In Montreal, a couple we'll call Frank, 56, and Patricia, 57, have retired early.
Through decades of hard work in the high-tech sector, they have built up $2,350,000 in assets. They also have a house with an estimated price of $400,000. They live relatively simply and well within their incomes. Their problem is how to manage taxes on their RRSP withdrawals and Frank's pension, which currently produces a pretax income of $66,000 a year.
Facelift asked Caroline Nalbantoglu, a registered financial planner with PWL Advisors in Montreal, to work with the couple in order to devise strategies for tax management and estate planning.
"I have been considering a joint and last-to-die life insurance policy, but I am not sure if I would be better off maintaining flexibility and managing the money myself rather than getting locked into monthly life insurance premiums," Frank explains. "The alternatives to life insurance might be investments in a summer residence or other real estate property."
What our expert says
"The problem that Frank and Patricia present is one of comparing life insurance as a financial plan to a straight investment with none of the benefits of a life policy," Ms. Nalbantoglu explains. "The couple would like to leave their estate to their two grown sons after the death of the second parent. So we should examine the couple's life expectancies."
The life expectancy of a 56-year-old non-smoking male is 25 years from now or 81 and that of a 57-year-old non-smoking female is 28.5 years from now or about 86 years, she explains. These are just averages. If they are in good health, they may live longer. But we have to go with the mortality tables.
Assuming that Frank is the first to die at age 81, there will be no tax consequences if Patricia inherits everything. On her death at age 86, the estate would consist of about $1.8-million in her registered retirement income fund.
The non-registered estate is hard to estimate. If there have been no withdrawals, then it would be worth about $4.8-million. They will also have a principal residence which, assuming that house prices rise at an average 4 per cent a year, would be worth about $1.2-million. As a principal residence, it would be tax exempt when sold. However, in the year of the survivor's death, the RRIF would be taken into income at a peak tax rate, which is currently 48.2 per cent. That would generate a tax of $868,000. We cannot predict the growth of the non-registered portfolio and therefore are leaving it out of the tax estimate.
Even with this large tax bill, the sons would inherit a large estate. Frank and Patricia can buy life insurance to ensure that the estate is not depleted by taxes at death.
They can get a joint, last-to-die term-to-100 policy with $500,000 of coverage for $4,750 a year in premiums. Using Patricia's life expectancy, they will have paid $130,245 in premiums during the life of the policy. Alternatively, they can pay $5,940 for the same policy for 20 years. At the end of the 20 years, they will have paid $118,800 in premiums and accumulated $117,800 in guaranteed surrender value. At this point, they can decide if they want to maintain the policy and allow the accumulated value to continue paying the premiums or cancel and collect the surrender value.
The issue is whether they want to have their estate pay taxes directly or, in a sense, prepay the taxes via a life insurance contract, Ms. Nalbantoglu says. But there is no need to drain their registered retirement savings plans and invest in their non-registered accounts. That strategy makes sense in that RRSP withdrawals or payments through RRIFs are at full income rates while non-registered assets can generate dividends and capital gains taxed at lower rates. Taxes have to be paid at some point and predicting decades of capital gains is too uncertain to be worthwhile.
What may be more important than juggling capital gains would be purchase of critical illness insurance, Ms. Nalbantoglu says. This can be more expensive than life insurance and harder to obtain since the insurers take into account health and family history of illness. But having a critical illness policy would mean that a serious illness such as cancer or heart disease would not deplete the family's fortune.
There is also the alternative of crystallizing capital gains now, paying taxes on those gains, and gifting money to the children to buy their own homes. If those homes are the children's principal residences, then their value will increase free of tax. Paying taxes now could be less expensive than paying them in 25 years, Ms. Nalbantoglu says.
For now, Patricia is withdrawing funds from her $320,000 RRSP using a RRIF. She is in a low tax bracket and the withdrawals are therefore relatively tax efficient. It would be even more tax efficient to take only the minimum from her RRIF and take additional funds from her non-registered assets of $450,000.
Her minimum RRIF withdrawal in 2007 will be about $8,000. Adding in $5,000 of taxable investment income, she would pay about $700. With Frank's $36,000 annual pension, with $14,000 allocated to her and $5,000 each in investment income, they will each be taxed on $27,000 of income. Net family income would be $44,600, well above expenses of $34,500 a year.
Patricia could stop RRIF withdrawals and split Frank's pension. Then net family income would be $38,000, but enough to meet their expenses.
At 60, each partner should apply for Quebec Pension Plan benefits. Frank will get the maximum benefit reduced by 0.5 per cent a month for each month prior to age 65 that benefits begin. That would give him $7,536 a year. Patricia would receive $2,856 on the same basis. Their expenses will have grown to $38,830, assuming 3-per-cent average annual inflation. Frank's RRSP will have risen to more than $1-million and Patricia's RRSP will have a value of $428,000. Their non-registered portfolio, assuming no withdrawals, would be worth about $1.1-million, Ms. Nalbantoglu says.
By age 69, Patricia's RRSP will have $723,500 in assets. The minimum annual withdrawals would be $32,489.
A year later, Frank will have to convert his RRSP to a RRIF. He will have registered assets of $1.7-million and his minimum withdrawal will be about $80,700. Old Age Security, currently $5,607 a year, is likely to face some clawback erosion in spite of pension splitting. However, at Patricia's age 69, family income is likely to be $173,300. After tax and splitting Frank's pension, their net income should be about $117,300, compared with expenses of $52,184, again assuming 3-per-cent annual inflation and 6-per-cent annual growth of invested assets.
"This couple has worked hard to accumulate their nest egg," Ms. Nalbantoglu says. "They can afford insurance that will effectively prepay taxes on deemed disposition at death, but even without that insurance, their children will inherit sufficient assets to build their own nest eggs."
Client situation
Frank, 56, and Patricia, 57, are retirees who live in Montreal.
Net monthly income: $2,875.
Assets: House $400,000; RRSPs $1,070,000; taxable accounts $850,000; cars (3) $30,000.
Total: $2,350,000.
Monthly expenses: Property taxes $417; utilities & phone $333; food $500; dining out $84; entertainment $412; clothing $125; cars' fuel & repairs $420; auto & home insurance $334; charity & gifts $250. Total: $2,875.
Liabilities: None.
