Recently there has been a surge in the number of clients inquiring about the taxation of inherited qualified accounts, such as: Registered Retirement Savings Plan (RRSP), and Registered Retirement Income Fund (RRIF). Individuals are confused on whether to liquidate the accounts, continue investing or transfer ownership. The situation gets even more complicated in the case of a non-resident (non-Canadian) beneficiary.
In this article, AG Tax cross-border tax professionals have discussed the tax treatment of RRSP and RRIF accounts by the Canada Revenue Agency (CRA), and U.S. Internal Revenue Service (IRS), so that both: the annuitant and beneficiary(ies) can be prepared in case such a tax situation arises.
Taxation of RRSPs & RRIFs on Death in Canada
Pursuant to the Income Tax Act of Canada, when an RRSP owner dies he is deemed to “cash-in” his RRSP at the prevailing fair-market value (FMV). This income is then reported on the final income tax return of the decedent along with other reportable taxable income, and taxed at the time of his death. The amount of tax payable depends on the taxable income bracket and marginal tax rate of the decedent. As the tax liability will be paid from the estate of the decedent, the beneficiary will receive 100% of the amount tax-free.
There are situations, however, where the amounts may be rolled over to beneficiaries without paying the tax at death. If the decedent has designated a beneficiary to the RRSP/RRIF, and the account is rolled over to either the spouse/common-law partner or children, the following rules would apply:
If the RRSP/RRIF account is rolled over to the spouse (including common-law partner)
The amount of the RRSP that has been transferred to the spouse is included in the taxable income of the spouse. The decedent must have designated the spouse as the sole beneficiary of the RRSP and the RRSP must be fully transferred to the spouse’s RRSP by December 31 of the year of death. The RRSP income will not be taxed as a part of the decedent’s estate, and the spouse can defer payment of tax on this income by rolling the RRSP proceeds into his or her own RRSP or RRIF or by purchasing an annuity with the proceeds.
Similarly, if a financially dependent child/grandchild is the designated beneficiary, then the portion of the RRSP/RRIF transferred is not taxed as a part of the decedent’s estate but rather taxed as a part of the child’s income. The child will be considered ‘financially dependent’ for tax purpose if the child‘s income for the taxation year following the year of the deceased’s death is not equal to or more than the basic personal amount used for the preceding tax year. This is also the case if the child or grandchild is impaired in physical or mental functions and their net income for the previous year was equal to or less than the basic personal amount plus the disability amount.
If the RRSP/RRIF is rolled over to a child, who is not disabled but was financially dependent on the deceased, he/she will be taxed on amount of RRSP income designated to him or her. However, if the child is below age 18, then the RRSP premiums can be completely or partially rolled over to an annuity for the child ending when the child reaches age 18. This roll-over is not allowed in the case of a dependent child above age 18.
If the financially dependent child or grandchild was dependent on the deceased because of physical or mental disability, then the RRSP or RRIF proceeds can be rolled to the their own RRSP or RRIF.
The Income Tax Act of Canada provides special provision for disabled children inheriting an RRSP/RRIF, wherein the parent(s) can create a discretionary trust for the child which can hold the RRSP/RRIF for the child. The reason for doing this is because the child continues to receive government assistance while receiving distributions from the RRSP/RRIF, however care should be taken that the RRSP balance is not too large as this could impact the assistance received from the government.
Tax withholding by the Financial Institution managing the RRSP/RRIF
In the case of Canadian resident, the Canadian financial institution which manages the RRSP/RRIF will withhold some portion of the withdrawal as tax withholding, which is approximately 10% of the withdrawal up to $5000, 20% for withdrawals between $5001 to $15,000 and 30% for withdrawals above or equal to 15,001, any excess will be refunded if the taxpayer is subject to a lower tax rate.
If the beneficiary is a nonresident of Canada, a flat 25% is withheld for tax purposes on any distribution/withdrawal from the RRSP . The non-resident beneficiary can then make an election under 217 of the Canadian Income Tax Act to file an income tax return if the overall tax would be less than 25%. This election is usually beneficial when the non-resident beneficiary has low or no other taxable income. There is a procedure available to reduce withholding if an election will be paid, however, since it is quite a time-consuming process normally we at AG Tax prefer to simply let the financial institution withhold the necessary amount and file a return for refund of the excess withholding.
U.S. Taxation of RRSPs & RRIFs
In the U.S., a deceased taxpayer is taxable on the fair market value of assets owned at death. There is an exemption available for smaller estates. If the owner of the RRSP is a U.S. citizen or Green-card holder is subject to U.S. estate taxes, the estate executor would need to report the fair market value of the RRSP/RRIF on the U.S. estate tax return of the decedent. Canadian residents may also be subject to U.S. estate tax if the RRSP holds any U.S. investments.
U.S. beneficiaries of RRSP’s will not be taxable upon receipt of the inheritance as estate tax is payable by a decedent. They will, however, be taxable on any income earned in the plan after the date of death until the time the funds are received. If the decedent was a nonresident of the United States at the time of death, the inheritance will be required to be reported on Form 3520 in the year it is received by the U.S. beneficiary if the amount exceeds $100,000. The Form 3520 is attached to the Form 1040 being filed by the U.S. beneficiary for the year.
If a spouse or common-law partner inheriting the RRSP is a U.S. resident or green-card holder, they will be considered to inherit the RRSP at fair market value as of the date of death and taxable on income accruing in the RRSP from the date of death. Should the amount be transferred to the RRSP of the spouse, the RRSP would be eligible for the treaty election to defer U.S. taxation until amounts are withdrawn from the plan.
As no two tax situations are the same, it is highly recommended that a person consult their tax professional and estate lawyer to properly create an estate plan that addresses their assets to avoid probate, and minimize the income and estate taxes on death. Likewise, a beneficiary of an estate should always consult a tax professional regarding the ownership of the inherited assets to avoid adding significant tax burden that could result from owning the asset in the present or future years.
AG Tax LLP Can Help
If you have any tax-related queries, need assistance with tax planning or filing your tax returns please contact us. Our team comprises of highly experienced tax professionals with extensive knowledge of US and Canadian tax laws as well as cross-border compliance.
Furthermore, as a full service accounting firm, AG Tax assures complete assistance with even your most complex tax needs.
We can assist with:
- Canadian Personal and corporate tax returns
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