Trust Wills and Tax Savings
I’ve already expanded on some of the other reasons people might want to set up trust for their heirs rather than providing them money or other assets directly in my June newsletter. Sometimes, the tax savings may be the only reason for leaving things in trust. I’ll spend the rest of this article spelling out some of the tax benefits this can provide and will do my best to avoid legalese whereever possible and to make this more enjoyable reading than an instruction manual.
One of the favourite terms in tax planning is called “income-splitting.” This refers to ways of legally having income that would otherwise be taxed in one person’s hands at a higher rate taxed on another tax return at a lower rate. The savings can be huge. If $10,000 can be removed from one tax return where it could be taxed at up to 43.7% (B.C.’s highest tax rate) and taxed on another return at 20.06% (B.C. lowest tax rate), then we’re already looking at savings of over $2,300. The results can be even better! If the person receiving the income has enough unused tax credits, it might even be possible to turn a potential $4,370 tax bill into a tax liability of . . . $0. Even more exciting, for people receiving dividends from Canadian publically traded companies, income-splitting can theoretically be the difference between paying taxes on the dividends or getting money back from the government on the same dividend income.
Now that you hopefully can see how income-splitting is good thing, I’ll try to explain how Trust Wills and Life Insurance Trusts can allow you to income-split from beyond the grave. Most of these savings apply on any income earned after an inheritance has been received, then reinvested. As this seems like a good place to use a list, I’ll outline how trusts are taxed and how they can be used for income-splitting:
- Trust Income is Taxed Separately. The first key point is that the trust is taxed as a separate legal entity and files the same tax return people use, although it can’t claim some credits or deductions, such as the personal income credit which lets all Canadians keep their first $10,400 of income without paying any tax on it. In B.C., a trust pays approximately 20.06% on the first $1 of income. If the heir had received their inheritance directly received this $1 would be added to whatever other income the heir earns. For example, if the heir was already earning $150,000, the extra dollar would increase the taxable income to $150,001 and the last dollar would be taxed at 43.7%. Accordingly, having the trust declare the income means huge saving.
- Trusts Allow You To Choose Who Pays the Tax. Any trust has 2 basic options when it receives taxable income and pays it out to beneficiares – it can declare the income and pay out an after-tax amount or it can pay out the full amount and make the beneficiary declare the income on his or her tax return. For example, a trust earning $1 could pay out $.80 to a beneficiary after declaring the income and paying $.20 in tax directly. The beneficiary does not have to include the $.80 on his or her tax return because the trust has already done so. Alternatively, the trust could pay out the full $1 and make the beneficiary pay tax on it. If the beneficiary doesn’t have any other taxable income, however, this could mean paying out over $10,000 to a beneficiary with neither the trust or the beneficiary having to pay any tax on it .
- Trusts Can Have Multiple Beneficiaries and allow the Trustee to Determine Who Gets What. A “discretionary” or “sprinkling” trust is set up so the Trustee has the discretion to pay out (or “sprinkle”) as much or as little income earned by the trust to any of the named beneficiaries in whatever amounts the Trustee decides. Accordingly, if you leave a trust for your child and his 5 own minor unemployed children and the trust earns $50,000 in income, it is theoretically possible for the Trustee to pay $10,000 to each grandchild through your son and pay no tax on the money. If your boy was otherwise in the top tax bracket, this can result in savings of over $21,800 in taxes in a single year! Your boy would have to spend the money on his children, but he could likely use the money to pay expenses that would have otherwise come out of his pocket. Moreover, if he is the only Trustee or gets to appoint Trustees, he still has effective control over the trust, which is one the things that parents want to ensure when setting up trusts for their children in the first place.
- Tax-Paid Income from A Trust Doesn’t Affect Most Government Benefits. Once the trust pays tax on income and distributes after-tax amounts to beneficiaries, this income generally doesn’t affect most government benefits, such as the Age Credit and OAS pensions. Both of these government benefits get reduced as a person’s income increases. Accordingly, if the trust can pay the taxes and pass along the net amount to beneficiaries, this allows beneficiaries to get both the benefit of their inheritance as well as maximizing their income-related government benefits.
- Income Kept Inside a Trust is Taxed at the Trust’s Rate. While this means that you don’t have the ability to pick from multiple tax returns to minimize taxes, income does get taxed inside the trust at the same marginal rates that apply to people. In other words, trusts use the same tax brackets and rates people use so trusts can generally earn a lot of money that will be taxed at the lowest tax bracket. If you have a working child who is laying aside a bunch of money for retirement, the trust can allow savings to build quicker, as the tax bill will be lower. When it is time to withdraw the money during retirement, the trust can pay any additional taxes so your child maximizes government benefits and doesn’t have to pay personal taxes at a higher rate.
- As Trusts Can Lend To Beneficiaries, Trusts are Still Useful for Heirs with Mortgages. Many parents seem to dismiss trusts on the grounds that their kids will use all of their inheritance to buy a house or pay down existing debt. On the hand, if the trust document is carefully drafted, the trust can lend selected beneficiaries money, even at 0% interest if this is specified. As a result, even though a high income child might need all of her inheritance to pay down school costs or buy a home, the trust may come in useful down the road. In addition to potentially providing more protection from creditors or divorce, your child might appreciate the potential tax savings from a trust when she has the money to pay the trust pay, has children of her own to income-split through the trust or if she wants to open a professional corporation. In other words, although the trust may not be useful now, it might still be a valuable tool for your child down the road or at retirement.
- Assets Can Be Transferred to Beneficiares on a Tax-Deferred Basis. First the bad news. Every 21 years, any unrealized capital gains inside the trust are taxed as if they had been sold then repurchased. Now the good news. At any point, the assets can be transferred to the beneficiares without triggering a tax bill. The beneficairy ends up with the same unrealized capital gain and will be taxed when the beneficiary sells or dies. This means that if your heirs want to wind up the trust, they could always just transfer the assets out to themselves without triggering a tax bill if the trust allows this.
- Spousal Trusts Defer Capital Gains Like Gifting Directly to a Spouse. If you gift directly to your spouse at death, s/he inherits in the same tax position you had before death and no bill is triggered until s/he dies or sells the asset. A “Spousal Trust” provides the same benefits. Moreover the 21 year rule discussed in the previous bullet does not apply while the surviving spouse lives, although there will be a deemed sale when the spouse dies, just as if s/he owned the assets personally. On the other hand, the assets in a trust aren’t subject to probate fees on the second spouse’s death, which can mean tax savings. As well, the total tax bill at the last death can still be significantly lower because the trust and the deceased may still be able to income-split. There are rules for how a spousal trust is set up. Essentially, the surviving spouse must be entitled to all of the income from the trust each year and must be the only person entitled to the capital in the trust while s/he lives. As a result, sometimes spouses set up one trust at death for all the assets with big capital gains and another for that spouse and other beneficiaries that does not have all the restrictions of a spousal trust so as to maximize income-splitting.
Anyway, to wrap things up, the key points are that trust can save your heirs a bunch of money and most importantly, can be useful regardless of your heirs’ tax brackets. There is a big jump in tax rates between the lowest and second lowest tax brackets, so trusts for heirs who aren’t making big money can still make a big difference, especially if the trust can protect government benefits during retirement. If you are interested in learning more about trusts and possibly using them to both protect your heirs and make their inheritance go further, give me a shout!