Significant Changes to Canada Tax Rules for Testmentary Trusts

Testamentary TrustOne of the major changes in the recent Canada Federal Budget was the elimination of a significant tax saving vehicle through the use of a testamentary trust. From a tax perspective, we’ve been allowed to do use testamentary trust (the trust that is created upon someone’s death) to gain a major tax advantage upon somebody’s death ever since family trusts came into play.

Forgive me for this rather morbid example but it is necessary to understand the concept at work here. Let’s say mom and dad pass away with a significant amount of wealth. They have four children that have their own families, their own income and don’t want any more income directly in their hands.

Previously, mom and dad could leave their estate to a testamentary trust for their grown children and those trusts are taxed as another individual and are subject to the same graduated tax rates that you and I pay.

2014 Canada Federal Budget Eliminates Graduated Rates

The graduated rates that previously made testamentary trusts an effective tax savings vehicle have been eliminated in the 2014 Canadian Federal Budget.  Basically, any benefit of using testamentary trusts as an estate planning tool is no longer applicable. This is unfortunate as this method of estate planning saved a lot of money but it has been eliminated in the recent Canada federal budget changes.

Using another example, let’s say mom and dad had a million dollar stock portfolio and they’ve been paying tax on it themselves. When they pass away, you now own that portfolio so any income it earns – let’s say $100,000 a year – is now going to go directly on your personal tax return. Any income that it earns is now your income as the owner.

What we used to be able to do is leave that million-dollar investment portfolio in a trust with your name that you directly control while retaining the ability to withdraw it all at any time.

Here’s the big difference: You would file taxes as two separate people: one for the trust that your parents left you and one for yourself.

Breaking Down The Difference

  • If the estate made $100,000 in interest income in a particular year from it’s investments and that was your only income, you would pay about $26,000 in taxes.
  • If you already had a $100,000 salary at your job and then your parents passed away, you would pay $70,000 in taxes after the additional $100,000 in interest income was added into the picture.
  • If we still had the ability to file separate tax returns for your trust holding $100,000 in investment interest income and a separate tax return for your $100,000 salary.
  • This would have allowed you to save an additional $18,000 every year by filing separately in this particular example.

From zero dollars to the maximum tax bracket is where all the savings is. You start off paying zero tax in the first tax bracket and move to 20% at the next rate, then 29% and so on. The total you could save would be $18,000 but now we can’t save that anymore as the government has eliminated this in the recent Canadian federal budget update.

Reevaluate Your Testamentary Trust In 2014

It’s understandable that the government would want to change this because if mom and dad pass away with several kids, each of them would have been able to save up to $18,000 a year in taxes with this planning method. That adds up very quickly over the years so it is unfortunate that we lost it.

We did know this was coming as they announced it in the summer time but they are not grandfathering any existing wills. We were really hoping to see that because a lot of people have done that tax planning hoping it was going to work but they’ve taken it away. Nothing existing has been grandfathered – it affects all trusts with a taxation year starting in 2015.

If you do have a testamentary trust, speak with your legal and tax advisors as soon as possible to determine your best course of action.
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