I have seen many problems for loved ones when a person dies before they had a chance to update their beneficiary designations, including unintended tax consequences. I will describe the tax consequences more below. Your estate planning is more than just drafting and signing your Will. You must look at all your assets and analyze how they are legally held and understand how certain assets will be automatically distributed outside your estate when you die. Assets that have a named beneficiary do not form part of your estate and, as such, are not distributed according to your Will.
If you hold a life insurance policy (individually or with your employer’s group plan), registered accounts (RRSP, RRIF, TFSA) or segregated funds, then you should have filled in forms letting the financial institution know who to send the funds to when you die. You may pick a person, a charity or name your estate. If you choose a person, sometimes the financial institution also allows you to pick an alternate or contingent beneficiary(ies) in case the first person you choose dies before you. You may also choose more than one person and pick the portion that each person may have. Typically, you would name adult(s). Minor children should not be named directly on registered accounts but in most circumstances, you may name minor children on an insurance policy if you name a capable trustee for them. There are other ways to benefit minor children, but those strategies will not be discussed here.
The cases I have come across involved people dying with a significant amount of group life insurance through their employer or an RRSP. In all the cases I have personally dealt with, when the deceased first fill out their forms with their employers or financial institution, that person did not yet have a spouse and/or children. Often, the single person designates a sibling, a parent or niece/nephew as the beneficiary(ies). The problem arises when that person unexpectedly dies after getting married and/or having children. They had intended for their new spouse and/or young children to benefit from these assets but because they neglected to turn their minds to their new family circumstances, others now get the benefit of those funds. Occasionally the other family members have been known to renounce their benefit and give the surviving spouse the insurance or registered funds but unfortunately, this is rare.
In the last year or so, I worked on two files where the beneficiary designations where not updated and the spouses and young children suffered significantly from a loss of assets and had to endure an unnecessary tax burden. Finally, they also had unexpected legal costs to try to resolve the issues. In both cases, the spouses had filled in the forms prior to marriage and did not update them with the employers or financial institutions.
As you can imagine such a situation can cause an enormous amount of stress and family disharmony. In the case of a RRSP or RRIF, the situation is further magnified by the fact that these assets are fully taxable as straight income as of the date of death. However, if the surviving spouse is the named beneficiary, then tax rules allow the spouse to defer the taxes during his or her lifetime. But this tax deferral is lost if the funds are given to anyone else. In practice, this means when the entire fund is given to another relative, the estate bares the entire cost of the tax, which means even less money is available for the beneficiaries of the Will who may be the surviving spouse and/or children. Essentially, the surviving spouse who did not receive the RRSP/RRIF proceeds now also has to pay for the taxes in respect of it out of the estate.
If you have life insurance policies (including ones through your employer), registered accounts or segregated funds, I recommend that you review your beneficiary designations with your employer and financial institutions. I urge you not to wait to do this. It is not unheard for information on these forms to be entered incorrectly into databases or for forms to get lost years later; so even if you think you have things in order, mistakes do happen and double checking is worthwhile.
If you are in doubt about how to fill out the forms, you should consider naming your estate as the beneficiary. This way, your Will instructs how your life insurance policy or registered funds will be distributed. As long as you continue to update your Will to reflect changes in your life, your loved ones will benefit from those assets (assuming there is no estate litigation). The only downside is that the assets which form part of your estate will be subject to probates fees, if any. In British Columbia this fee is 1.4% of the total value of the Estate and varies depending on where you live. But it is a small amount for your estate to pay compared to benefiting the wrong individual(s) at the end of your life.
If you are a financial professional, I recommend you take the time to review the beneficiary designations annually with your clients to make sure they are appropriate depending on their changing life circumstances. There may also be legitimate reasons for naming other family members or loved ones and for having the funds fall outside of an estate so those strategies should be discussed as well, and your client’s intentions should be documented in writing.
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