Not knowing this simple tax rule causes problems in estates

I recently dealt with a question from a reader about paying "his portion" of the taxes on a RRIF, which he and another person are going to receive as they are the named beneficiaries of the RRIF. This is something that I hear very frequently, as it's commonly thought that a person receiving an asset must be the person who pays the tax on it. Unfortunately, this is not correct and it causes many problems and disputes in estates where executors don't seek professional guidance.

Let's say that the RRIF in question is worth $100,000, or $50,000 per beneficiary. Let's also say that the tax owing on the RRIF is going to be $30,000, or $15,000 per beneficiary. Plenty of executors (and beneficiaries for that matter) believe that this means instead of getting $50,000 each, the two beneficiaries are going to receive $35,000 each (50,000 - 15,000 = 35,000). This, however, is not the way the tax is paid.

What happens in reality is that each beneficiary receives his or her full $50,000. The $30,000 tax comes out of the estate itself. This means that the tax on the RRIF is paid from the bank accounts, investments, house or other assets owned by the deceased, even if the estate is being left to other people.

This is because the tax on the RRIF is a debt owed by the person who passed away. The RRIF itself is no smaller on the date of death, and so the whole thing must be given to the person(s) named. The law says that debts of an estate are paid from the residue of the estate first, so that's where the payment must come from.

Many people who do estate-planning without legal or tax advice never realize how easily their intent to treat everyone fairly can be upset by their failure to understand this rule. For example, let's say a mother leaves her $200,000 RRSP to her son, and the rest of her estate, which also adds up to about $200,000, to her daughter. She wants to treat them equally and thinks she has achieved this.

What she doesn't realize is that when she passes away, her son will get the whole $200,000 RRSP. The estate will pay the tax on the RRSP. Let's say the tax is $60,000. This means her daughter will receive $140,000. If there are other bills or taxes, the daughter will receive even less. This isn't even close to what the son will inherit, the mother's wishes don't go as planned, and it's quite possible that a dispute will ensue between the son and daughter.

The same rule applies to other assets that give rise to tax when the owner dies. For example, a person who owns rental properties or a lake cottage will also have tax to pay on death, and these taxes are paid out of the estate.

It's possible to draft a will to state that the person receiving an asset should also pay the tax bill associated with the asset, but almost nobody ever does that. I think more people would do that if they were only aware that it was possible. And if they were only aware of the rule in the first place.