Seeking the perfect mix
Couple wants tax-saving retirement plan to juggle many sources of income
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Hey there, time traveller!
This article was published 28/11/2015 (2563 days ago), so information in it may no longer be current.
Vincent and Alexandra have been retired a few years already — and they’re savouring every moment of it.
They have travelled extensively, and they plan to carry on globe-trotting for another 10 to 15 years until around age 75.
“Our expenses are approximately $80,000 per year, including $30,000 for travel,” said Alexandra, a former small-business owner.
But as they relish retirement, they wonder if their finances are set up properly to fund their newfound zeal for adventure.
Most of Alexandra’s $3,500 of net monthly income is paid in dividends from a corporation that is no longer active. After selling much of the business a few years ago, she kept the company intact as an investment vehicle to produce tax-efficient income.
Vincent also receives income from the corporation to top up his work pension for a total income of about $3,000 after taxes every month. That covers the day-to-day living costs.
“Right now, we travel using our money in savings,” Alexandra said.
Cash for travel is drawn from a savings account worth $226,000. They also have about $600,000 in RRSPs and about $43,000 each in tax-free savings accounts (TFSAs), which they have yet to use.
All their money — including more than $800,000 in the corporation — is invested in low-yielding conservative investments.
“We’re not invested in the stock market so we get very little (return), and I think that sometimes it’s foolish, but at the same time, we don’t have the guts to go into the stock market,” she said.
The couple has an accountant advising them how to draw income, but they’ve never had a financial plan and are not sure they’re building a truly tax-efficient and lasting retirement income.
“Where do we take money from for the most efficiency tax-wise?” Vincent said.
Do they rely heavily on tax-friendly dividend income from the corporation? Or should they focus on grinding down their fully taxable RRSPs?
And most importantly: “Do we have enough money to keep up with our lifestyle?” Vincent said.
“That’s our most pressing issue.”
Certified financial planner Daryl Diamond is the author of Your Retirement Income Blueprint: A Six-Step Plan to Design and Build a Secure Retirement. The Winnipeg adviser with Diamond Retirement Planning said Vincent and Alexandra should have more than enough money to afford their retirement plans.
In fact, they could live mostly off the earnings from their savings if only their investments offered slightly better returns.
“Between their personal and corporate holdings, they have more than $1.7 million of income-producing assets,” Diamond said.
If their investments could earn a five per cent annual return, they would generate about $80,000 annually.
“When you add that kind of income to their government benefits and Vincent’s pension, split between two taxpayers, the after-tax cash flow would fund their basic needs and travel budget.”
The problem is their investments are earning a 1.5 per cent return after taxes in most cases.
Their conservative approach to investing is understandable; losing money in the markets is unsettling. But by not investing in equities they are missing out on two of the most tax-efficient ways to generate income.
While they can benefit from having corporate earnings paid out to them as dividends, retained earnings inside the corporation — passive income — are subject to high taxation because all the investments are generating interest income.
“Simply stated, the interest earned on their retained earnings is taxed at a rate of nearly 50 per cent,” Diamond said.
If their assets were invested in dividend-producing stocks, the earnings would be taxed at a lower rate.
That’s because eligible dividends would be taxed in the hands of Vincent and Alexandra instead of the corporation.
“The dividends basically flow through to the shareholders and are taxed as such in their hands,” Diamond said.
Capital gains inside a corporate structure can also help form a more tax-efficient income for the couple.
“When the invested retained earnings realize a capital gain, the non-taxable portion could flow out to Vincent and Alexandra through the company’s capital dividend account on a tax-free basis,” Diamond said.
Of course, the most important consideration is finding an acceptable investment mix that would not cause Vincent and Alexandra much anxiety.
Yet, they should consider the following: not all losses are market-based. When it comes to GICs and savings, particularly in a corporate investment account, they are losing money on taxes and inflation. And those losses are essentially guaranteed.
Still, conservative investments have a big role to play in their portfolio — only in a different account: the RRSP (or a registered retirement income fund — a RRIF). Here their money can grow slowly and tax-sheltered — something that can’t be accomplished as well inside a corporate account.
There are no concerns about tax-efficiency in an RRSP or RRIF because withdrawals are taxable as normal income.
Consequently, they receive no tangible reward for taking on more market risk.
Given they’re seeking a tax-saving strategy, Diamond cannot underscore the importance of developing a plan that uses both accounts in tandem.
“If they employed a more tax-efficient investment structure for the retained earnings, that would certainly open the door to use a combination of RRIF income and income from the corporation,” he said.
Essentially, both accounts defer taxation.
The difference is withdrawals on retained earnings can be taxed more favourably in certain circumstances and, unlike RRIFs, there are no minimum withdrawals for income.
This is why Vincent and Alexandra should consider a plan to strategically draw on their registered accounts sooner rather than later to ensure paying as little tax as possible.
This can be accomplished by withdrawing income up to the next highest tax bracket, for example, with the excess above their spending needs funding the TFSAs.
More broadly, the trick to building a tax-efficient retirement income is brewing the ideal mix — one that withdraws money from the right place at the right time.
A crucial component is always having accessible savings, but only as much as required. Already they have a large pool of liquid assets to serve that need: $226,000 in cash. But they also should have a short- to medium-term pool of capital, which would involve a laddered investment strategy involving bonds or GICs with maturities of one to five years.
The upside of this approach is always having money coming due feeding their immediate income needs, while capital from their longer-term investments — such as equities — can be efficiently sold and reinvested in five-year maturity GICs or bonds to replenish the laddered holdings.
But the main take-away is Vincent and Alexandra require a little more balance of risk and return in their portfolio to execute a truly tax-efficient strategy.
That doesn’t mean a lot of exposure to markets. If they started by changing half of their assets in the corporation to dividend-paying equities, for example, their overall asset allocation would still reflect a very conservative mix of 75 percent fixed income and 25 per cent equities.
“In fairness, they’re in a good situation: even with low rates of return they may be fine given how much capital they have to create the income they want, but they need to take a hard look at their investment strategy,” Diamond said.
“The conservative approach may be intended to preserve capital, but it’s likely to have the opposite effect.”