Segregated funds are no tax panacea

When I hear a strategy like the one presented, I think, “What problem is the strategy trying to solve, and will it create other issues?” The obvious problem here is tax on death. In your case, an $840,000 RRIF on death may result in about $400,000 lost to tax. When you die, the total value of your registered retirement savings plan (RRSP) or RRIF is added on top of your other income for the year, and the total is taxable. Tax isn’t a problem for you, but it is a cost to your kids because the tax reduces their inheritance. If you ever speak to someone who is not a fan of RRSPs, it is often because they are thinking of the tax on RRSPs/RRIFs. 

The second part of this strategy involves investing in segregated funds and, although segregated funds can sound appealing, I won’t present them as a solution for everyone. In simple terms, a segregated fund is a mutual fund in an insurance wrapper. The insurance wrapper brings with it a death benefit guarantee, a maturity guarantee, creditor protection, and bypass of probate.

The death benefit guarantee insures that, upon your death, your beneficiaries will receive the market value of your investments, or 100% or 75%, depending which option you choose, of your out-of-pocket investment. In addition, many segregated funds allow you to reset the death-benefit guarantee, but when you do this, it resets the maturity guarantee. The maturity guarantee promises that if after 10 years of making your investment, you will be returned 100% or 75% of your initial investment depending on the option you choose. 

Segregated funds also provide creditor protection and the ability to name a beneficiary on a non-registered account. The ability to name a beneficiary means the funds can bypass your estate and avoid estate administration tax, better known as probate. 

The downside of seg funds

These features all sound great, and they are, but they come with a cost, and you already have a couple of these features with your RRIF.  Depending on the mix of 100% and 75% guarantees you choose, the annual management expense ratio (MER) on a seg fund will be 0.5% to 1.25% higher than the underlaying mutual fund. A 75% death benefit and maturity guarantee is the less expensive option, with the 100% death benefit and maturity benefit being the most expensive. That can be a big drag on your investment returns. For example, on your portfolio of $840,000, this means an extra cost of $4,200 to $10,500 per year, depending on the level of guarantees.     

The death benefit guarantee provides good protection when combined with the resets. Resetting the death benefit guarantee when the portfolio hits a new high locks in a higher floor for your beneficiary. The guarantee grows with your portfolio rather than staying fixed at your original deposit.  

As for the maturity guarantee, looking at historical returns, it would be rare for a diversified balanced portfolio to be worth less after 10 years, which makes the maturity guarantee less valuable for a conservative investor.

With a named beneficiary, your RRIF has creditor protection and will bypass your estate, avoiding probate, anyway. Plus, the additional cost of the segregated funds will likely surpass the cost of your probate fees within five years.   

The practicalities of the transfer

Let’s circle back and think about how to get the money out of your RRIF and into a non-registered segregated fund. If you take it all out in one shot you will be paying the tax you want to avoid, but much earlier, and you will have about 50% less to invest. Segregated funds don’t eliminate RRIF tax; the tax is triggered when you withdraw from the RRIF regardless of where you invest the proceeds.

Rather than collapsing your RRIF, you could increase the amount you withdraw so it is depleted by about your age 80. This means paying higher taxes while you are alive but less tax on your death and maybe more money going to your beneficiaries. Leaving money in your RRIF that you don’t need allows it to compound tax-free.

Adding money to a non-registered investment likely means there will be a taxable distribution each year made up of a combination of interest, dividends, or capital gains. This tax is another drag on investment growth. Then, finally, on your death there will be capital gains tax to pay. 

Pam, as I mentioned at the beginning, this sort of strategy is one you really want to model out first with a financial planner. It sounds simple: minimize tax on your estate by getting rid of the thing that is going to create the most tax. But there are too many other connecting variables that should be understood before taking on a strategy like the one presented.  

If maximizing the benefit going to your daughter is your goal, then consider drawing extra from your RRIF to add to your tax-free savings account (TFSA) first, and then your daughter’s tax shelters, such as a first home savings account (FHSA), registered education savings plan (RESP), TFSA, RRSP, and home mortgage.  

Make sure you have enough money to live on yourself. Maybe you want to take out extra and travel more. Sometimes the best estate plan is to spend more, do more, give more, and die with close to nothing. The tax issue on your estate gets solved while you have more fun!  

Read more Ask a Planner columns:

About Allan Norman, MSc, CFP, CIM

With over 30 years as a financial planner, Allan is an associate portfolio manager at Aligned Capital Partners Inc., where he helps Canadians maintain their lifestyles, without fear of running out of money.