The tax-planned willCreating tax savings for your spouse and the next generation

Lawyers and notaries often recom-mend the creation of trusts withinwills for reasons that do not relateto tax. Common scenarios includethe management of property foryoung beneficiaries or the disabled,or for a spouse where there is adesire to preserve the capital for thenext generation. While these are allvalid reasons for the creation of trusts,the tax-savings opportunities of testa-mentary trusts are often overlooked.

First a little background A trust is a legal relationship underwhich a person, referred to in trustjargon as the “settlor”, gives upownership of property and transferscontrol over the property to a trustee,or group of trustees, who managethe property for the benefit of otherpersons, called the “beneficiaries”.When a trust is referred to as a testa-mentary trust, it means control overthe property was transferred to thetrustees as a consequence of thedeath of the settlor. This is in contrastto an inter vivos trust, where thetransfer of property is made duringthe lifetime of the settlor. The termsof a testamentary trust are mostcommonly documented within thewill of the settlor. However, outsideof Quebec, a testamentary trust canalso be created under the terms ofan insurance beneficiary declaration

made separate from the settlor’s willfor the purpose of receiving proceedspayable under life insurance policies.The distinction between inter vivostrusts and testamentary trusts isimportant for reasons of taxation.While the undistributed annualincome of an inter vivos trust is taxedat the top personal rate (top personaltax rates range from a low of 39% inAlberta to a high of 50% in NovaScotia)*, testamentary trusts benefitfrom the same graduated rates of taxas individuals. The ability to createa separate taxpayer in the form of atrust, with access to its own graduatedrates, is a significant tax-planningopportunity.

Example of tax savings Let’s first examine how a testamentarytrust can save tax for a surviving spouse:

George is a retired businessmanwho earns an annual income of$50,000 from his non-registeredinvestments. His spouse, Ellen, is aretired teacher who earns approxi-mately the same amount as Georgeeach year from her pensions andRegistered Retirement IncomeFund (RRIF). Both Ellen andGeorge are over the age of 65 andqualify for Old Age Security (OAS)and Canada Pension Plan(CPP)/Quebec Pension Plan (QPP).

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Their combined after-tax income is$99,345, calculated as follows:

Investment income (George) $50,000

Pension income (Ellen) $50,000

CPP/QPP($11,520 each) $23,040

OAS($6,222 each) $12,444

Total income $135,484

Combined tax(Federal & Ontario)* (30,169)

Combinedafter-tax income $105,315

Now let’s assume that Ellen is awidow and, like most marriedCanadians, George had left hisentire estate directly to his survivingspouse. In these circumstancesEllen’s after-tax income would be$78,512, calculated as follows:

Investment income $50,000

Pension income $50,000

CPP/QPP $11,520

OAS $6,222

Total income $117,742

Combined tax & repayment of OAS* (39,230)

After-tax income $78,512

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In comparison to their combinedafter-tax income while George wasstill living, Ellen’s after-tax incomehas dropped by $26,803. While theloss of George's OAS and CPP makeup a large portion of the difference,Ellen's tax bill is $9,061 higher thanthe combined family tax bill whenGeorge was still living. With Ellennow reporting all the investmentincome that was reported by George,she has been pushed into a highertax bracket and is now subject toOAS clawaback.

In Canada, Old Age Security isreduced at the rate of 15% forevery dollar of income in excessof $67,700*, resulting in a totalrepayment of Old Age Securitywhen income levels reach approxi-mately $109,700. When Old AgeSecurity is taken into account, seniorswith income in excess of $67,700 aresubject to the highest rates of taxationin Canada. In this example, Ellenpays tax on her income between$83,089 and $109,700 at an effectivemarginal rate in excess of 51.9%.

What could George have done differently? Let’s assume that, instead of leavinghis estate directly to Ellen, Georgecreated a trust for Ellen under hiswill. The trust would provide Ellenwith a right to all income generatedby the trust’s investments and thetrustees would have the power toaccess the trust’s capital for Ellen’sbenefit. Ellen could even be one ofthe trustees involved in the trust’smanagement.

So how would such an arrangementbenefit Ellen? As a trust createdunder George’s will would be a testa-mentary trust, an opportunity existsto income split. Ellen would receiveall of the trust’s income to use asshe sees fit, but an Income Tax Actelection can be made allowing thetrust to retain responsibility forreporting the income. Let’s return toour example to highlight the benefitof such an income-splitting strategy.

Investment income (Reported by trust) $50,000

Pension Income (reported by Ellen) $50,000

CPP/QPP $11,520

OAS(reported by Ellen) $6,222

Total income $117,742

Total tax* (25,781)

After-tax income $94,987

For Ellen, the tax savings wouldamount to $13,449 annually. Evenafter paying some additional fees forthe preparation of a trust tax return,many would view the tax savings assignificant. If the assets fromGeorge’s estate produced a higherlevel of income, the savings wouldbe greater.

What about the next generation? High tax bracket children can alsobenefit from this income-splittingstrategy. Receiving their inheritanceindirectly through a testamentary

trust can give a high tax bracketbeneficiary the ability to generatea higher level of after-tax income.Separate trusts can be created undera parent’s will for each child and hisor her respective family. Discretion isusually given to the trustees over thedistribution of income among familymembers. Annual income can bedistributed to the high-tax bracketbeneficiary for his or her own use,but the income can be taxed at lowerrates within the trust. Alternatively,when income can be used to benefita person with little or no income oftheir own (such as a beneficiary ofschool age or university age) it maybe preferable to have the incomereported in the hands of the benefici-ary. This will allow for the utilizationof the beneficiary’s basic personaltax credit, which shelters the first$10,527 of income from federal tax*.

The tax efficiency of a trust can befurther enhanced if the trust’s invest-ments produce “eligible” dividendincome earned from Canadiancorporations. Where trust incomeis used to assist a beneficiary withno other income, such a beneficiarycan receive up to $50,530 in dividendincome before having to pay federalincome tax (although in a fewprovinces some provincial tax willbe payable beginning at lowerincome levels).

Who should consider the tax-planned will? Anyone who has accumulated wealthin the form of non-registered assetsshould consider this strategy. Such

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assets could include, but would notbe limited to, real estate, stocks,bonds, mutual funds and shares inprivate corporations. Also take intoconsideration the proceeds of any lifeinsurance policies that will be payableon death. Very often retired businessowners and farmers are good candi-dates, but by no means is the strategyrestricted by occupational back-ground. From a tax standpoint, thedecision to utilize a testamentarytrust turns as much on the incomethat can be generated from the trust’sassets, as it does on the underlyingvalue of the assets. If the potential

beneficiary is a surviving spouse, themajor limitation relates to RegisteredRetirement Savings Plans (RRSPs),Registered Retirement Income Funds(RRIFs) and other forms of registeredaccounts. With these types ofaccounts, significant tax deferral willbe lost if, on your death, the accountsare not transferred to your spouse intheir registered form. In the eventyou have no surviving spouse, direct-ing registered accounts through yourwill to a testamentary trust can stillbe good tax planning.

First steps In consultation with your accountant,we'll determine whether this strategymakes sense for you and estimate thepotential tax savings that can beachieved. Let's talk soon to determinehow a tax-planned will can assist yourfamily.

*Tax rates, exemptions and benefits are as of January 1, 2011 and assume residency in Ontario.Written and published by Investors Group as a general source of information only. It is not intended as a solicitation to buy or sell specificinvestments, nor is it intended to provide tax, legal or investment advice. Readers should seek advice on their specific circumstances froman Investors Group Consultant.

™Trademark owned by IGM Financial Inc. and licensed to its subsidiary corporations.

“The tax-planned will – Creating tax savings for your spouse and the next generation” ©Investors Group Inc. 2012. MP1065 (04/2012)