There could be a hefty tax bill to pay if your client dies with funds in an RRSP and hasn’t specified a beneficiary.

Assuming the RRSP has not yet matured, the fair market value of the property held in the RRSP at the time of death, along with any other amounts the client received from the RRSP during the year, will have to be included in income and reported on the individual’s tax return for the year of death.

What’s more, adds Gena Katz, an income tax specialist with Ernst & Young LLP in Toronto, the funds will be taxable at the client’s top marginal rate. That could be as high as 46%, depending on the province in which the client lives.

But tax planning can reduce the burden for most clients. The client can name a surviving spouse or common-law partner as sole beneficiary of the RRSP and the funds can then be rolled over, leaving the taxes to be paid upon the death of the second spouse or partner.

In effect, Katz explains, the spouse or common-law partner takes over the RRSP and becomes the successor annuitant.

The Canada Revenue Agency says two conditions must be met:

> the spouse or partner must be named in the RRSP contract as the sole beneficiary of the RRSP; and

> before Dec. 31 of the year after the year of death, the spouse or partner must tell the RRSP issuer to transfer all the RRSP property directly to an eligible registered plan or fund, or to an issuer to buy an eligible annuity.

A page on the CRA’s Web site (www.cra-arc.gc.ca/E/pub/tg/rc4177/rc4177-05e.pdf) explains the rules and includes examples of how to calculate the tax liability under various circumstances.

Even if the surviving spouse is not named on the RRSP contract, she or he may still be entitled to a rollover. But the funds would first go into the deceased’s estate. The will might specify the person who was intended by the deceased to inherit various assets. The CRA says if the will states the spouse or common-law partner is entitled to amounts paid under the RRSP or is the sole beneficiary of the estate, an election for a rollover may be made.

Lea Koiv, a senior advisor in taxation at Standard Life Assurance Co. of Canada in Toronto, says the surviving spouse and the legal representative of the estate — the executor — can then sign an election, filed with the CRA, to provide for a rollover of the RRSP to the surviving spouse.

Even if the spouse is not named as beneficiary in the will, there may be some entitlement to RRSP funds by virtue of family law, says Katz.

When RRSP funds pass through the estate, Koiv warns, they have to be included with other assets and thus become subject to probate fees. In Ontario, for instance, probate fees are $250 plus 1.5% of the portion of the estate in excess of $50,000.

As well, she notes, there’s a risk of the amount being exposed to creditors if the deceased has debts that must be paid from the estate. It’s better to name the spouse or common-law partner on the RRSP contract, she advises. That way, the funds can be transferred speedily and easily.

What if there is no surviving spouse? Tax rules allow for a dependent child or grandchild to be named as the beneficiary on the RRSP contract. In fact, Katz explains, as a result of changes in 1999, a dependent child or grandchild can be named as beneficiary, regardless of whether there is a surviving spouse. Amounts paid out of the RRSP in these circumstances are then taxed in the beneficiary’s hands, not the estate’s.

For tax purposes, a dependent child or grandchild is someone whose income is less than the basic personal amount for the tax year — $8,839 in 2006 — and who was financially dependent on the deceased at the time of death. If the child or grandchild is dependent because of infirmity, the dependent’s income for the year preceding the year of death must not exceed the basic personal amount plus the disability amount — $6,741 for 2006.

When a dependent child or grandchild is named as beneficiary, options for the beneficiary may be limited. If the RRSP funds are rolled over to a child or grandchild who is a minor and who is financially dependent on the deceased but not infirm, Koiv says, the beneficiary may purchase an immediate annuity for a fixed term not exceeding 18 years minus the age of the minor at the time of acquisition. If the financially dependent child or grandchild is over age 18, adds Katz, the funds transferred will be fully taxed as income to the child.

@page_break@If the dependent child or grandchild is infirm, Koiv says, she or he may transfer the funds to an RRSP, a RRIF or an annuity. Koiv also notes the federal Finance Department is currently reviewing additional options that might be provided to infirm dependents.

If the RRSP has already matured and been converted to a RRIF or annuity when the client dies, similar rules apply. For example, if no qualified beneficiary is named, the fair market value of funds in a RRIF or the commuted value of an annuity will have to be declared as income on the deceased’s final tax return. But rollovers to a surviving spouse or dependent child are still possible.

In fact, Katz notes, if a surviving spouse has not yet reached age 69, funds from the deceased’s RRIF may be rolled over to the surviving spouse’s RRSP. Otherwise, payments from the deceased’s RRIF or an annuity can simply continue to the surviving spouse, who is named as successor annuitant. The transition is generally seamless and the amount is not included in the deceased’s final tax return.

It is worth noting, Koiv says, that while no further contributions can be made to the deceased’s RRSP after death, it’s still possible for his or her executor to make a one-time contribution to a spousal plan in the name of the surviving spouse — assuming the deceased had RRSP contribution room — so that a deduction can be claimed on the deceased’s final tax return.

As well, she notes, relatively new provisions under the Income Tax Act allow for a charity to be designated as beneficiary of an RRSP. Funds in the RRSP are paid directly to the charity; the fair market value of the RRSP gets included in the income of the deceased, but a charitable donation receipt is available to offset the tax liability on the final tax return.

Your client may not have any “qualified beneficiaries” — a surviving spouse and/or dependent child — for an RRSP rollover. But there could be other family members to whom the person would like to leave assets, such as adult children who are not dependent, other relatives or friends. To protect the estate so the maximum amount possible is left, Koiv recommends purchasing insurance to cover the tax liability. A term-to-100 policy is relatively cheap, she says, and non-taxable insurance proceeds can then be used to pay the taxes. IE