Picture this: You’ve spent decades building up your RRSP, only to see over half of it disappear to taxes when you pass away. But there are some very effective methods to prevent that from happening. Let me explain.
RRSP Taxes on Death
A lot of our clients are shocked to hear this, but when you die, your entire RRSP balance is added to your income for that year and taxed at your highest marginal tax rate.
Here’s how that works:
Example: Meet Michael. Michael has an RRSP balance of $700,000 at the time of his death. The ACB, or what he originally purchased his investments for, is $500,000. But here’s the catch:
Many people think that only the capital gains or 50% of the profits will be taxed, but that’s not how it works. The full $700,000 is added to Michael’s income, and his estate is taxed on that amount. This pushes his income into the highest tax bracket of 53% in Ontario.
At a marginal tax rate of 53%, Michael’s estate would owe $371,000 in taxes on his RRSP alone. This leaves just $329,000 for his beneficiaries after taxes.
If that sounds like a terrible deal for you, you’re right. Nobody wants to donate 53% of their hard-earned money to the CRA. Instead, let’s keep it for your loved ones. Here are 5 strategies, from easiest to hardest, to minimize this tax—plus a bonus tip for business owners to potentially avoid it altogether.
Strategy 1: Spousal Rollover – Tax Deferral to a Surviving Spouse
How it Works:
If you have a spouse or common-law partner, upon your death, your entire RRSP balance can be rolled over to their RRSP or RRIF tax-free. This means no immediate taxes are due, allowing your spouse to defer paying taxes until they start withdrawing the funds.
Example:
Michael passes away with an RRSP balance of $700,000. Instead of that $700,000 being taxed at 53%, it is transferred tax-free to his wife, Emily’s RRSP. Emily won’t have to pay taxes until she begins withdrawing from the account.
Pros:
- Immediate tax deferral.
- Gives the surviving spouse control over when to withdraw funds, allowing for potential tax savings in future.
Cons:
- Only works if you have a spouse or common-law partner.
- The taxes are deferred, not eliminated—they will still be due when the spouse starts withdrawing and also when they pass away. This strategy is only a temporary solution.
Strategy 2: Dependent Children – RRSP Rollovers
How it Works:
In certain cases, you can transfer your RRSP to a dependent child or grandchild tax-free, typically if they’re financially dependent due to age or disability.
Example:
David passes away with a $500,000 RRSP. His 17-year-old granddaughter, Lily, qualifies as a dependent due to her disability, so the RRSP is transferred to her tax-free. Without this rollover, the $500,000 would be taxed at 53%, leaving only $235,000 for his beneficiaries. With the rollover, Lily won’t owe taxes until she starts making withdrawals, potentially paying less later.
Pros:
- Avoids immediate taxes if the dependent child qualifies.
- Provides financial support for children or grandchildren in need.
Cons:
- Strict rules; the child must be dependent due to age or disability.
- Not available for most adult children.
Strategy 3: Convert to a RRIF for Early, Structured Withdrawals
How It Works:
Instead of leaving your RRSP untouched and risking a large tax hit at death, you can convert it to a RRIF (Registered Retirement Income Fund) once you retire and start making structured withdrawals. This approach allows you to manage the amount you withdraw annually, spreading it over multiple years to keep your taxable income in a lower bracket and reduce the overall tax burden.
Example:
David retires at 65 with $600,000 in his RRSP. Rather than delaying withdrawals, he converts his RRSP to a RRIF and begins withdrawing $40,000 each year. This $40,000 adds to his annual income but keeps him within a manageable tax bracket.
If David had waited longer to withdraw, his RRSP could have grown to a huge amount, likely pushing him into the top tax bracket and resulting in up to 53% of the amount going to taxes. By withdrawing gradually through his RRIF, he minimizes taxes year by year and controls his taxable income more effectively.
Pros:
- Smooths out your tax bill over several years, avoiding a lump-sum tax hit.
- Allows for better tax planning by giving you control over annual withdrawal amounts.
Cons:
- Taxes are still due on withdrawals, even in smaller amounts.
- Requires careful planning to avoid withdrawing too much, which could push you into a higher tax bracket and deplete your RRSP too quickly.
This is the strategy we help our clients with most often here at Blueprint, which is helping them manage RRSP withdrawals effectively to save the most possible on taxes.
Strategy 4: RRSP withdrawal to pay for life insurance
How It Works:
To protect your RRSP from the big tax hit when you pass away, you can buy a permanent life insurance policy. The payout from the policy covers the tax bill, so your loved ones get the full value of your RRSP. Here’s a clever twist: you can use small, gradual RRSP withdrawals (like mentioned in the previous strategy) to pay the insurance premiums, spreading out the tax and making the payments manageable.
Example of Actual Clients
John (age 72) and Mary (age 70) are real clients of ours here at Blueprint Financial. They have a joint RRSP balance of $900,000, and without proper planning, their estate would have faced a $450,000 tax bill (at a 50% marginal tax rate in Ontario). To prevent this, they chose to purchase a joint last-to-die permanent life insurance policy with a minimum death benefit of $632,074. This is designed to cover the entire tax bill and leave extra funds for their heirs.
John and Mary’s insurance policy required $50,000 in annual premiums for the first 6 years. Instead of paying the premiums out of pocket, they decided to withdraw $50,000 per year from their RRSP to cover the cost. By doing this gradually, they spread out the tax burden over time, avoiding a huge lump-sum tax hit.
After 6 years, the policy is fully paid up, and they no longer needed to worry about paying premiums. When John and Mary eventually pass away 10 years later, the policy has grown to $777,431. This life insurance payout will cover the estate’s tax bill.
Pros:
- Double benefit: The insurance payout is completely tax-free, and using RRSP withdrawals to fund the premiums reduces the RRSP balance, which lowers the final tax hit at death. Effectively, it trades RRSP income for tax-free growth within the life insurance policy.
- By paying the premiums through gradual RRSP withdrawals, John and Mary avoid having to make large upfront payments.
- After 6 years, the policy is fully paid up, with no further premium payments required, and the life insurance payout continues to grow tax-free.
Cons:
- Not everyone qualifies for life insurance, especially for those with pre-existing health issues.
- The $50,000 annual RRSP withdrawals for the first 6 years are taxed as income, which can increase their tax liability during that time.
- Careful planning is necessary to avoid pushing them into a higher tax bracket due to these withdrawals.
In the end, John and Mary bought this insurance policy and were grateful for the peace of mind this plan provided, knowing their estate would be preserved for their heirs and that their tax obligations were covered.
Strategy 5: Income Splitting – Managing RRSP Taxes on Death with Spousal RRSPs
How It Works:
The higher-earning spouse contributes to a spousal RRSP in the name of the lower-income spouse. The lower-income spouse can withdraw these funds gradually in retirement, lowering the overall RRSP balance, and reducing the large tax hit when the RRSP holder passes away.
Example:
Mark is in a 45% tax bracket, while his wife, Susan, will be in a 20% tax bracket when she retires. Mark has contributed $20,000 annually to Susan’s spousal RRSP over the years, and he receives a tax deduction for his higher tax bracket.
As they enter retirement, Susan withdraws $40,000 per year from her spousal RRSP. These withdrawals are taxed at her 20% rate, significantly lower than Mark’s 45% rate. This approach not only helps the couple save taxes during retirement but also reduces the overall balance of Mark’s RRSP. By the time Mark passes away, his RRSP balance is smaller, and the estate faces a smaller tax hit on death.
If Mark had retained all of the RRSP funds, his estate could have faced a significant tax bill upon his death. By strategically splitting income over the years, the RRSP value was reduced gradually at taxed at a lower rate, resulting in much lower taxes paid overall.
Pros:
- Reduces the RRSP balance at death: By shifting withdrawals to a lower-income spouse, you reduce the size of the RRSP balance, lowering the tax bill when one spouse passes.
- Allows for tax-efficient withdrawals during retirement, lowering the tax hit during life and death.
Cons:
- Only effective if one spouse is in a lower income bracket.
- Requires careful planning and contributions to the spousal RRSP over time to see maximum benefits.
Bonus Tip for Business Owners: Using an IPP (Individual Pension Plan)
How It Works: For business owners, an Individual Pension Plan (IPP) offers a tax-efficient way to transfer wealth to the next generation. Unlike an RRSP, which is fully taxed as income upon death, an IPP allows you to add your children as members, effectively passing the plan on to them. When you pass away, the IPP is taken over by your children, avoiding the large immediate tax hit that occurs with RRSPs. Instead, they are only taxed as they withdraw the funds, spreading the tax liability over many years.
Example: Paul, a business owner, has built up $500,000 in his RRSP. He decides to transfer these funds into an IPP and contribute more to it via his corporation. The IPP grows to $1.5 million over the next 15 years. Paul adds his two children, Jason and Emma, as members of the IPP. When Paul passes away, Jason and Emma take over the IPP. Unlike an RRSP, they are not immediately taxed on the full balance. Instead, they’ll pay tax only as they withdraw funds, which allows them to control the tax impact and potentially keep themselves in lower tax brackets.
Pros:
- Deferred taxation: Unlike an RRSP, where the entire balance is taxed upon death, the IPP spreads the tax liability over many years as the children make withdrawals.
- Lower tax impact: By withdrawing funds gradually, Jason and Emma can keep themselves in lower tax brackets and reduce the total taxes owed.
- Tax-efficient wealth transfer: The IPP is passed to the children without an immediate tax hit, preserving the full value of the estate.
Cons:
- Withdrawals are still taxed: Although the tax is deferred, Jason and Emma will still be taxed on withdrawals as personal income, similar to an RRSP.
- IPP management: Jason and Emma will need to manage the IPP and ensure that withdrawals suit their income needs and tax situation.
- Corporation involvement: Children must be employed by the business and receive T4 income to participate in the IPP.
We’ve helped a lot of business owners set up IPPs recently and have coordinated with accountants to make sure everything is running smoothly. The IPP is a very powerful tool for tax and estate planning.
Setting up an IPP is kind of like getting exclusive VIP access to a retirement club—it offers higher benefits and tax perks that not everyone can tap into.
Running Multiple Strategies: A Smart Way to Save on Taxes
Think of tax planning like building a house. You don’t rely on just one material to construct a solid home—you need a strong foundation, walls, and a roof to create something durable. The same goes for your financial plan: combining multiple strategies is like using the right materials at the right time to build a strong, tax-efficient future. By layering these approaches, you can drastically reduce taxes both during your lifetime and when passing your estate to your loved ones.
Here’s a common “blueprint” we often use with clients:
Example: Gradual RRSP Withdrawals + Life Insurance + Income Splitting
Meet David and Emma. David earns more than Emma, so he contributes to her spousal RRSP. When they retire, Emma withdraws from her RRSP at a lower tax rate, saving them thousands. Meanwhile, David begins making gradual RRSP withdrawals to spread out the tax burden.
To further protect their estate, they purchase life insurance, which will cover the taxes owed on David’s RRSP after he passes, ensuring their children inherit the full estate tax-free. Here’s the twist: David uses his gradual RRSP withdrawals to cover the insurance premiums, reducing the tax hit further and effectively trading his RRSP income for a tax-free life insurance payout. This strategy not only smooths out their tax burden but also maximizes the inheritance for their loved ones.
At Blueprint Financial, we help you build a strong financial foundation using the right strategies. For custom tax solutions, visit our website. We’ll help you maximize savings and protect your estate. Don’t forget to like and subscribe for more tips!
Navigating RRSP taxes can be complicated, but with the right strategies, you can keep more of your savings for your loved ones. We specialize in guiding clients through custom solutions to minimize RRSP taxes and protect estates here at Blueprint. Check out our website for ongoing tips and services on securing your financial future.
