At the age of 75, Torontonian Grace Azure (not her real name) is trying to adjust her personal and financial life. Following the death of her husband, a scientist, earlier this summer, she finds herself with heavy burdens. She has nothing but investment income to support her and her 45-year-old, partially disabled daughter, Monica, for the rest of their lives.
Grace Azure, 75, recently became a widow. She faces a transitional tax year in 2003 when her income is likely to be $80,000. In 2004, she would have gross income of $114,000, including RRIF income of $70,650 if she keeps both her own Registered Retirement Income Fund and her late husband’s RRIF. Her problem is to minimize taxes while preserving an estate for her daughter.
1997 Honda, $10,000; house, $450,000; non-registered stocks, $600,000 (stocks are 70 per cent of portfolio, bonds 30 per cent); RRIFs, $900,000; rental property $600,000 (annual profit on property after expenses, $14,000; life insurance, $200,000. Total assets, $2.76-million.
Food, $1,100; phone, $100; gas, hydro, water, $300; realty tax, $280; auto insurance, $100; gas, maintenance, $75; travel, $600; golf club, $325; charity, $125; drugs, $200; medical insurance, $175; life insurance, $370.
Grace, born in Italy, came to Canada 50 years ago and through hard work, she and her late husband built their fortune. Now, her problem is taxation. On top of her own $80,000 investment income estimated for 2003, she will receive payments from her husband’s registered retirement income fund. The payments would add to her income and impose additional taxes on money that she does not need right away.“I was shocked to realize that, as a result of inheriting my husband’s RRIF, I will have to pay a huge tax bill on money that law compels me to take,” Grace says.“I don’t need this money for myself, but I have a real need to preserve the capital for Monica after I am gone.”Grace has three choices for her husband’s $400,000, which, as the named beneficiary, she inherits.
She could roll it into her own RRIF with no tax due. This allows her to receive payouts from the RRIF, with minimums set by law. At age 75, for example, she is obliged to take 7.85 per cent, which works out to $31,400 this year.
Grace could turn the entire RRIF or any part of it into an annuity, and receive whatever payments she can obtain in the annuity market.
Or, she could collapse the RRIF in whole or in part. If she collapses the entire RRIF, she would take $400,000 into income and pay about $186,000 in tax at the peak Ontario rate of 46.41 per cent. It is an option seldom taken.
Grace’s situation is complicated by the different tax rates applicable to her non-registered portfolio and her and her late husband’s RRIFs. While sales of stocks and dividends generated in her non-registered portfolio will be at preferential tax rates, the $400,000 in her husband’s RRIF will be taxed at Grace’s top marginal rate on top of other income, whether the money is taken out in a lump sum or is spread over a period of years.
Collapsing her late husband’s RRIF would allow the money to be invested in a non-registered account in which it would produce tax-advantaged capital gains and dividends. Should she pay the tax now in full and receive tax-advantaged returns in dividends or capital gains, or keep the RRIF and go with partial deferral of income within the plan?
What our expert says
Facelift asked Michael Cherney, a Toronto-based certified financial planner and lawyer, to work with Grace on her tax issue. As he sees it, the complexities of her situation boil down to a few facts.
Grace says she can get by on $47,000 a year after tax, or $62,000 before tax, he explains. The problem now is to minimize taxes so that Monica will have the fullest benefits possible from Grace’s estate.
A complex tax minimization strategy could help Grace to cut her taxes, Mr. Cherney notes. She can borrow $186,000, the tax that would be due if she collapses the RRIF in one tax year, and then use the loan to replace the $186,000 of assets she had to sell to pay those taxes. This way, the RRIF is restored to $400,000. Grace then need pay only interest on the $186,000 as well as, of course, paying that money back to the lender.
Since Grace’s assets already generate more income than she spends, it should not be hard to divert some of that income, as well as the tax savings realized from her scheme, to pay down the loan, Mr. Cherney says.
Thus the advantage of Grace’s plan to collapse the $400,000 RRIF is that she will be able to reduce the income of this money from $31,400 this year to perhaps just the dividends on a diversified stock portfolio that could average 2.5 per cent, or $10,000. That move would reduce her net income, thus allowing her to receive $2,850 a year more in Old Age Security payments that would be clawed back if she took the required minimum payouts from the $400,000 in her husband’s RRIF.
As Mr. Cherney notes, if Grace can generate a return on assets above the interest she pays on the $186,000 and if that return is taxed at lower rates than the payments from the RRIF, she will have lowered taxes while maintaining the integrity of her husband’s fortune.
Mr. Cherney says that the Canada Customs and Revenue Agency has recently lost court cases in which it denied interest deductibility for certain loans. Now CCRA will allow deductibility of interest on the loan that is used to pay for new investments that would be purchased to replace the assets sold to pay the taxes. CCRA is reviewing its position and legislation on interest deductibility. While CCRA would not reach back to reassess Grace’s taxes already paid in respect of the plan, it could challenge her treatment of them going forward after its position is revised.
Assuming that Grace follows the collapse, borrow and reinvest plan, then she should hold income-producing assets within her own $500,000 RRIF in order to postpone taxation, the planner recommends. She should hold assets that produce capital gains and dividends subject to preferential tax rates outside her registered plan, the planner says.
There is a serious down side to Grace’s plan, however.
As Mr. Cherney notes, when one takes on debt, one adds risk to the portfolio. If the returns on Grace’s investments after the RRIF collapse don’t at least cover interest due on the loans she has taken out to replace assets sold to pay taxes, she will face a shrinking asset base, he warns.
As Grace ages, she might lose some of her considerable financial skills. Adding yet another layer of complexity to the sophistication of her investments could ultimately backfire, Mr. Cherney warns. In future, she may find it useful to buy annuities to pay her income during her life and to pay her daughter for the rest of her life.
There is risk in levering her investments on her financial acumen, Mr. Cherney warns. “I find it hard to recommend that anyone at any age should add debt and potential risk to a portfolio when it is not necessary. Grace already has $2-million of assets for the remainder of her very frugal life and what will probably a growing asset base to support her daughter. With so much money, why take chances?”
Complexity has another down side for Grace, the planner says.
Since her daughter has demonstrated no ability to handle finances and, indeed, has had a tendency to spend beyond her means, it would not be advisable to leave her with a complicated estate. If Grace does follow through on her plan to change the character of the $400,000 asset, she will have to consider use of a trust and to find trustees for money that may be left to her daughter.
The information is used for illustrative purposes only and is based on the perspectives and opinions of the owners and writers only. It is provided with the understanding that it may not be relied upon as, nor considered to be, the rendering of tax, legal, accounting, financial or other professional advice. Investors should always consult an appropriate professional regarding their particular circumstances before acting on any of the information here. It may also contain projections or other “forward-looking statements.” There is significant risk that forward looking statements will not prove to be accurate and actual results, performance or achievements could differ materially from any future results, performance or achievements. All information provided is believed to be accurate and reliable, however, we cannot guarantee its accuracy or completeness.
Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the Prospectus or Fund Facts documents before investing. Mutual funds are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated.