RRSPs and Corporations - Your Silent Creeping Tax Liability

Happy New Year and I hope 2022 brings you and your family good health and a quick return to something resembling normality. This is my first blog post since December 31st when I officially retired from my public accounting firm. The term “retired” is used loosely. I look at it as a bit of a sabbatical after almost 40 years in public accounting. I will be looking for a new opportunity outside the public accounting realm in accordance with the terms of my retirement agreement, possibly in the family office, multi-family office or investment manager space; I am too young (at least in my own mind) to full stop retire.

Back to the topic at hand. In late December I was updating a retirement spreadsheet I have for changes in my current circumstances and future income tax minimization. 

 

In reviewing the income tax section of the spreadsheet, the quantum of my future or "deferred" tax liability struck me once again. Whether you are currently working, near retirement or in retirement, you have silent creeping tax liabilities accumulating in your Registered Retirement Savings Plan ("RRSP") and/or corporation [for me, in my professional corporation ("PC")]. In my experience, we tend to "forget" or minimize this tax liability, so I though I would discuss it today.

RRSPs are Great while you are Working, not as Great when you Retire

I think most readers will know this, but to quickly recap, contributions to a RRSP result in a tax deduction in the year made (or subsequent year if you don’t fully claim the contribution) and your RRSP grows tax-free until you convert the RRSP by the end of the year you turn 71. For most people, a RRSP works well as their contributions are made at a time their marginal tax rate is higher than they expect in retirement, so they have an ultimate tax savings. Despite the tax effectiveness of your RRSP, the value is somewhat of an illusion, as you are also accumulating a large, deferred tax liability, as the entire value of your RRSP will be taxable in your retirement.

There are a couple options for a RRSP when your turn 71, including a lump sum withdrawal, the purchase of an annuity or the option most people select, converting their RRSP into a Registered Retirement Income Fund (“RRIF”).

Once you convert your RRSP into a RRIF any future withdrawals are subject to income tax (you are now paying tax on your accumulated lifetime contributions and earnings that were tax-free in your RRSP) a sometimes nasty surprise in quantum for some people. You must start drawing your annual minimum RRIF payment by December 31 of the year following the year you establish your RRIF. Since you will typically still be 71 the year following the establishment of your RRIF, the minimum withdrawal will be 5.28% (you may be able to use your spouses age to lower the withdrawal rate) and will rise each year to around 10.2% by 88 and the withdrawal rates will continue to rise dramatically after age 88.

Each year this minimum withdrawal will be taxable on top of any old age security, CPP, pension income and any other investment or other type of income you earn. The marginal tax rate on these RRIF withdrawals can be substantial depending upon your financial circumstances. Luckily for many, you can elect to split your RRIF pension income with your spouse (Form T1032 -Joint Election to Split Pension Income) and thus, you can often lower your effective family tax rate through this election. However, even with the election, the deferred tax hit on your RRIF withdrawals can still be substantial.

Corporations – You have only Paid Part of the Tax

As noted above, I was struck by the quantum of my tax liability for not only my RRSP, but the investments retained in my PC. For purposes of this discussion, consider a PC to be the same as any corporation you may have. Most active companies will have paid corporate tax historically anywhere from say 12% to 26%, depending upon the corporate province of residence. You have thus deferred anywhere from say 20%-40% in tax by keeping the earnings in your corporation (again depending upon the province). Assuming you need to take money from your corporation in retirement, you will then have to deal with this deferred tax liability when you take the money (typically as a dividend).

Similar to a RRIF, you will owe income tax on this deferred tax (the deferred tax is less than your RRIF, since the corporation paid some tax, whereas you paid no tax on your RRSP). If you have been earning investment income in your corporation, you may have some tax attributes like refundable tax to reduce your tax liability, but the original money earned and deferred by the original active company is still subject to a tax hit even though it is now co-mingled with investment income earned on these deferred earnings. Without getting technical, you still have a large, deferred tax liability as you withdraw funds from your corporation.

Income Taxes and Your Retirement Withdrawal Rate

I have written a couple times on how much money you need to retire. In 2014, I wrote an extensive six-part series titled How Much Money do I Need to Retire? Heck if I Know or Anyone Else Does! (The links to this series are under Retirement on the far-right hand side of the blog). 

 

I updated this series between January and March 2021. Most of my various retirement articles and series revolve around the 4% Withdrawal Rule, which is one of the most commonly accepted retirement rules of thumb. Simply put, the rule says that if you have an equally balanced portfolio of stocks and bonds, you should be able to withdraw 4% of your retirement savings each year, adjusted for inflation, and those savings will last for 30-35 years.

In Part 1 of the original 2014 series, I had a section on some of the criticisms of the 4% rule. The first and the most impactful limitation being the model does not account for income taxes on non-registered accounts and registered accounts Note: many of the studies I discuss in both 2014 and again in 2021, still support that the 4% withdrawal works despite any income tax limitations, but I thought it important to reflect this limitation of the rule.

 

I plan to write a future blog post on possible tax planning that you can consider to minimize the tax hit from your RRSP/RRIF and corporation in retirement.

 

As discussed above, where you have a RRSP and/or corporation, income taxes are a creeping liability. Thus, it is important to ensure that when you are younger, you are cognizant of these taxes and as you get closer to retirement, you ensure you have a financial plan that accounts for these deferred/creeping taxes.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

Steve Stamkos, Olympic Medals and Income Taxes

As a sports enthusiast, I am always interested in stories that combine sports and income tax. Today, I want to discuss a couple of these stories:

1. Steve Stamkos resigning with the Tampa Bay Lightning in June and the income tax considerations he would have had to ponder (if he ever truly considered the Toronto Maple Leafs as a final destination).

2. The income tax that Canadian Olympic gold, silver and bronze medalists have to pay on the bonuses they earned in winning their medals.

Steve Stamkos Signing

If you are a hockey fan, you were well aware that Steve Stamkos ("Stamkos") was a free agent this spring and that there were rumours negotiations were not going well with his current team, the Tampa Bay Lightning. As result, many Toronto Maple Leafs fans were hopeful Stamkos would sign with the Leafs, his hometown team (some fans felt that spending money on Stamkos at this time would

impact the current Leafs rebuild and thought such a move would be a year or two early - but I digress).

In the end, Stamkos resigned with Tampa Bay for a reported contract of $68,000,000 over eight years (or, an average $8.5 million a year), paid as $9.5 million in each of the next five years, followed by $7.5 million, $6.5 million and $6.5 million in the final three years. It was also reported that Stamkos' base salary will sit at $1 million each year, with the rest being paid as a signing bonus.

While Stamkos was deciding where to sign, there were various discussions on whether he would provide Toronto with a hometown discount to offset the preferential U.S. tax system. With the possibility that one of the NHL’s top players would potentially be moving teams, sports writers quickly had to get up to speed with economic and income tax issues.

I asked a friend last June (who prepares U.S. tax returns) to run some numbers comparing Stamkos’s average $8.5 million salary for a Florida resident to an Ontario resident assuming there was no foreign exchange issue (I did this to solely isolate the income tax consequences and to avoid the complications of dealing with fluctuating F/X rates and the purchasing power of the $U.S. – but yes, this would be a large factor in any decision). BTW: I understand that all NHL players are all paid in $U.S.

My friend ran some tax numbers based on a U.S. resident with single filing status using 2015 tax rates/brackets, and assumed no itemized deductions to keep things simple. He determined the income tax on an $8,500,000 salary would be around $3,320,000, or about 39.06%. Given the top U.S. federal marginal rate for 2015 and 2016 is 39.6%, this rate is in the ballpark as the top bracket for a single taxpayer is reached at $413,201 for 2015 ($415,051 for 2016).

A huge factor in calculating the income tax variance between the U.S. and Canada is there is no state personal tax in Florida. However, hockey players are taxable in the various U.S. states/cities where they play away games (which would likely push the average tax rate into the low 40s).

If Stamkos had decided to play for the Leafs in 2016 (again, assuming a neutral exchange rate for purposes of this discussion), his tax payable would have been approximately $4,510,000 and his average tax rate at 53.10% and his marginal rate at 53.53% (accounting for the increase in tax rates implemented by the Liberals). Thus, if Stamkos had decided to play for the Leafs, he would have owed approximately $1,190,000 more in income tax than in the U.S. and his average tax rate would have been 10-13% higher depending upon all the facts.

It is interesting to note that if the U.S./Canada exchange rate was $1.30 for his entire contract, Stamkos would have been neutral, from a purely cash flow perspective, in signing with Toronto.Yet, per this article, totally speculative and without confirmation, Stamkos supposedly wanted $14million to come to Toronto.

After reviewing the above, you now know why Stamkos and many other players must take into account the income tax considerations when deciding on which team and country to play.

Olympic Gold – Not Tax-Free

During the Olympics, The Globe and Mail ran a story written by Alicia Siekierska titled “It’s gold – for the taxman. In this article she noted that the Canadian Olympic Committee awards Olympic athletes with bonuses (wow, I never knew this. How un-Canadian to incentivize winning for our athletes :)  if they make the podium: $20,000 for a gold medal, $15,000 for a silver medal and $10,000 for a bronze medal).

The article discussed that the Income Tax Act paragraph 56(1)(n) considers only certain prescribed prizes as tax exempt. As noted in Income Tax Folio S1-F2-C3, “Section 7700 of the Regulations defines a prescribed prize as any prize that is recognized by the general public and that is awarded for meritorious achievement in the arts, the sciences or service to the public. It is a question of fact whether a prize is considered to have been recognized by the general public for purposes of section 7700 of the Regulations. In making such a determination, one should consider whether there is evidence suggesting a high level of public awareness of the prize and the extent to which the announcement or receipt of the prize is widely publicized by the media. For example, a Nobel Prize given to a scientist or the Governor General's Literary Award given to a professional writer would qualify”.

The article noted that the Olympics are not considered a public service and thus, the medal bonuses paid to athletes such as Penny Oleksiak and Andre De Grasse will be taxable.

The article quotes William Innes, a tax litigator with Reuters LLP. Mr. Innes states the CRA’s position on taxing Olympians prize money is “outrageous”. He feels winning an Olympic medal should fall under the service to the public section noted above. He goes on to say “I would think that the average man or woman on the street would hold that somebody getting an Olympic medal is providing a service to the public”.

For the Penny Oleksiak’s and Andre De Grasse’s of the world, this is probably a bit of a mute issue, as they will receive significant endorsement opportunities dwarfing the bonus money. But for the typical less high profile medal winners who do not have significant funding, it seems unfair they are taxed on their Olympic bonuses. You would think there would be some co-ordination in policy between the Olympic Committee and the CRA.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.

What "You May Be Worth Someday" Statements

I recently had to complete an updated net worth statement for my firm’s partnership banker. After completing the statement, my net worth seemed higher than I expected. However, as I reviewed the statement, I realized that this document would be more accurately considered, at least in my case, as a “what you may be worth someday statement".

I say this because if I removed my house from the net worth statement (I intend to live in my house as long as I am physically able) and discounted my partnership interest to account for the multiple variables that could affect that value, either up or down, my net worth statement looked a lot leaner. If I made these adjustments, my net worth statement would reflect how I view my current net worth and provide me a better visual of my retirement building net worth.

This revelation made me smirk. You see, a common complaint I hear from my clients is that they are “worth way more on paper or dead and not worth much in tangible today value”. I smirked a second time when I realized my wife had to sign off on the form. I constantly drive her nuts when I tell her that we have to pay far more attention to our retirement funding and now she was going to see a standard net worth statement that was misleading in my mind.

So why do I consider net worth statements misleading? If you are an employee and you do not own your own business, the statements are misleading because the majority of your net worth is most likely real estate based. Real estate value generally comes in three forms; your principal residence value, cottage value and investment property or vacant land value.

Let’s break down these components. While there is no denying the value of your principal residence, the reality is many people wish to continue living in their principal residence until they are either unable to physically do so, or it becomes a financial requirement to sell or reverse mortgage their home. Thus, I consider a house a net worth backstop and the only value you can currently attribute is the incremental value you would recognize if you were to either downsize your home, sell your home and rent or reverse mortgage your home. In fact, as I reflect further, you probably need another variation of a net worth statement, a "retirement net worth statement" to account for the difference in net worth between your current home and the cost of your downsized home or debt related to any reverse mortgage. 

In regard to investment properties, the value is a fairly hard number; since the property or land is not required for shelter. However, the value of the second property or vacant land can only be maximized if you do not have to liquidate on an urgent basis and you sell when market conditions are strong. Thus, the current value attributed to an investment property could be significantly overstated depending upon the current economic climate and the demand for the investment property; however, it should definitely form part of your net worth statement.

Cottage properties are a bit of a hybrid. Cottages may be similar to a house in that you intend to use your cottage until you are physically unable, or they may be like an investment property, you wish to sell upon retirement. Finally, some people intend to sell their cottages to their children for "hard cash".

If you have a business, your net worth and retirement are often both dependent upon the value you realize for your business. The vagaries of realizing that value are why I consider a net worth statement misleading. If you have a service business such as mine, there is less risk initially in starting the business since if it does not take off, you take your clients and work for another professional firm. However, once the business is established, its value is subject to market conditions such as supply and demand (the accounting profession is top heavy in age), technological advancement of the practice  and its condition when you are ready to sell or, in my firm’s case, transition to the next generation of partners. I have had many a client sell their business sooner rather than later because they were concerned that when they were ready to sell their business, the business or economy may have taken a turn for the worse and they would not realize what they required for retirement. Sometimes these clients have sold at a substantial discount for “a bird in hand”. What I will realize on my share of my firms partnership interest will be determined by such things as the economy, tax laws (say a flat tax is enacted) and our succession plan.

Finally, net worth statements have the same flaw as many retirement plans; they do not account for the impact of income taxes. If I reduced the value of my RRSP by 46% and reduced the value of my partnership interest for the inherent income taxes, again my net worth statement would look significantly different.

So what is the takeaway from this post? First, don’t get mesmerized by a real estate inflated net worth statement. Second, you should probably assume a discounted value for your business, and finally, remember; your future tax liability has not been accounted for on your net worth statement.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

Stocks with Capital Gains- To Give unto Ceasar or not

I have always been confounded by people who are reluctant to sell a stock that has increased in value because they have to pay capital gains tax. It goes without saying, that income taxes can have a significant impact upon your portfolio’s value over time. Obviously, the longer you can avoid paying income tax, the greater capital you will have at work. However, some people are so adverse to paying income tax on their stock gains, that they are paralyzed from making a sound investment decision.

The underlying question that I will try and address in this blog is: how much a factor should the income tax on your capital gain be when selling shares, if you cannot find a viable replacement equity? I suggest it should be a non-factor.

It should be noted that this blog will revolve around the sale of individual stocks, not mutual funds; as some corporate class funds can be utilized to defer capital gains. I have also not considered an equity monetization strategy based on the assumption that for most readers, monetization is not practical, as I have only seen it used one or twice in all my years practice.

While writing this blog, I came across an interesting statement in Sacha Peter’s Divestor Blog (a favourite on my blog roll) that was right on topic. In his blog “Links and after-tax calculations,” Sacha states that he finds it personally very frustrating to hold onto investments that have appreciated beyond what he considers to be its fair value, but he is "prevented" from selling these stocks because of the capital gains taxes that he would incur.

I commented on Sacha’s blog that I did not really understand his comment. I stated that "Capital gains tax in Canada is 23% or less and to me, that is not an onerous rate. Yes, one never wants to pay tax, but I see people hold onto stocks because they don’t want to pay the tax on stocks that have appreciated past their fair value and the stock sharply corrects. To me, 23% or less is not a large detriment to take a profit when you compare it to the 46% you pay on interest and employment income and compare it to the potential true cash loss you may incur by holding a stock that should be sold.”

Sacha’s response to my comment was “I agree with you from a practical perspective. Academically I outlined a scenario in my previous post that illustrates the situation.” Sacha then provided the  example below which follows the conventional wisdom in regard to selling stocks. This conventional wisdom is succinctly expressed by Greg Forsythe of the US security firm Schwab; "Sell an existing holding if another stock compatible with your risk tolerance is available that provides higher return potential after subtracting any taxes and transaction costs in executing the swap".

Sacha says “Let’s take a hypothetical investment between two securities. Security ABC is a perpetual bond, paying $10 per unit. Security DEF is a perpetual bond of the same issuer, with substantively the same seniority/call provisions as ABC, paying $8 per unit. Your marginal rate (to make the math easy) is 50%.

Let’s pretend you bought ABC for $80, netting a pre-tax yield of 12.5% and after-tax yield of 6.25%. If ABC is now trading at $100/share, what price does DEF have to be in order for the decision to be a net positive? Assume frictionless trading costs, and capital gains taxes are payable immediately upon disposal. For this to be a break-even transaction, your $95 ($100-$5 tax) in after-tax dollars must equal the income of the prior portfolio, mainly $10. $10/$95 = 10.53%, so you must buy DEF below $76/unit in order for your transaction to make financial sense."

Sacha continues "I will again completely agree that this academic exercise is of little use in the grey and fuzzy world of investing in that you never quite know whether you got fair value correct and whether the geniuses on the other side of the computer screen think their idea of fair value is higher or lower.”

Just to be absolutely clear, I am not picking on Sacha. I asked him if I could use his response in this blog, I am just using his response for discussion and illustration purposes. In the above response, Sacha compares two securities based on coupon rate and unrealized gains. His example requires comparable alternatives and is not necessarily his analysis for the sale of a single stand alone stock.

Now, I am not the academic or mathematician that Sacha is, but I guess my issue with conventional wisdom is should one not consider the valuation of a stock and the net proceeds that will be achieved after-tax instead of always looking for a break even alternative or stock with a potentially higher return (i.e.: an alternative may not always be available when you wish to sell a stock and thus, should the income taxes then not become a moot point?).

To illustrate, if I bought Nortel at $50 and sold it at $100, since I thought $100 was fair value, I would have had approximately $88 in my pocket after-tax. Now, look at the many Canadians who held onto Nortel as it rose in price. As I recall, many people were concerned Nortel was way overvalued, but they did not sell their shares because they did not want to pay the large income tax bill associated with their gains. Following with the above example, when Nortel was $130, you could have sold and realized approximately $112 after-tax. At $115 you would have realized $100 after-tax and, as noted above, at $100 you would have realized approximately $88 after-tax.

However, many Canadians held on and did not sell until the $60 range or less. At $60 you would have realized approximately $57 after-tax. Your net after-tax loss of not selling at a pre-determined fair value of $100 was $30 or more, even after paying the income tax.

It is my suggestion that once you feel a stock has hit full value, place a stop-loss order at that pre-determined value and look past the paralyzing income tax decision to your after-tax proceeds and return. Deal with what you will do with those funds as a standalone question.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.