You've just found out that your great aunt left a substantial inheritance
that is yours, tax-free. The bad news is that if you invest your inheritance
rather than spending it right away, you could be faced with a significant tax
burden on your annual investment earnings.
Let's illustrate by way of example: Aunt Nellie has just left you $2-million,
which you decide to invest. Being extremely conservative, you decide to park
your windfall in an interest-bearing GIC paying 5%.
Each year, you'll receive $100,000 of interest income taxable at your
marginal tax rate. Let's say you're still working and pulling in $120,000
annually, putting you in the highest marginal tax rate, which averages 45%
across Canada. As a result, when the earnings on the inheritance are added to
your salary, you would pay an additional $45,000 of tax annually.
With some advance planning, your annual tax bill could have been dramatically
reduced. The tool used to do this is a testamentary trust.
A trust is not a legal entity but rather a type of relationship that
separates the legal rights to property from the use and enjoyment of that
property.
A testamentary trust is a special type of trust that is created upon an
individual's death through specific instructions in the will.
The trustee of the trust (the executor or estate representative) maintains
legal ownership of some or all of the deceased's assets for the benefit of
others, known as the trust's beneficiaries.
Under our tax law, there is a significant tax advantage granted to
testamentary trusts that is not available to trusts created while you're alive
(known as "inter-vivos" trusts).
A testamentary trust is considered to be a separate individual taxpayer who
is taxed on any income earned at the normal graduated tax rates.
By contrast, inter-vivos trusts are taxed on any income earned, and not
distributed, at the highest marginal rate, starting from the first dollar of
income earned.
So, how much can you actually save by having your investment income earned
and taxed inside the trust as opposed to earned and taxed in the hands of the
inheritor?
Once the annual earnings have been taxed inside the trust, the after-tax
amounts can be distributed to the beneficiaries tax-free.
Unfortunately, once you receive an inheritance, it's too late to use a
testamentary trust for tax savings. The trust must have been set up in the
deceased's will to allow your inheritance to flow directly into the trust as
opposed to transferred into your hands.
A quick word with Aunt Nellie before she died would have gone a long way to
achieving significant tax savings for the years ahead.