Excerpt from The Professional Corporation – Multi-Generational Tax Planning
Multi-generational planning can affect both you and your heirs. If you consider your current situation and then project it into the future, you may well find two very different outcomes.
Suppose you are currently working and inherit $600,000 from a relative. You could use the tax-free money you inherited to pay off any debt you might have and then use the money you were using to make payments for investment purposes. As your investment pool grows you would probably have an ever increasing amount of investment income. This investment income would be added to your employment income and taxed at higher rates. For example, if your employment income was $130,000 and your investment income was $30,000, you would pay tax at the high rate on the entire $30,000. If you lived in Ontario the tax on the $30,000 would be about $13,923.
If you didn’t have debt and invested the $600,000 you would still end up with the same situation, with investment income added on top of your employment income. But what if you were to split income with yourself by having your relatives change their will?
Instead of having your inheritance paid directly to you, you have the money paid into a trust. The trust would be defined in your relative’s will and would name you as the trustee of your own trust. As previously mentioned, trusts are separate legal entities and as such are subject to tax. The major difference between the taxation of these trusts versus an inter vivos trust is that a trust created in a will is defined as a testamentary trust and is taxed using marginal tax rates. One difference between the taxation of testamentary trusts and an individual’s is that testamentary trusts are not eligible for personal exemptions. However, approximately the first $40,970 is taxed federally at the low tax rate of 15 per cent.
In our previous example, your employment income was $130,000 and your investment income was $30,000. Using a testamentary trust to receive an inheritance would result in an annual tax savings of about $7,923. Instead of the money coming directly to you, it is paid to the trust. The money is invested in the trust and the income is declared by the trust. The trust will pay tax of about $6,000. The net trust income will be $24,000 ($30,000 – $6,000). The $24,000 is added to the capital of the trust and can be removed by the capital beneficiary tax-free. This means that every year you could have the trust declare the investment income, pay the tax at its own marginal rates and then remove the after-tax amount as tax-free capital.
Multi-generational planning can also involve your children. In a typical case, a couple with children will have their wills drawn up to read something like this: “If my spouse Patti survives me by 30 days then I leave everything to her and if something happens to both Patti and me, or she does not survive me by 30 days, then I leave everything “in trust” for my children Justin and Brittany.”
Why not generation plan with your spouse and children? Instead of leaving all your estate to your spouse and asking them to use the money to raise the children, why not leave some money “in trust” to your children with your spouse as the trustee? If you have two children you could save over $20,000 per year in income tax. How?
Suppose you died last night and left your spouse $2,000,000. If they invested this money at 7 per cent it would generate $140,000 of taxable income. If they happened to work and continued to earn $40,000 per year their gross income would be $180,000. Personal income tax on this amount would be $67,000. That would leave them $113,000 to maintain the family’s lifestyle.
Instead of leaving everything directly to your spouse, suppose you left $900,000 in a spousal trust, $400,000 in a trust for each of your two children and gave your spouse the remaining $300,000 as a direct gift. Assuming the same 7 per cent rate of return the tax situation would now look like this:
|First child’s trust||$28,000||$5,700||$22,300|
|Second child’s trust||$28,000||$5,700||$22,300|
|Spouse’s personal gift||$21,000||$6,300||$14,700|
The surviving spouse can have the after-tax income from the children’s trusts available to raise the children along with the capital. These trusts can be kept throughout the lifetime of the children but are subject to the…