The Blunt Bean Counter

Monday, July 25, 2016

The Best of The Blunt Bean Counter - How Much Money do I Need to Retire? Heck if I Know or Anyone Else Does! - Part 6

This summer I am posting the "best of" The Blunt Bean Counter blog while I work on my golf game. Today, I am re-posting Part six of my 2014 six part series titled "How Much Money do I Need to Retire? Heck if I Know or Anyone Else Does!" If you have not read this series, the links to each part of the series can be found down the right hand side of my blog, under the retirement section.

The intention of Part 6 of the series was to attempt to provide an actual range of numbers for your nest egg. However, as noted below and throughout the series, there are so many permutations, combinations and unique situations, that you should only view the number below as wide ranging guesstimates and understand this was more of a fun exercise then an attempt to provide a concise retirement number.

Finally, please note that some of the tax numbers and RRIF information is now outdated. If you wish, you can easily skip my personal attempt to arrive at a "number" and go directly to the Comparing Apples to Oranges to Pineapples section and you will not miss much and save reading energy.

How Much Money do I Need to Retire? Heck if I Know or Anyone Else Does! - Part 6

Parts 1-5 of this series highlighted the challenge in determining a definitive retirement number. Nevertheless, against my better judgment, today you will receive some simplistic retirement nest egg calculations; since we all like to know what everyone else thinks their number should be. Who the heck knows, if any of these numbers will be in the ballpark or not.

Before I get to the numbers, you will read about some Canadian income tax idiosyncrasies and the impact income taxes and inflation have on your anticipated retirement withdrawal amount.

Made In Canada Idiosyncrasies

One significant issue for retired Canadians is that your annual minimum Registered Retirement Income Fund (“RRIF”) withdrawal starts at 7.38% and averages approximately 8% of your actual RRIF balance over the first ten years. If your spouse is younger, you can elect to use their age to calculate your minimum RRIF withdrawal amount, which will lower your yearly required withdrawal. In either case, where the majority of your retirement funds are in your RRIF, the required withdrawal may be substantially higher than the 3-4% you plan to withdraw annually from your retirement nest egg (However, as per my example for Mr. and Mrs. Bean below, if you can split pension income with your spouse, the income tax cost of the excess withdrawal may be mitigated).

A discussion of how to manage the drawdown of your RRSP and take into account the minimum RRIF withdrawals is too fact specific and beyond the scope of this series. I may however, post a future blog on this topic.

For higher income Canadians, their Old Age Security may be clawed back as their retirement income increases. For 2014, the clawback starts at $71,592 and your OAS is fully clawed-back at $115,715.

I am The Blunt Bean Counter –So let’s get Tax Centric

As discussed way back in Part 1 of this series, the 4% withdrawal rule ignores income tax. Thus, I will provide you with some examples of how income taxes may impact your selected retirement withdrawal rate. These examples illustrate the tax centric framework I use for one of my own retirement nest egg estimates, which I then compare with other retirement calculators, formulas, etc. proposed by other expert retirement planners.

You will note my model is just a variation on the 4% rule and still ignores investment fees. However, I am going to assume you use low cost ETF’s so that your costs are minimal or if you use an investment advisor, your returns are at least market after accounting for your management fees ( ha ha). I am also going to assume the yearly inflation adjustment under the 4% rule will cover off inflation if not overcompensate for it. Just accept these assumptions for the time being. I know Michael James is flipping with the investment fee assumption.

Sample Data – Mr. and Mrs. Bean

Let’s say Mr. and Mrs. Bean each expect to receive full Old Age Security (approx. $6,500) upon retirement and that Mr. Bean and Mrs. Bean anticipate they will receive $12,000 and $6,000 respectively a year in CPP retirement benefits. Finally, assume Mr. and Mrs. Bean will have equal RRIF’s or make the election to split pension income such that they will each receive $50,000 in RRIF payments in Scenario 1, $40,000 in Scenario 2, $30,000 in Scenario 3, $25,000 in Scenario 4 and $20,000 in Scenario 5.

Using the sample data above, here is the Bean’s income tax situation upon their retirement.

Mr. Bean	Scenario 1	Scenario 2	Scenario 3	Scenario 4	Scenario 5
Old age security	$6,500	$6,500	$6,500	$6,500	$6,500
CPP	$12,000	$12,000	$12,000	$12,000	$12,000
RRIF	$50,000	$40,000	$30,000	$25,000	$20,000
Total income	$68,500	$58,500	$48,500	$43,500	$38,500
Tax payable	$14,400	$11,100	$7,700	$5,800	$4,500
Net after-tax amount	$54,100	$47,400	$40,800	$37,700	$34,000

Mrs. Bean	Scenario 1	Scenario 2	Scenario 3	Scenario 4	Scenario 5
Old age security	$6,500	$6,500	$6,500	$6,500	$6,500
CPP	$6,000	$6,000	$6,000	$6,000	$6,000
RRIF	$50,000	$40,000	$30,000	$25,000	$20,000
Total income	$62,500	$52,500	$42,500	$37,500	$32,500
Tax payable	$12,600	$9,100	$5,600	$4,200	$3,000
Net after-tax amount	$49,900	$43,400	$36,900	$33,300	$29,500
Combined after-tax	$104,000	$90,800	$77,700	$71,000	$63,500

The Tax Effect – Ouch

In Scenario 1, Mr. and Mrs. Bean will pay almost as much in personal income tax ($27,000) as they receive in OAS and CPP ($31,000). Consequently, their true cash available for spending is essentially the gross withdrawal from their RRIF’s, likely a huge cash flow surprise for Mr. and Mrs. Bean. In Scenario 2, taxes eat up approximately 2/3 of Mr. and Mrs. Bean’s pension income. For Scenario’s 3-5, the impact of taxes though still significant, starts to decrease as a percentage of pension income and overall income under each of those scenarios.

Playing with Numbers to get a Tax Centric Number

At this point, let’s play with some of these numbers and see if we can come up with a crude ballpark number for the Bean’s retirement nest egg. As I stated on day 1, this framework is clearly limited, is

based on the 4% withdrawal rule and has no academic basis and should not be relied upon as the sole determinant for your own retirement planning.

Determine Your Spending Requirements

One of the most important inputs into any retirement calculation is your anticipated spending. Mr. Bean, who is an anal accountant, has used Quicken for years to track his spending and can project which of these expenses he will still have in retirement. The amount he needs to add to his projected spending amount for travel is his “retirement wildcard”, but Mr. Bean is comfortable he can estimate this amount and not be materially wrong. Your spending requirement should really be a yearly calculation and should typically account for higher spending in the early years of your retirement and lower spending in the later years, plus account for one-time expenses like a car purchase, helping pay for a child’s wedding or assisting your child buy a house; however, for this crude calculation, I just use a set spending rate.

Reverse Engineering Mr. Bean’s Retirement Needs

[Note: For purposes of this example I am assuming all the Bean's funds come from a RRIF to exaggerate the income tax effect; in reality, you will probably have anywhere from 20-40% of your retirement funds in a non-registered account(s). In addition, I do not try and account for the fact the required RRIF withdrawal may be in excess of 4%].

Once Mr. Bean determines his spending requirements, I can work backwards to help him determine his retirement number under my tax-centric formula. For example, if I assume the Bean’s spending requirement is going to be $71,000 a year in retirement and they have $31,000 in pension benefits, the Bean’s will need to make up a $40,000 retirement shortfall before I factor in income taxes. By co-incidence Scenario 5 reflects that exact situation. The Bean’s will each draw $20,000 from their RRIFs and have a combined income before tax of $71,000 ($38,500 + $32,500).

Of course, Scenario 5 reflects that after tax, they will only have $63,500 to spend, which is $7,500 short of their needs. Thus I need to gross-up the $40,000 withdrawal so the Beans can achieve their required retirement objective of $71,000 a year. Luckily I have a tax program that makes this easy to determine (you can do this with your personal tax program if you do your own taxes or use an online calculator) and when I run the numbers, I determine the Bean’s will need to take $50,000 or $25,000 each from their RRIFs (instead of the $40,000 or $20,000 each I required before tax in Scenario 5) to net out to their required $71,000 a year spending requirement. Again by a strange co-incidence, this is essentially Scenario 4 above.

Mr. Bean is short a few beans.

Since the Bean’s will need approximately $50,000 before inflation for each year of retirement (in addition to their CPP and OAS), I can now utilize the 4% withdrawal rule to estimate the amount of money they will need to retire. The magic number is $1,250,000 ($50,000/.04), which if you believe the 4% rule, will allow the Bean’s to withdraw $50,000 plus inflation for approximately 30 years or $71,000 after-tax including their pension income. If the Bean’s want to provide a measure of safety and use a 3% withdrawal rate, they would require a nest egg of $1,666,666 ($50,000/.03). Mr. Bean however told me to stick with the 4%, since as an accountant; he has led a stressed life and does not anticipate making it past 85 anyways.

The above calculation results in an inflated magic number as it assumes 100% in registered funds. In reality, the number would be based on a draw-down between your registered and non-registered accounts.

When I told Mr. Bean these results, he was thoroughly depressed. However, with my warped sense of humour, I went on to tell him if he was to retire in ten years and he required $50,000 in non-indexed RRIF withdrawals (CPP and OAS are indexed for inflation) he would actually require approximately $61,000 in yearly withdrawals if inflation averaged 2%. That would push him closer to Scenario 2 above. That would mean he would require almost $80,000 in RRIF payments and using a 4% withdrawal rate he would need to have $2,000,000 at retirement, a staggering number. Personally, I think you cannot look at a 2% inflation rate and just inflate your spending expectation. I would suggest wage increases may partially offset these increases and presumably the extra 10 years of investment returns and new deposits would make it possible to get to $2M in 10 years even if they don’t have $1.25M now. In any event, it is a sobering calculation.

Comparing Apples to Oranges to Pineapples

When I started this series, I was foolish enough to think that I could utilize the Bean's income and spending parameters to provide you with comparable nest egg numbers using various retirement expert's formulas. However, as I discussed in Part 5, there are multiple variables and assumptions that affect each calculation which makes an apples to apples comparison impossible. This will be vividly demonstrated as I walk through the various comparisons below.

Yet, I thought it would still be interesting to see how various retirement experts and their formulas, equations etc. compare when given the same retirement spending level and the same pension numbers. It is enlightening, if not slightly amusing, to see how the retirement variables are applied and the significant variances in the final nest egg determination.

What a Financial Planner Says

William Bengen, the man behind the 4% rule, says that “Where the client has any degree of complexity to their retirement situation at all, I find I must have financial planning software to incorporate all these factors….The financial planning software is essential to blending all these elements and coming up with a withdrawal rate and the use of Monte Carlo, and so forth—I just find that essential”.

So I took Mr. Bengen’s advice and had a financial planner run some numbers on his software for me, based on the above $50,000 RRIF requirement and $31,000 of pension income. In the end our comparison was not apples to apples. His software forced him to make various assumptions I could not include in my crude calculation and he wanted to use a 3.5% real rate of return. He also decided he wanted to allocate the non-registered and registered accounts equally amongst other assumptions I could not make with my limited tax centric model. So what did his software reflect as the required nest egg? His number was $1,335,000.

In this Globe and Mail article from last week, the financial planner comes up with a retirement nest egg of $1,240,000 with a couple retiring at 65 and planning to spend $75,000 a year, with a life expectancy of 95 who receive two-thirds the maximum CPP/OAS payments ($25,000 a year) and who achieve an annual return of 5 per cent, in an environment of 2-per-cent inflation.

Jim Otar’s Retirement Asset Multiplier

I next turned to Jim Otar, a financial planner and mechanical engineer (what is with engineers and retirement?). Jim is the author of Unveiling the Retirement Myth. Jim considers there to be three basic risks for retirement financing:

1. Longevity risk
2. Market risk
3 Inflation risk.

He uses an asset multiplier to factor in these risks. Jim does an awesome job of using “plain English” in this article “Do we have enough to retire?”.

You may not believe this, but I had done all my calculations above before I found Jim’s article. Honestly, it is just a fluke he used $70,000 as his required retirement spending (versus my $71k) and $32,000 for his pension income (versus my $31k). When I use Jim’s multiplier of 28 x my $40,000 pre-tax shortfall, I come to required retirement assets of $1,120,000. I am not sure how, or if Jim even factors in income taxes, into his multiplier.

Moshe Milevsky’s Equation

In Chapter 1 of Mr. Milevsky’s book , “The 7 Most Important equations”, he has a chart showing how much money you need for a 30 year retirement based on a real (after inflation) spending amount. Now to be fair to Mr. Milevsky, he says his first equation does not address taxes and you should use his final all-encompassing equation in Chapter 7. However, that chapter is about sustainable spending and I can easily grab a number from his Chapter 1 chart, so I will use the numbers in this chart and take some liberties with my calculations. If I gross my required spending up to $50,000 to account for taxes as I did in my tax centric model and use a 3% real return rate that Mr. Milevsky says in his book is reasonable in today's economic environment, his equation would reflect a retirement nest egg of approximately $990,000.

However, I have read where Mr. Milevsky has stated that in general you need 20-30 times your anticipated spending in retirement, so I think $990,000 would be at the low end of what he would suggest, so I will take the liberty of saying he would probably be more comfortable using a number closer to $1,100,000 for comparison purposes.

Michael James

I asked Michael to use his calculator that I discussed in Part 3, to determine the Bean’s required nest egg. He assumed an allocation of 15% in bonds, 15% fully safe and 70% in stocks. He also assumed a 4% real return for stocks and a 2% real return for the bonds. He also assumed a very efficient ETF portfolio with fees of only 0.2%:

Michael determined if the Bean’s want to live indefinitely, they will need a nest egg of approximately $1,680,000. If they plan to live to the age of 95, they will need approximately $1,070,000. If they plan to live to 90 they will need around $960,000 or so.

If Michael used a 2% Management Expense Ratio (“MER) instead of his ultra low cost MER of 0.2%, his figures jump to $3,250,000 if you plan to live indefinitely, $1,270,000 for age 95 and $1,090,000 for age 90.

Summary of $71,000 Spending Requirement

If the Bean’s require $71,000 to spend in retirement after-tax (including $31,000 in pension income), the various calculations would suggest that they should be shooting for a nest egg at the low end of $1,100,000 to $1,350,000 at the high end.

As noted above, I have taken liberties with some of the calculations and the variables would change for your specific assumptions and facts. Like I say in my title, who the heck really knows what you need to retire; all these numbers may be consistently wrong, but the above at least provides a starting point of some sort, even if simplistic.

What if the Bean’s have a $104,000 after-tax Spending Requirement?

Since my chart for the Bean's includes a scenario (#1) where they have a requirement for a $104,000 in after-tax spending ($131,000 in pre-tax income), let's see what the various formulas would reflect as their nest egg requirement for that level of spending.

Blunt Bean Counter – $2,500,000 ($100,000 RRIF/.04%=$2,500,000 for a 100% registered account).

Jim Otar –$2,044,000 (as the $104,000 is an after-tax spending amount and Jim uses a pre-tax spending shortfall, I have estimated that spending shortfall to be approximately $73,000)

Financial Planner –$2,250,000 using the same variables as noted in the prior example.

Moshe Milevsky –$1,978,000 at 3% real return, $2,100,000 at 2.5% return (as per his chart in Chapter 1 for a $100,000 after-tax shortfall).

Michael James – if you want to live indefinitely you will need approximately $3,370,000, if you live to age 95 the magic number drops to around $2,150,000 and at 90, it's $1,920,000 and finally, at 85 it's approximately $1,650,000.

If Michael used a 2% MER instead of his ultra low cost MER of 0.2%, his figures jump to $6,510,0000 if you plan to live indefinitely, $2,530,000 for age 95 and $2,190,000 for age 90.)

Summary of $104,000 Spending Requirement

If the Bean’s require $104,000 to spend in retirement after-tax (including $31,000 in pension income), the various calculations would suggest that they should be shooting for a nest egg at the low end off $2,000,000 to $2,500,000 at the high end.

Canadians Know Best

A recent BMO Harris Private Banking survey said that Canadians with investable assets of $1million or more say they need on average $2.3 million to live out their ideal retirement lifestyle. Based on the above, it looks like they are in the ballpark.

Final Caveat

Throughout this series, I’ve shared with you my research and analysis and provided you with as much information as possible so that you can try and determine (or at least consider) the assets you need to accumulate for your own retirement nest egg. There is not one definitive number. Keep in mind, one size does not fit all. My retirement funding includes the sale of my partnership interest; yours may include the sale of a business or a severance payment for taking early retirement. The point being, we all have unique situations.

Conclusion – This Series is Finally Over!!

After going through the analysis I provided to you, I've determined that I am much further away from my retirement goal than I had anticipated and I will still be working for several more years. I now wish I had a company pension. The largest surprise of this exercise to me is that I may give consideration to purchasing an annuity with some portion of my retirement funds, to ensure I have a constant minimum cash flow. Depressing as this exercise was, it brought some clarity to my retirement planning. I also realized that I have no idea whose Monte Carlo simulator will hit the jackpot and that historical data can be interpreted in so many ways it leaves your head spinning.

I do know a multitude of factors beyond my control may impact my expected withdrawal rate (see Part 5 for the laundry list) and thus as a result, I will have to:

1. Be flexible in my spending requirements and may need to be open to working part-time in retirement

2. Review, revise and refine my retirement plan on a consistent basis to account for financial and life events and any changes in my behaviour
In conclusion, I hope my quest or journey for freedom 55,65,75, helps guide your retirement planning.

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.

Monday, July 18, 2016

The Best of The Blunt Bean Counter- Inheriting Money - Are you a Loving Child, a Waiter or a Hoverer

This summer I am posting the "best of" The Blunt Bean Counter blog while I work on my golf game. Today, I am re-posting a June, 2014 blog post on how people act when they become aware they will inherit money from their parents or grandparents.

This topic is a bit controversial and the post became the basis for an article by Adam Mayers of the Toronto Star on inheritances, titled Inheritances are about love, money and greed.

Inheriting Money - Are you a Loving Child, a Waiter or a Hoverer

In February 2012, I wrote a blog post titled “Is it Morbid or Realistic to Plan for an Inheritance?”. I knew this was a touchy subject and would elicit various reactions from my readers. In the post, I stated that to “ignore the existence of a significant future inheritance that would impact your personal financial situation may be nonsensical” from a financial and retirement planning perspective.

Whether you believe you should plan for an inheritance or not, is your own personal decision. Today I want to deal with the behaviors and actions of those who stand to inherit money from their parents. Over the last 25 years, I have dealt with the tax, financial and psychological issues surrounding numerous client estates. I have observed the actions of those who will be the recipients of an inheritance and have found their behavior anywhere from fascinating to sickening.

I have found people who will inherit money fall into 4 groups:

1. The Loving Child

2. The Pragmatic Loving Child

3. The Waiters

4. The Hoverers

The Loving Child

For this group, their parents come first and money is secondary. Typically, these children are very close to their parents throughout their life and call and see them on a consistent basis, often weekly, or even daily. They have always helped their parents with their medical needs or in some cases with their financial needs, without giving it a second thought; because, their parents are well, their parents. This group would tell you they would give back any inheritance, if it allowed them another day to be with their parents and would consider it blasphemy to plan for an inheritance.

The Pragmatic Loving Child

This group is a subset of #1. These children love their parents and just want their parents to enjoy their lives, even if it means that they spend the children's inheritance. Children in this group may consider the reality that they will likely receive an inheritance. Even so, they do not want to take it into account in their planning and it is only at the insistence of an accountant or financial planner that they would even consider such.

The Waiters

I am not sure who coined this term, but I have seen it used many times. Waiters are described as children waiting for their parents to die, so that they can benefit from their parents assets. Waiters are considered to have a warped sense of entitlement to their parent’s money. I have observed several waiters over the years, some who went into debt to live a lifestyle based on an assumed inheritance. In my limited sample size, the children have always received their inheritance. However, one day I would love to see the face of a waiter when a lawyer informs them their parent decided to leave everything to charity instead of them.

The Hoverers

Hoverers are an even lower species than the waiters. These children often pay little or no attention to their parents their whole life, but when their parents get sick or older, they start hovering around. Many years ago one of my clients was very sick and was expected to pass away any day. I received a call from one of his children. I assumed the call was going to be the bad news that my client had passed away and the child was going to provide me the details of the funeral. The call was indeed to tell me their parent had passed away, but they were not calling to tell me about the funeral arrangements; their question to me was when they could start accessing their inheritance. I just felt sick to my stomach.

Don’t ask me why I decided to write about this topic. I guess as I have stated many times in my blog, I am just fascinated by how money affects people’s behavior. Thankfully, most people fall into the first two groups. If you are a Waiter or Hoverer, consider taking a good look at yourself in the mirror.

Monday, July 11, 2016

The Best of The Blunt Bean Counter - Probate Fee Planning- Income Tax, Estate & Legal Issues to Consider

This summer I am posting the "best of" The Blunt Bean Counter blog while I work on my golf game. Today, I am re-posting a June, 2011 blog post on Probate Planning that has had over 27,000 page views, making it one of my most popular.

It has been my experience, that many people are so concerned with minimizing their probate fees, that they often inadvertently create substantial income tax and/or legal issues that dwarf the benefits from the probate savings. So be careful and obtain professional advice when undertaking probate planning.

Probate Fee Planning - Income Tax, Estate & Legal Issues to Consider

Planning to reduce or eliminate probate taxes requires one to navigate a minefield of income tax rules, joint tenancy and right of survivorship issues and legal precedents. Questions of legal versus beneficial ownership of property and evidence of intention often come into play. The scary thing is, that this type of planning is often done by the uninformed.

When I started writing this post months ago, my objective was to provide probate planning techniques. However, as I wrote and researched, I realized the legal concepts were extremely complex and beyond my area of expertise. Consequently, this blog post became more conceptual in nature than initially planned. After reading this blog, I hope it becomes clear to you that you need to consult a tax or estate lawyer when undertaking any significant probate planning.

Probate Fees in Ontario

In Ontario, probate fees (technically called the “estate administration tax”) are levied on a deceased taxpayer’s estate at the rate of $250 on the first $50,000 of assets and $15 per $1,000 thereafter. Consequently, if a person were to die with assets of $1,000,000, the estate would have a probate fee liability of $14,500. An estate of $5,000,000 would have a probate fee liability of $74,500. For the other provinces, see this summary.

Two of the more common strategies to minimize probate fees are making gifts and transferring assets to joint tenancy. While these techniques may reduce or eliminate probate fees, they can create significant income tax and estate issues if not done properly.

Gifts to children and your spouse

If cash gifts are made during a person’s lifetime, they will reduce the value of his or her estate for probate purposes. If the gift is made to a child under 18 years of age, the income earned on the gifted property (i.e.: interest and dividends) will be attributed back to the person making the gift for income tax purposes. Where a cash gift is made to a spouse, the income earned on these assets (i.e.: interest and dividends as well as capital gains and losses) is attributed back to the person making the gift for income tax purposes. Cash gifts made to children who have attained the age of 18 do not invoke the income attribution rules in the Income Tax Act. So, you can make a gift to an 18 year old child which will reduce probate fees and not create any income tax problems.

Where non-cash gifts of capital property (such as gold or stocks) are made to a person other than your spouse, the property is deemed to be sold at its fair market value for income tax purposes. Thus, if a mother were to gift 1,000 shares of BCE having a total cost of $10,000 and fair market value of $30,000 to her 20 year old son, she would realize a capital gain for income tax purposes of $20,000, even though the shares were not sold and no money was received.

In an effort to avoid probate fees, some families seek to “add” the names of children to the title of a surviving parent’s home. This is done by transferring the title to the house from the surviving parent (“original owner”) to the children and surviving parent, as joint tenants (the “new owners”). Upon the transfer, the original owner/parent is treated for income tax purposes as having sold a portion of the transferred house based on the number of new owners. For example, if the new owners were parent and two children, each new owner will be treated as owning a one third interest. This means the original owner/parent in this example will be considered to have disposed of a 2/3 interest in the house. The 2/3 sale would be tax-free due to the principal residence exemption. However, 2/3 of any increase in value from the date of the gift until the house is ultimately sold will not be eligible for the principal residence exemption (assuming that the children have their own principal residences). If you are into horror stories, check out Jim Yih's blog for a nightmare of a story of a parent that put a child on title to her principal residence.

Situations such as the above may be avoided in certain circumstances where a lawyer knowledgeable in tax and/or estate law separates legal from beneficial ownership before the transfer. The Canada Revenue Agency (“CRA”) has stated that where there is a change in legal ownership without a corresponding change in the beneficial ownership (the real value is in beneficial ownership), there is not a disposition of the asset for tax purposes. What could be accomplished in the above scenario is a transfer of legal title only, without changing beneficial ownership. This would have no income tax implications but would assist in dealing with probate issues.

A further problem with transfers to joint tenancy (such as the home above) arises because with a joint tenancy, the entire title will pass to the last person alive which often is not the intent of the parent. For example, if a bank account belonging to Mom is transferred into a new account in the names of Mom, Son and Daughter, as joint tenants with right of survivorship, and Mom and Son die together, Daughter would become the “owner” of the entire account. This was not likely the intent of Mom, who likely wanted the split the account between her two children (or her grandchildren if one of her children passed away) – if not for trying to save probate fees, Mom would have never done this.

Joint Tenancy can be problematic-The Pecore Case

If property is held as joint tenants with a right of survivorship, on its face, the property will pass automatically to the surviving joint owner and is therefore not subject to probate fees. I have seen many cases where parents put their adult children’s names on bank accounts and investment portfolio accounts. The parents consider these accounts to now be exempt from probate, yet the parent continues to report the income earned on these investments in their own name for income tax purposes. As noted above, it is the CRA’s view that if beneficial ownership has not changed there is no disposition for income tax purposes, which is in accordance with the parents plan above. However, in the CRA's opinion, the probate transfer will not be effective, thwarting the parents plan above (Note: I have had various estate lawyers tell me that are not concerned with CRA's view on probate, since they do not administer this legislation).

Many parents fail to look past the probate issue and their intention in regard to the funds is unclear, i.e., is it the parent’s intention that the funds held jointly with one child belong to that child or do they belong to all their children and there is an understanding that the child on the account will share with their siblings?

This issue was addressed in Pecore v Pecore , a 2007 Supreme Court case where the court addressed these two potentially conflicting intentions. Legally, these two intentions are known as the presumption of a resulting trust and the presumption of advancement. The presumption of resulting trust means that when a parent dies, the transferred assets form part of their estate and will be passed on to the beneficiaries of the will, typically all their children. The presumption of advancement presumes any transfer to a specific child belongs to that child. The potential for conflict is rife where a parent transfers assets into joint tenancy with one child for ease of administration.

In the Pecore decision, the Supreme Court stated that where assets are transferred without consideration (such as to a child to avoid probate) that the presumption of resulting trust will operate in almost all cases save transfers from a parent to a minor child. This means that where a parent transfers assets into a joint account with one child, there must be evidence of the intention to make a gift to that specific child. As I am not a lawyer, I cannot state what counts as irrefutable evidence, but from what I have read, a written document is a minimum requirement.

A good summation of the various legal concepts discussed above is found here in this article by lawyer James Baird.

If done correctly and carefully, gifting, creating joint tenancy arrangements and separating legal from beneficial ownership can result in the reduction or elimination of probate fees. However, as discussed above, probate planning can lead to unintended income tax and estate implications. It is thus essential that you engage a lawyer who is comfortable in dealing with these issues, most likely a tax or estate lawyer when undertaking any significant probate planning.

Monday, July 4, 2016

Gone Golfing for the Summer of 2016

Druids Glen Ireland

This summer, I will again be posting a “Best of The Blunt Bean Counter” blog each week; so I can spend some time golfing and enjoying the good weather with my family.

As this is now the third year in a row, that I have posted my "Best of" during the summer, maybe a more appropriate title should be; "The Sort of the Best of The Blunt Bean Counter".

Anyways, you can read them again if you wish and if not, I won't take it personally. I hope you have a great summer and I will see you in September, if after six years I can come up with something new to write about.

Monday, June 27, 2016

What Small Business Owners Need to Know - Section 85 Rollovers

Section 85 of the Income Tax Act ("Act") provides for the transfer of certain assets with inherent tax liabilities to a corporation on a tax-deferred basis. Thus, accountants often utilize this section of the Act, to meet many of the objectives small business owners have.

Section 85 is most commonly used as follows:

1. Incorporation of a business – A sole proprietor has decided that their business is growing and ready for the next stage (incorporation). They can transfer all of their business assets to the new corporation under section 85.

2. Sale of a proprietorship – Section 85 helps sole proprietors looking to sell their business utilize the capital gains exemption by providing under certain circumstances for the transfer of their assets to a new corporation in exchange for shares; and those new shares are sold shortly thereafter. The typical 24-month holding period requirement for the use of the capital gains exemption will typically not apply in this situation (this is technical and your accountant should be consulted to ensure all criteria are met).

3. Crystallization of capital gains – A small business owner can make use of the capital gains exemption by using section 85 to transfer their current shares back to their corporation in exchange for new shares redeemable at a higher value – usually up to the maximum capital gains exemption available. For 2016, the exemption is $824,117 which is indexed annually. See this this blog post on the complexities of accessing the capital gains exemption.

4. Estate planning and income-splitting – Section 85 can help transfer an individual’s business to a future generation and allow the growth of the business to accrue to the new generation also allowing for dividend sprinkling. However the attribution rules and “kiddie tax” should also be considered when dealing with minor children.

5. Asset Protection – Section 85 allows small business owners to transfer assets usually land and building used in their active business out of their operating company to a holding company on a tax-deferred basis.

Some Technical Details

Section 85 is a valuable tool for corporate transfers because of the flexibility provided by a tax attribute known as the elected amount (“EA”). The parties involved in the transaction (typically the small business owner personally and corporation they own) can choose within limits, what the EA is and that becomes the deemed proceeds of disposition of the selected assets. Thus, in most transactions the parties elect the EA to be the adjusted cost base of the asset being transferred and thus, there is no gain, since the EA is the same as the cost. For example: if you have an asset with a cost base of $100 and a fair market value of $100,000, you could elect at $100 to avoid any adverse tax consequences.

If you elect a higher EA than the adjusted cost base, a capital gain will result. In cases where a small business owner wants to “crystalize” their capital gains exemption, they will often elect to trigger a gain equal to their capital gains exemption to bump-up their cost base of their shares and thus the small business owner pays no tax as their capital gains exemption eliminates the capital gain, however, alternative minimum tax may sometimes apply.

In order for subsection 85(1) to apply, both the taxpayer and the corporation must jointly elect in prescribed form T2057 – Election on disposition of property by a taxpayer to a taxable Canadian Corporation. There are various administrative matters that need to be considered when filing this election.

Section 85 is probably one of the most powerful and most utilized tax planning tools for tax practitioners. Therefore careful planning should be undertaken. When planning to utilize section 85 rollover, the below factors should be considered or adverse tax consequences could apply!

1. What types of property can be transferred? Attention needs to be taken when determining what types of property to transfer under section 85. The most commonly mistaken property that cannot be transferred is real property held as inventory i.e. land and building (Note: most people hold their real estate as capital property and not inventory). However other planning can be achieved to rollover real property held as inventory to a corporation on a tax deferred basis.

2. Should you transfer accounts receivable under section 85(1)? Other provisions of the Act should be considered to allow for the most tax efficient rollover of A/R.

3. What type of property can be received for transferring assets to the corporation? Can you receive cash or a promissory note in return without triggering punitive income tax consequences?

4. Do you have to receive shares in return for the assets being transferred? Can you receive a fraction of a share?

5. What type of corporation can you transfer the assets to on a tax deferred basis? Can it be a non-resident corporation or non-resident individual?

6. Determining the amount to elect if intellectual property is being transferred (i.e. goodwill)?

Once the assets are transferred to the corporation, there is no mirror provision available to roll them back out. It is generally advisable to include a price adjustment clause in case CRA does not agree with the estimated FMV of the property transferred (it is recommended that a valuation be undertaken to support the fair market value). The CRA recently published an Income Tax Folio: S4-F3-C1 – Price Adjustment Clauses that deal with the various types of situation in which a price adjustment should be included.

Other items to remember include GST/HST. Usually this tax will apply to the transfer price or the FMV of the assets. However an election can often be made which would allow the transfer of the assets to be exempt from GST/HST if certain conditions are met.

Section 85 is a very powerful provision of the Act and must be used with care. All of the above questions should be considered prior to commencing a rollover. There are other issues not mentioned above due to complexity. Always consult a tax specialist when dealing with rollovers.

[Thanks to Lorenzo Bonanno of BDO Canada LLP, for his assistance with this blog post]

Small Business Owners - Get on my Mailing List

If you are an owner-manager and/or a shareholder in a corporation and have not signed up for my corporate mailing list, please email me at bluntbeancounter@gmail.com

I will be sending out specific mailings on matters of importance to small business owners and I am considering, depending upon the interest, holding a roundtable for small business owners who are in the Toronto area. [I have not yet sent out a mailing, as I have been busy with December 31st corporate year-ends due June 30th. I will for sure send out something this summer].

Monday, June 20, 2016

Life Insurance - Review Your Coverage

Many of us purchase life insurance between the ages of 30 and 40 and subsequently pay no further attention to our life insurance needs. Today, I have a simple objective: to encourage you to review your current coverage.

Ask yourself this question. Has there been a change in your personal circumstances since you last purchased life insurance? If the answer is yes, now is the time to ensure you have sufficient coverage.

We hate paying life insurance for two reasons:

1. It forces us to accept our mortality.

2. As we age, the cost of life insurance becomes prohibitive, so most people who are lucky enough to live a full life, let it lapse (especially in the case of term insurance) and thus, have paid substantial sums of money for no monetary return (although, I think living is probably a fairly good non-monetary return).

Luckily, most of us get over these two hurdles and purchase life insurance to cover, amongst various things, the following:

1. Income replacement – life insurance acts as a replacement of income for the deceased person. This is very important where one spouse/partner is the breadwinner. The objective here is to allow your family to live in the manner they are accustomed to.

2. Financial security for dependents – somewhat related to #1, insurance ensures your spouse/partner is taken care of the rest of their life, and your dependants are financially covered until they are ready to join the workforce.

3. Mortgage protection - insurance pays off the family’s largest debt, typically the mortgage on their home.

4. Funding of University - many parents want to ensure their children are educated and use insurance to backstop that goal, in case they were to pass away.

Your Life Insurance Coverage Check-up

You may wish to review the following items or issues, to ensure your current life insurance coverage is up-to-date:

1. Your current salary or self-employment income – review your income. Has it changed significantly since you put your initial life insurance in place? If the answer is yes, and you are like most people in that your monthly family spending has expanded in proportion to your higher income, you will need more insurance to replace that income and increased family spending.

2. Life Expectancy – life expectancy continues to increase. In Canada, the average female is expected to live to about 84 and the average male to about 80. There is approximately a 25% chance one spouse/partner will live to the age of 95. The question for you is: what assumptions did you make about life expectancy when determining your life insurance needs for you and your spouse/partner/family? You may want to revisit those assumptions.

3. Debts – review your current debt load. Has your mortgage increased or decreased? Have you tapped into your Line of Credit for home renovations or investment purposes? Have you incurred any new personal debt?

4. University – many children attend university outside of Canada because the enrollment at many Canadian professional schools is very limited. Do you think your child(ren) may need to do such? If so, those costs could be 3-5 times higher than those of a child who studies in Canada.

5. Cottage – do you plan to leave the cottage to your children? You may want to ensure you and your spouse/partner have enough insurance to cover the taxes on the last of your deaths.

6. Estate Planning – some parents wish to use their insurance to leave a legacy to their children. If that is you plan, is your current insurance sufficient? If you are one of those parents, consider converting part of your term insurance to permanent insurance, if your policy allows such, or consider purchasing some new permanent insurance. If you have a private corporation, consider a corporate funded insurance policy as discussed in this blog post.

The above discussion is fairly simplistic. As noted, the main objective of this post is to have you review your current life insurance, to ensure it is sufficient for your current needs. If you determine your insurance is insufficient, make an appointment with your insurance advisor.

Monday, June 13, 2016

The Income Tax Implications of Divorce Where You Own a Home and a Cottage

A few months ago, I was at a party when one of the party-goers started chatting to me about their
divorce. I ended up fielding various financial questions for which I referred them back to the matrimonial lawyer (I should have known they were not talking to me because of my bubbly personality).

But all was not lost. One of the questions they asked me about was the income tax implications of transferring their principal residence to their name, and the cottage to their spouse, as part of their divorce. As these transfers are often “messed up” and/or ignored in divorce agreements, I realized they had a least provided me a future blog topic. So today, I discuss the implications of transferring your home or cottage to your spouse upon divorce.

Principal Residence Exemption

In general, where you have lived in your home since its purchase, any gain upon the sale of that home is tax exempt because of the principal residence exemption (“PRE”). Where you own a house and cottage, things get more complicated, as you and your spouse may only designate one residence between you for purposes of the PRE, for each tax year after 1981 (prior to 1982, each spouse could designate one principal residence and thus you could possibly claim the PRE on both your home and cottage).

If you are happily married and own a home and cottage, in general, when you dispose of the properties, you would allocate the PRE to the property with the largest yearly capital gain. This calculation can be complex and typically leaves one property as taxable, or at least partially taxable (i.e. you may have owned your home 5 years before you purchased your cottage, so you have 5 years of PRE to claim on your home).

Where a couple is divorcing, how you allocate the PRE claim on your cottage and home is often problematic.

Spousal Rollover on Divorce

Unless you elect otherwise, where you transfer capital property, the Income Tax Act provides for a tax-free rollover to your former spouse if the transfer is in settlement of their property rights (transfers by title pursuant to a court order or provincial legislation also are provided for). In plain English, you can transfer, say a cottage, to your former spouse with no immediate income tax consequences, although, they assume the cost base of that cottage.

The Issue

One would think that based on the PRE and the tax-free spousal rollover, that where a divorcing couple has a home and cottage, things should be simple. However, since a couple can only claim one PRE during the marriage (other than when a spouse who was throughout the year living apart from and was separated under a judicial or written separation agreement) that is definitely not the case. This one PRE rule per couple is clearly noted in this interesting case, Balanko v The Queen.

Consequently, it is vital that the right to the PRE or the allocation of the PRE must be accounted for in any marriage settlement, for both purposes of the actual claim, and the related income tax one of the spouses may incur. If the use of the exemption is not addressed in the separation agreement, it is then a first-come, first-served claim.

In this article, the authors on page 1122 suggest that you consider at the time of separation or divorce that you complete a principal residence designation Form T2091.

Example

Say Tom and Katie are seeking a divorce and jointly own a family home (the home cost $300,000 and is now worth $1,000,000) and cottage (the cottage cost $500,000 and is now worth $1,000,000). In their divorce settlement, they agree that Tom will take the home and Katie the cottage (in real life, the house and cottage values and related income tax costs may be disproportionate and the value and tax discrepancy is equalized in some manner). This cross transfer of title can be done tax-free as discussed above; Tom assumes a cost base of $300,000 on the family home, and Katie a cost base of $500,000 on the cottage.

Katie has plans to sell the cottage immediately and to buy a new house. Katie’s lawyer and tax advisor decide to keep silent on the issue as to who can claim the PRE, since they know she will claim it first. Should Katie claim the PRE, Tom could be stuck with a tax liability approaching $175,000 when he eventually sells the home.

Luckily for Tom, he has hired sharp advisors. They raise the issues during the divorce negotiations. After some back and forth, the parties agree that Katie will claim the PRE; however, Tom is entitled to an extra $87,500 in family assets to equalize him for his future income tax liability.

If you and your spouse have a home and cottage and are unfortunately in divorce proceedings, or in a dissolving marriage, it is imperative your family lawyer and/or tax advisor consider/negotiate which spouse will be entitled to the PRE and whether a PR designation and/or tax equalization payment needs to be considered.

This blog post is for general information purposes only. The author is not a lawyer and the discussion above does not constitute legal or other professional advice or an opinion of any kind. The information above is provided solely to raise awareness of the issue. Readers are advised to seek specific legal advice regarding any specific legal issues.