Income splitting and avoiding probate on death are possibly two to the most popular financial planning strategies in Canada. However, a trust is an effective tool to avoid probate and provide your heirs a flexible income splitting opportunity.
What Is A Trust?
A trust is simply an agreement to have one party (the trustee), manage assets for another party (the settlor) for the benefit of another (the beneficiary).
A trust is commonly used to separate the legal and beneficial ownership although this is certainly not a requirement.
To find our more about trusts, please the related articles entitled What Is A Trust? and Types of Trusts.
Trusts & Income Tax
When a trust is established the lifetime, it is known as an inter-vivos trust whereas an trust established on death and under the terms of a Will is known as a testamentary trust.
A trust can either retain its income or allocate it out to the beneficiaries. income allocated to the beneficiaries is tax in their hands while the income retained in the trust is tax at the trust tax rate.
The tax rate for an inter vivos trust is flat and at the top personal marginal tax rate (39% to 50% depending on the province).
For testamentary trusts, the tax rate is the same as an individual except that there are no personal tax credits. For testamentary trusts, the trust itself may be used as an income splitting vehicle.
Probate & Income Taxes
Probate is a court fee imposed to confirm the executor of an estate and the validity of the will. Any assets that are specifically mentioned in the will will be subject to the calculation of the probate fee. Certain assets that allow you to name a beneficiary (i.e. insurance, segregated funds, other insurance contracts, RRSPs, and RRIFs) are said to pass outside the estate and are not included in the calculation of probate fees.
For more on probate, see my article entitled How to Minimize Probate Fees.
Avoid Probate & Income Split
This strategy works best with life insurance polices or other insurance products that allow a beneficiary designation since these products allow trust settlement options in their terms.
You first modify your Will to establish testamentary trusts for your beneficiaries. Then you have the insurance beneficiary designation set to funds these trusts on death.
What Happens At Death?
When you pass away, your will establishes a trust and the insurance contracts will pay directly to the trust and by-pass probate.
The assets in the insurance trusts are then invested and the income is taxed inside the trust as opposed to in the beneficiaries hands. Income is paid out of the trust on an after tax-basis and viola, probate is avoided and income is split!
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