CKUA

[Arctec]

Scrimping brings wealth and tax angst for couple

ANDREW ALLENTUCK
Saturday, February 03, 2007
In Toronto, a couple we'll call Harry, who is 57, and Gladys, who is 56, have built up nearly $1.8-million in financial assets. Self-employed, they have been winding down their consulting businesses, looking forward to making use of assets accumulated earlier in their lives when their combined incomes of $150,000 a year were three times their current level.

Harry and Gladys have a house with an estimated market value of $315,000 plus $23,000 in cash. Those items push their total assets up to about $2.15-million. They have $50,000 of permanent life insurance, which should be enough to pay taxes on the death of the second partner. They have, as well, put aside $100,000 for each of their two adult children. They have no debts, but when they retire and begin receiving income from their registered retirement savings plans, Canada Pension Plan and Old Age Security, they worry about what they expect will be a heavy tax load.

"Have we lived too much in the future and not enough for the present?" Harry asks. His question reflects the broader issue of the amount of retirement income he and Gladys can expect.

What our expert says

Facelift asked Derek Moran, a registered financial planner who heads Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Harry and Gladys in order to devise a plan for managing future taxes and, as well, to ensure the security of their future retirement income.

"Harry is like a Depression baby," Mr. Moran explains. "I admire his disdain for waste of any kind. His possessions are partly made up of hand-me-ups, as he calls them, things his kids bought and don't use any more."

The problem that Harry and Gladys present is one of tax management and asset protection, Mr. Moran explains. The couple have followed the right principles of saving and investing, but they have failed to balance the distribution of those assets. Gladys's RRSP has a present value of $1,044,400, which is 74 per cent of their total RRSPs. Neither has a company pension, so the handling of the RRSPs will be vital to their future, he adds.

In planning that future, Harry has taken on the role of actuary. He assumes that Gladys will live to 105 and that he will die much earlier, perhaps from an accident. He has made no allowance for inflation in his projections. But he worries endlessly about taxes that will be payable on the substantial income that will be produced by his and Gladys's registered retirement income funds.

Harry has considered borrowing $500,000 for an investment within his RRSP and paying interest costs out of the cash flow within his plan. RRIF income tax would be reduced by interest costs.

That plan does not mesh with Harry's personality, however. He loathes debt and he would be troubled if the returns from the borrowed money were to be less than the interest cost. As well, he and Gladys have $385,450 in non-registered assets that produce reportable income.

The concept of borrowing to produce income and generate costs would work as long as stock markets remain bullish or at least reasonably steady. But if the markets in which he has invested turn bearish for a long time, he might lose his nerve. After all, at his age and with his pessimistic expectation of death by chance, it would be irrational to try to wait out a long bear market, the planner explains.

Tax planning is the core of the investment strategy, Mr. Moran says. If the government's pension-splitting proposals become law and are broad enough to include both government and private source pension flows, then the only major problem would arise if one spouse died much earlier than expected. The survivor would inherit the other's registered plans and non-registered assets. The survivor's income would then be higher and harder to manage.

Gladys can expect to live to age 87, which is another 31 years. She could begin RRSP withdrawals in 2007. If she did that and assuming 6-per-cent annual growth of assets and 3-per-cent average annual inflation, she could withdraw $50,698 a year until age 92. If her real return was to rise to 5 per cent, she would be able to withdraw $63,790 a year, the planner says. Each estimate assumes exhaustion of funds by age 92. All figures are in 2007 dollars.

Harry's RRSP has a present value of $369,270. His life expectancy of 82 gives him another 25 years to live. With a 3-per-cent real rate of return, he can withdraw $20,589 a year. If his returns were to rise to 5 per cent a year, he could withdraw $24,953 a year for the next 25 years on the same basis as Gladys, Mr. Moran notes.

Harry has earned 68.8 per cent of the maximum Canada Pension Plan credits, while Gladys has earned 47.6 per cent of the maximum. The current CPP maximum payout is $10,365 a year. At age 65, Harry would therefore receive $7,131 a year and Gladys would receive $4,934, Mr. Moran estimates. They could begin payouts before age 65, receiving sums reduced by 0.5 per cent a month for each month prior to age 65 that they begin their benefits. Tax considerations suggest that Harry and Gladys start taking money out of their RRSPs and defer CPP applications until each reaches age 65.

Harry and Gladys will each receive $5,903 of Old Age Security beginning when each reaches 65.

The couple's combined income, based on real returns in 2007 dollars, will therefore be not less than $61,535 for Gladys and $33,623 for Harry. On top of that, they will be able to use their non-registered portfolio, currently $365,450, plus $23,000 cash.

Setting aside the non-registered assets, these projections show total annual income of $95,158. If the pension income is indeed split to give each partner $47,570, then the OAS clawback, which now begins at $63,511, would have no effect, Mr. Moran says.

The only remaining issues concern life insurance. The whole life policy in place has a death benefit of $50,000.

Rather than continuing to pay premiums, they can put the policy on a premium holiday and allow annual costs to be paid from the capital within the policy, Mr. Moran says.

"This couple has achieved income security on their own resources," the planner says. "They worry needlessly about tax issues. The proposal of the government to split pension incomes for tax purposes relieves their concerns and compensates for the imbalance in their RRSPs. As long as they remain invested in conservative, diversified assets and keep management fees down, they should have a retirement without financial problems."

Interested in a free Financial Facelift? Then drop a line to the writer at 444 Front St. W., Toronto M5V 2S9 or [e-mail]

Client situation

Harry, 57, and Gladys, 56, live in Toronto.

Net monthly income: $4,500

Assets: Harry's RRSP $369,269; Harry's taxable investments $76,396; cash $11,500; Gladys's RRSP $1,044,397; Gladys's taxable investments $289,055; house $315,000; cars $35,000.

Total: $2,140,617

Monthly expenses: Property taxes $194; utilities and maintenance $579; phones $152; cable, Internet $97; food $487; dining out $150; entertainment $300; fitness club $60; clothing $130; car fuel, repairs $536; transit $45; education $100; vacations $535; car and home insurance $443; life insurance $300; medical insurance $50; charity and gifts $227; savings $115.

Total: $4,500

Liabilities: None.