid with the RRIF minimum withdrawals with our accelerated withdrawal strategy. We also show the difference between the two withdrawal strategies. In Michelle’s case, and remembering that she attaches equal weight to tax paid by her estate to tax paid while alive, the accelerated withdrawal results in less total tax paid.
If Michelle was indifferent to the tax liability after she died then she would have no incentive to accelerate withdrawals and give up the benefit of the RRIF tax shelter.
Suppose that Michelle is somewhere between the two extremes: she attaches more weight to keeping taxes low when she is alive than when she is dead. To provide a specific example, suppose Michelle considers a tax dollar saved after she is dead has only half the value of one saved when she is alive. We will call this the medium utility scenario. In the figure below we show the difference between the withdrawal scenarios when:
A curve along the horizontal axis indicates that Michelle would gain no advantage from accelerated withdrawals. We can see this is the case for the first half of Michelle’s retirement when she has only a medium utility for the impact of taxes paid by the estate. For Michelle, accelerated withdrawals only make sense if she is really concerned about taxes paid by the estate.
An option for offsetting taxes paid by the estate is insurance that pays a benefit upon death equal to the estate obligation. An estimate of the expected cost of insurance for Michelle (if she was insurable) would be to multiply the estate income tax due by the probability of dying at any particular age. While the estate income tax fall with age as the RRIF is depleted the probability of dying increases.
A complete rendering of Michelle’s situation requires a host of other factors such as total consumption needs, other sources of income, tax credits and portfolio volatility. Nonetheless, simple models can illuminate key decisions as a pre-cursor to more detailed financial planning.
1 To avoid repetition, we assume the RRSP has been converted to a RRIF. We assume Ontario residency.
2 We assume Ontario residency.
3 We use estate income tax as shorthand for the income tax paid by Michelle’s estate. Not to be confused with tax levied on the transfer an estate in some countries.
4 We assume the LIF is subject to Ontario jurisdiction
