How to leave money to an adult child with no investing know-how

Q.  When my husband and I pass away, our only son will be in line for a significant inheritance. Being realistic about his capabilities, we need to pass along this legacy in a responsible way; our son will not be capable of handling a lump sum. Our wish is to have the money reach him in monthly increments throughout his entire life, and also to protect it from a future spouse should that marriage fail. We have no other close relatives and are considering putting the money into a trust, but my understanding is that the funds would be taxed at up to 53%. Are there any alternatives?
–Dee

A. This is a tough one. Since you don’t feel your son is capable of managing his inheritance, you’ll either need someone to manage the funds for him; find a financial product that will do it, such as a life annuity (more on that in a moment); or some combination of the two.

I know you don’t have close relatives who could manage the inheritance on behalf of your son—but even if you did, would you want to leave them with that responsibility? That could entail a lot of work over the long term. Plus, a relative would have every right to charge a fee similar to that of a professional trustee.

A financial product that you may want to consider is a life annuity. These are financial products purchased from life insurance companies, and designed to pay guaranteed incomes for life, just as pension plans do for retirees.  Your son will have a monthly income for the rest of his life, and the money will be protected. There are no upfront fees to pay with annuities, but there are costs built into the product.

What you give up with an annuity like this is income flexibility and distribution, tax planning opportunities, the potential to earn higher investment returns, legacy planning for your son’s children (meaning that once your son passes, there will be no more money), and the possibility to influence the behaviour of your son and any grandchildren you might have.

I’ll touch on a few of those issues below, but consider getting an annuity quote to compare the annuity income against the income you think you may be able to generate with an investment portfolio managed by a trustee.

Here is an annuity example. If your son is 65 years old when you pass, $1 million will buy him an annuity income of about $5,000 a month for life. To compare and find the rate of return an investment portfolio needs to earn to match the annuity, I’ll draw the portfolio down to “zero” at assumed life expectancies of ages 90 and 100. The respective rates of return on the investment portfolios would be 3.57% and 5.07%. The longer your son lives, the better the annuity return.

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Another alternative, as you suggest, is to have the money put into a testamentary trust with a hired professional trustee to manage it. You’re correct that every dollar earned in the trust will be taxed at the highest marginal tax rate, and the trustee fees may appear high, but in return you gain flexibility, which I’ll describe below, and your son and his inheritance will be looked after and protected for the rest of his life.

Dee, you expressed concern about the costs associated with this option. I’ve listed the potential fees below but, of course, your situation may be different:

• Initial setup: This is a one-time fee of $2,000 minimum and any applicable taxes.
• Trust administration fee: An annual fee of 0.5% will be payable based on the average market value of assets under administration, subject to an annual minimum fee of $5,000 and any applicable taxes.
• Investment management fee: An Investment Management fee will be payable as a disbursement of the trust and will be charged quarterly, or at such other frequency as determined by the investment manager, at the then prevailing rate of the investment manager.

The way I look at those costs, Dee, you would be paying 0.5% above your current investment management fees. Is that too much to guarantee your son’s lifetime welfare? You might even find that the investment management fees at a large institution are lower than your current management fees.

For you to make an informed decision, it’s important to review how a trust is taxed at a basic level, and then look at some of the benefits of using a testamentary trust and a professional trustee to handle your son’s inheritance.

A trust pays tax on its annual income minus annual distributions. In other words, if the trust earns $100,000 and pays out $100,000 the trust has no tax to pay.

A trust is considered a separate tax payor, meaning your son and the trust would file their taxes separately. This is a big deal in the first three years of the trust, when it can be designated as a Graduated Rate Estate (GRE) and you can split income. I’ll explain: Normally, all trust income is taxed at the highest marginal tax rate in the province where it resides, except for the first 36 months, when it can be designated as a Graduated Rate Estate. So, in the first 36 months, you can split income and save tax. If your son inherited your money directly, there would be one tax return and no opportunity for your son to split his personal income with the income earned on his inheritance.

When funds are withdrawn from the trust, the trustee can decide who pays the tax: the trust or the beneficiary. The trust money will be taxed at the highest rate of tax no matter the amount of money withdrawn or who pays the tax, with the exception of those first 36 months. So even if your son has very little income, the income he receives from the trust will be taxed at his marginal tax rate.

Note that it is just the income that is taxable. The original amount deposited into the trust is not taxable. Any income that is taxed in any given year and left in the trust is added to the capital and is not taxed a second time when withdrawn.

On a basic level, that’s how a trust is taxed. Now let’s look at some of the benefits.

1. Control. If you want to encourage certain types of behaviour, you can add a clause to the trust that will help shape that behaviour. Examples may include:

• If your son maintains a job for “x” years his monthly income will increase.
• If your daughter-in-law leaves the marriage her income will stop.
• Your grandchildren will each receive a car if they graduate high school with an 80% average.
• International travel or grandchildren’s sports are always paid by the trust, etc.

2. Income Splitting. As discussed above, for the first 36 months, while graduated rates apply, income can be split between the trust and the beneficiary (your son). As you may know, two people earning $100,000 each pay less tax than one person earning $200,000; it is the same thing with a trust and a beneficiary. In Ontario, the maximum tax savings per year over three years would be about $31,000.

3. Income Sprinkling. If your son has children of his own, money can be drawn from the trust to pay for their expenses and taxed at the children’s marginal tax rate. This can only be done while the children are minors.

4. Designated Income. I’m not sure of your son’s employment situation and income, but let’s assume he has an income that puts him at the top marginal tax rate. If he was to draw an income from the trust and pay tax, it would be taxed at the top rate. However, during the first 36 months of the Graduated Rate Estate (GRE), he could draw the money and have the trust pay the tax, instead of him. The difference between income splitting and designated income is that with income splitting, the income does not have to be paid out; it can be left in the trust to accumulate. With designated income, the trust income is paid out and used by the beneficiary.

Now that you’re aware of the things you can do with a testamentary trust, you should also understand the trustee’s responsibilities.

The trustee is responsible for overseeing the management of the investments, bookkeeping and tax returns. They need to understand and follow the terms of the trust, act in the best interest of the beneficiaries, and they generally can’t delegate their duties to anyone else. Depending on the complexity of the trust, there could be a lot of work over a long period of time.

Nobody likes paying fees, especially when you’re not sure of the value you’re getting for those fees. If your primary goal is to protect your son’s inheritance, and his lifetime income and lifestyle, then a professional trustee and testamentary trust may be the best way to go. You may also want to contact more than one professional trustee, including a non-bank trustee, before making a final decision.

Allan Norman is a Certified Financial Planner with Atlantic Financial Inc.

This commentary is provided as a general source of information and is intended for Canadian residents only. Allan offers financial planning services through Atlantis Financial Inc. and can be reached at [email protected]

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