FP Answers: What is the benefit of a graduated rate estate when doing estate planning?

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By Julie Cazzin with Andrew Dobson

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Q: I am in the process of estate planning for my 90-year-old parents. Both are still alive and doing fairly well, and I’m reading up on taxation for my own benefit. I came across a term called graduated rate estate (GRE). What is it exactly and what are its benefits? Will it save my parents any money? They have an estate worth roughly $5 million, comprising $4 million in real estate and $1 million in stocks and guaranteed income certificates (GICs). — Nicholas P.

FP Answers: Canadians pay income tax at graduated rates during their lives. The first $10,000 or so of annual income is tax free, but varies by province or territory. Higher levels of income move into higher tax brackets so that some of that income is taxable at progressively higher tax rates.

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A graduated rate estate refers to the preferential tax treatment of income earned by the assets of a deceased person after their death. Prior to 2016, Canadians could establish trusts in their wills that could hold assets with income taxable at the same graduated rates as an individual.

People could set up trusts for their spouse, children, grandchildren or others and have some of the investment income from their estate taxable at lower rates than if those same beneficiaries had the income added to their own income on their personal tax returns. This was typically only done for large estates, because of the ongoing legal and tax costs of maintaining these trusts.

As of Jan. 1, 2016, most testamentary trusts established on death became subject to tax at the highest tax rate. One exception was for a single graduated rate estate of the deceased for up to 36 months after death. This was done to prevent multiple trusts from being established to take advantage of multiple low tax brackets.

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Most people’s wills only contain trusts for minor children or grandchildren in the event they die while their beneficiaries are still young for practical reasons, not to save tax. Assets left to a spouse, adult children or grandchildren are generally payable to them directly without having them held in trust. As a result, most estates are settled within months of the individual’s death.

In the case of your parents, Nicholas, they have a sizable estate. If we assume the $4 million of real estate is their principal residence and the $1 million in stocks and GICs is non-registered with no deferred capital gains tax, your inheritance could be nearly $5 million even after costs. If you invested $5 million at a four-per-cent rate of return, that could generate $200,000 of annual income. Adding this income to your existing income could result in a lot of tax payable.

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If your parents’ wills left your inheritance to you in trust, rather than paying it to you directly, it could benefit from the graduated rate estate tax treatment on the $200,000 of investment income in the example above for up to 36 months.

If we assume your existing income is $50,000, annual tax savings could be around $20,000 per year. If your existing income is $100,000, tax savings could be more like $30,000 per year. It depends on the income sources, where you live and other tax deductions and credits, but you get the idea.

Obviously, the benefit could be huge if this graduated rate taxation could continue for many years. The dollars involved can be substantial even if only for 36 months under the new GRE rules.

If you have children or grandchildren, there could be other tax benefits for your parents to leave an inheritance to you in trust. If the beneficiaries of the trust were you and your children and grandchildren, you may be able to allocate some of the income to them to be taxed on their tax returns.

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This can be done by paying the income to them or using it to pay for expenses on their behalf. They may be in a lower tax bracket than the trust or you, and splitting income amongst multiple taxpayers could result in further tax savings.

A graduated rate estate would not save money for your parents. But it may reduce the subsequent tax you might pay on investing the inheritance compared to receiving it directly. It may require a change to their wills and the magnitude of your parents’ assets may make this worth considering.

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A taxpayer who dies is deemed to have sold all their assets with tax payable on their final tax return, unless those assets are left to a spouse. Beyond the graduated rate savings potential, there may not be much potential for saving tax on their death given their ages.

If they live in a province or territory with high probate or estate administration tax rates, there may be planning that can reduce those costs, which could be more than $75,000 on a $5-million estate.

One challenge you may have, Nicholas, is the complexity of having your parents make changes to their wills or estate planning at age 90. You can raise some of these points with them and consider advice from professionals such as an accountant and estate lawyer to get validation and to facilitate these changes.

But some people may be hesitant to consider strategies like these, even if they are beneficial, simply because they may be complicated or confusing.

Andrew Dobson is a fee-only/advice-only certified financial planner (CFP) and chartered investment manager (CIM) at Objective Financial Partners Inc.

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