Part V – Real Estate: Use Caution When Purchasing First Home

As of September 30, 2016, the price for a single family house has risen 22 percent, from September 30, 2015.  This could be discouraging for anyone not in the real estate market or for younger people looking to save for a down payment to buy a house.  With prices at historic highs, the temptation may be to rush into real estate before it goes higher.  Similar to the stock market, when you buy is extremely important.  Buying your principal residence is different which we will explain below.

The housing market is typically one area where using leverage (borrowed money) to purchase an asset has been good. Let’s walk through an example of leverage to purchase a single family home in Victoria.  According the Victoria Real Estate Board (VREB) the benchmark median value (September 2016) for a single family home in Victoria is $745,700.  Unfortunately, the exemption rules with respect to first time home buyers and property transfer tax are archaic and unrealistic in larger centres – property transfer tax of $12,914 would apply.   We think it would be beneficial if the province would adjust the qualifying value for exemption or at least allow some form of proration for affordable housing.  In Ontario, the Finance Minister  has announced that they will refund up to $4,000 from the land-transfer tax for first-time home buyers.

In addition to the purchase price, I estimate the following additional costs at a minimum: legal fees $750, house inspection $500, and house insurance $800. At a minimum, the immediate cash out-lay to purchase the home is $760,664.  To avoid CMHC insurance, a purchaser must put a down payment of 20 per cent, or in this case $152,132.80.  The remaining $608,531.20 must be financed or in other words, “leveraged”.

As noted at the very beginning, prices for Real Estate jumped 22 per cent in one year. It is, therefore, not unreasonable to stress test what would happen if real estate declined 10 per cent in one year.  If a 10 percent correction in real estate prices occurred, then this single family home example would decline $74,570.  Based on the down payment of $152,132.80, this would represent a loss on capital saved of 49 per cent.  Illustrating leverage to a younger person is essential in order to understand the associated risks.

In our first column we talked about the tax benefits of owning a principal residence – essentially no tax on capital gains. Canada Revenue Agency has a term called “personal-use property” which applies to a principal residence.  Any loss on the disposition/sell of a property which is used as a primary residence is deemed to be nil by virtue of sub-paragraph 40(2)(g)(iii) of the Income Tax Act.

If an investor entered the stock market with a non-registered account at a market high point before it pulled back, then, at least with the stock market, people are able to claim a capital loss and use it indefinitely.

Assuming a 25 year amortization and monthly payments, let’s do another form of stress test to see how a change in interest rates would impact payments on the $608,531.20 mortgage.   Assuming a mortgage at 3.2 per cent, the monthly payments would be $2,949.43.  If rates rise slightly to 3.7 per cent, the monthly payments would rise to $3,112.12.  In the near term it looks like rates will stay low, but a realistic view of the 25 year amortization should reflect rates rising off historic lows.  The best scenario would have the first time home buyer paying down as much of the principal before rates potentially rise to reduce the impact.

When interest rates go up, home prices tend to go down simultaneously. This would only compound the effect of the loss on capital saved in the short-term.

Taking a long-term vision and being sure that you can weather the stress tests above in the short-term are key factors prior to rushing in to buy a home. Similar to the stock market, we feel confident in the long-term that valuations will be higher than today.

Kevin Greenard, CPA CA FMA CFP CIM, is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the TC.  Call 250.389.2138. greenardgroup.com 

This is for information purposes only. It is recommended that individuals consult with their financial advisor before acting on any information contained in this article. The opinions stated are those of the author and not necessarily those of Scotia Capital Inc. or The Bank of Nova Scotia. ScotiaMcLeod is a division of Scotia Capital Inc., Member Canadian Investor Protection Fund.

Part IV – Real Estate: Creating Cash Flow from the Proceeds from Selling Your House

Prior to selling your home, we encourage you to have a clear plan of what the next stage would look like.

If that next stage is renting, then meeting with your advisor ahead of time is recommended.   Once you sell, the good news is that you no longer have to worry about costs relating to home ownership, including property taxes, home insurance, repairs and maintenance.

Budgeting, when your only main expense is monthly rent, makes the process straight forward.  The key component is ensuring the proceeds from selling your house will be invested in a way that protects the capital and generates income to pay the rent.

The first step is determining the type of account in which to deposit the funds. The first account to fully fund is the Tax Free Savings Account (if not already fully funded). Then open a non-registered investment account for the proceeds.  Couples will typically open up a Joint With Right of Survivorship account.  Widows or singles will typically open up an Individual Account.

The second step is to begin mapping out how the funds will be invested within the two accounts above. A few types of investments that are great for generating income are REIT’s (Real Estate Investment Trust), blue chip common shares, and preferred shares.  Not only do these types of investments offer great income, they also offer tax efficient income, especially when compared to fully taxable interest income.

When you purchase a REIT, you are not only getting the benefit of a high yield, but you are generally getting part of this income as return of capital. The return of capital portion of the income is not considered taxable income for the current tax year.

As a result of receiving a portion of your capital back, your original purchase price is therefore decreased by the same amount. The result is that you are not taxed on this part of the income until you sell the investment at which point if there is a capital gain you will be taxed on only 50% of the gain at your marginal tax rate. You have now effectively lowered and deferred the tax on this income until you decide to sell the investment.

Buying a blue-chip common share or a preferred share gives you income in the form of a dividend. The tax rate on eligible dividends is considerably more favourable than interest income.

Another tax advantage with buying these types of investments is that any gain in value is only taxed when you decide to sell the investment and even then, you are only taxed on one half of the capital gain, referred to as a taxable capital gain. For example, if you decide to sell a stock that you purchased for $10,000 and the value of that stock increased to $20,000, you are only taxed on 50% of the capital gain. A $10,000 capital gain would translate to a $5,000 taxable capital gain.

We have outlined the approximate tax rates with a couple of assumptions.  Walking through the numbers helps clients understand the after-tax impact.

To illustrate, Mr. Jones has $60,000 in taxable income before investment income, and we will assume he makes $10,000 in investment income in 2016.  His marginal tax rate on interest income is 28.2%, on capital gains 14.1%, and only 7.56% on eligible dividends.

If Mr. Jones earned $10,000 in interest income, he would pay $2,820 in tax and net $7,180 in his pocket.  If Mr. Jones earned $10,000 of capital gains, he would pay $1,410 in tax and net $8,590 in his pocket.  If Mr. Jones earned $10,000 of eligible dividends, he would pay $756 in taxes and net $9,244 in his pocket.

The one negative to dividend income for those collecting Old Age Security (OAS) is that the actual income is first grossed up and increases line 242 on your income tax return. Below line 242 the dividend tax credit is applied.  The gross up of the dividend can cause some high income investors close to the OAS repayment threshold to have some, or all, of the OAS clawed back which should be factored into the after tax analysis.  The lower threshold for OAS claw-back is currently at $72,809.  If taxable income is below $72,809 then the claw-back is not applicable.  If income reported on line 242 is above $72,809 then OAS begins getting clawed back.  Once income reaches $118,055 then OAS is completely clawed back.

The schedule for dividend payments from blue chip equities and preferred shares is typically quarterly.  For REIT’s, it tends to be monthly. Once you decide on the amount you want to invest, then it is quite easy to give an estimated projection for after tax cash flow to be generated by the investments.

Preparing a budget of your monthly expenses makes it easy to automate the specific cash flow amount coming from your investment account directly into your chequing account.

Kevin Greenard, CPA CA FMA CFP CIM, is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria.  His column appears every week in the TC.  Call 250.389.2138. greenardgroup.com 

This is for information purposes only. It is recommended that individuals consult with their financial advisor before acting on any information contained in this article. The opinions stated are those of the author and not necessarily those of Scotia Capital Inc. or The Bank of Nova Scotia. ScotiaMcLeod is a division of Scotia Capital Inc., Member Canadian Investor Protection Fund.

Part III – Real Esate: Benefits of Selling Real Estate Early in Retirement

In our last column we talked about CRA cracking down more on individuals who are non-compliant with respect to the principal residence deduction. Certainly individuals who have frequently bought and sold homes under the principal residence deduction will have to think twice and be prepared to be audited.

This article is really about the individuals who are contemplating a change in their life. Health and life events are often the two trigger points that have people thinking about whether to sell or not.   It can certainly be an emotional decision when it comes to that time.  Selling your home when you have control on timing when it is sold is always better than the alternative.

For our entire lives we have been focused on making prudent financial decisions and doing things that increase our net worth. There comes a point where you shouldn’t always do something that is the best financially.  If we only made decisions based on financial reasons you would never retire, you would work seven days a week, work longer days, and never take a vacation.  Throughout our working lives most people try to create a reasonable work-life balance.  In retirement I try to get clients to focus on the life part and fulfilling the things that are important to them.

Selling a principal residence could translate to a foolish move for someone looking at it only through net worth spectacles. I encourage clients to take off those spectacles and focus on what they truly want out of retirement and life.  At the peak of Maslow’s hierarchy of needs is self-actualization where people come to find a meaning to life that is important to them.   I think at this peak of self-actualization, many find that financial items and having to own a house, are not as important as they once were.

About ten years ago I remember having meetings with two different couples. Let us talk about the first couple, Mr. and Mrs. Brown who had just retired.  One of the first things they did after retiring was focus on uncluttering their lives.  They got rid of the stuff they didn’t need, and then they listed their house and sold it.  They then proceeded to sell both cars.  Shortly thereafter they came into my office and gave me a cheque for their total life savings.  Mrs. Brown had prepared a budget and we mapped out a plan to transfer a monthly amount from their investment account to their bank account.  They walk everywhere and are extremely healthy.  They like to travel and enjoy keeping their life as stress free as possible.  If any appliances break in their apartment it is not their problem, they just call the landlord.  Our meetings are focused on their hobbies and where they are going on their next trip.

I met another couple ten years ago, Mr. and Mrs. Wilson. They had also just retired.  They had accumulated a significant net worth through a combination of financial investments and they owned eight rental properties (including some buildings with four and six units).    At that time I thought they would have had the best of retirements based on their net worth.   The rental properties seem to always have things that need to get repaired or tenants moving out.  When I hear all the stories it almost sounds like they are stressed and not really retired.  Every year their net worth goes up.  Every year they get older, Mr. Wilson is now 75 years old and Mrs. Wilson is 72.  In the past I have talked to them about starting to sell the properties, to simplify their life and get the most out of retirement.   They are still wearing net worth spectacles and have not slowed their life down enough to get to the self-actualization stage.

My recommendation to clients has normally been to stay in their home as long as they can, even if this involves modifying their house and hiring help. This is assuming they have their health and the financial resources to fund this while still achieving their other goals.   Even in cases when financial resources do not force an individual to sell a house, the most likely outcome is that the house will be sold at a later stage in life and the proceeds used to fund assisted living arrangements.

Many people are house rich and cash poor. From my experience clients have two choices.  Option one is they can have a relatively stressful retirement trying to stretch a few dollars of savings over many years.  With this option you will likely leave a large estate.   Option two is selling the house and using the lifelong accumulation of wealth to make the most out of your retirement.    Although this option results in a smaller estate, you’re more likely to reach the self-actualization stage.

Kevin Greenard, CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the TC.  Call 250.389.2138. greenardgroup.com 

This is for information purposes only. It is recommended that individuals consult with their financial advisor before acting on any information contained in this article. The opinions stated are those of the author and not necessarily those of Scotia Capital Inc. or The Bank of Nova Scotia. ScotiaMcLeod is a division of Scotia Capital Inc., Member Canadian Investor Protection Fund.

 

A proactive advisor can cut your taxes

Clients are often unaware of investment alternatives, credits, loss-recovery options

I ask every new client to sign a Canada Revenue Agency (CRA) form T1013 – Authorizing or Cancelling a Representative. This authorizes CRA to release tax related information to me, referred to as a “representative.” It is an invaluable tax tool to proactively help clients.

Canada Revenue Agency’s website (cra-arc.gc.ca) is a great resource for general information.   On this website, representatives can access their client’s tax information. When I have clients sign the T1013, I request Level 1 authorization which enables me to view information only. There is no ability to make changes. The most obvious benefit for clients in signing the T1013 is that they no longer have to bring in a copy of their annual tax returns and applicable notices of assessments. This information is available online. I use it for a variety of purposes, primarily to give proactive advice to save tax dollars. Here are a few situations clients have encountered to which I was able to provide solutions as a result of having the T1013 on file.

Situation 1: In examining Mr. Red’s tax return, we noted he had to pay $456 in interest and penalties to CRA for not making his quarterly instalments on time.

Solution: We brought this to Mr. Red’s attention and provided automatic solutions that could help him. The first was that we could begin withholding tax on his RRIF payments. The second was that we could contact Service Canada and request that withholding tax be taken on CPP and/or OAS payments. A manual option was that we could make his quarterly instalment payments to CRA for him directly from his non-registered investment account.

Situation 2:   Mrs. Brown is a new client who transferred in a non-registered investment account. During our initial conversations, she said she prepares her own tax return. My evaluation of her past returns showed there was no carry-forward information for realized gains or losses on her investments. I confirmed that she had sold many investments over the years, but had not recorded these on her tax return.  

Solution: I explained that all dispositions in a taxable account must be manually reported on Schedule 3 (no tax slip is issued for this). We assisted her in obtaining previous annual trading summaries to calculate the numbers needed to adjust her previous tax returns.

Situation 3: Mr. Black has been contributing to his RRSP for many years. In the last year, his income dropped substantially and he was comfortably in the first marginal tax bracket. Mr. Black said he projected that his income would continue at the current level or decline as he approaches retirement.              

Solution: It no longer made sense for Mr. Black to continue to contribute to his RRSP account. His savings should be directed to a Tax Free Savings Account.

Situation 4: Mr. Orange received penalties for over-contributing to his TFSA accounts. In our first meeting, he explained that he had several TFSA accounts and had lost track of his withdrawals and contributions.

Solution: We outlined the rules with respect to TFSA accounts and any replenishment for a previous withdrawal must occur in the next calendar year. I also had him sign the T1013 form. I printed out all of his TFSA contributions and withdrawals from the online service. I recommended that he consolidate his TFSA accounts. I also provided copies of the CRA reports, including a report which shows his current year contribution limit.

Situation 5: Mrs. Yellow has been a long time client whose health has deteriorated over the years. In reviewing her tax returns, I noted that he was not claiming the disability tax credit.

Solution: I provided her with a copy of the Disability Tax Credit form T2201. I advised her to bring this to her doctor to have the form signed and submitted. A few months later, Mrs. Yellow received a letter back from CRA with their approval for her application. They also approved backdating her eligibility to 2009. In assisting Mrs. Yellow and her accountant with the T1-Adjustment form, we projected that she would receive a tax refund of $12,490. From now on, Mrs. Yellow will be able to claim the disability tax credit every year, resulting in significant tax savings.

Situation 6: Mr. White has, in the last few years, completed his own tax return using Turbo Tax. He has correctly reported the taxable capital gains on line 127 of his tax return during this period. Unfortunately, Mr. White did not initially key in his loss carry-forward information. Many years ago, Mr. White had a significant net capital loss on a real estate investment, and was not aware that he could apply his net capital losses to reduce his taxable capital gains on the stock sells.  

Solution:   I arranged a meeting with Mr. White and explained to him the importance of keying in the carry-forward amounts when starting to use Turbo Tax. I also showed him how he can use a T1-Adj form to request CRA change line 253 – Net capital losses of other years. Mr. White had to submit four T1-Adj for each year he missed applying his net capital losses. Combined Mr. White received a refund of $47,024 after all reassessments.

Situation 7: Mrs. Green has recently transferred her investments to us. We noted a few investments with significant losses that she has held in her account for many years.   There is little hope that these investments will recover in value. In reviewing Mrs. Green’s online account with CRA, I looked up all of her previously reported taxable capital gains and net capital losses. In this analysis, I noted she had substantial taxable capital gains three years ago that brought her income into the top marginal tax bracket.   Net capital losses can only be carried back up to three years. Mrs. Green was unaware net capital losses could only be carried back up to three years.

Solution: I recommended that Mrs. Green sell most of her investments that were in an unrealized loss situation. By selling these she triggered the tax situation and created the net capital loss. I printed off the T1A – Request for Loss Carryback form and explained to Mrs. Green how the form works. Mrs. Green was able to recover $29,842 after CRA carried the loss back and reassessed her tax return from three year ago.

Situation 8: Mr. Blue had stopped working at the age of 62, but his spouse was continuing to work a few more years. In looking at his CRA online reports, I noted he was collecting CPP and that this represented most of his income, which was below the basic exemption.  He had not thought about taking money out of his RRSP early as Mrs. Blue was continuing to work and they had enough money flowing in from her income and in the bank to take care of the bills. Mr. Blue had a sizeable RRSP account and Mrs. Blue will have a good pension when she retires that can be shared.

Solution: I explained to Mr. Blue that when he starts collecting OAS, pension splitting with his spouse, and having to withdrawal from his RRIF that his taxable income will increase significantly. We recommended that he convert a portion of his RRSP to a RRIF and begin taking income out on an annual basis immediately. We mapped out a plan to keep his taxable income around $35,000. With these early withdrawals, our projections would keep both Mr. and Mrs. Blue in the top end of the first marginal tax brackets throughout retirement.

Situation 9:   Mrs. Purple is extremely busy with work and has a great income. It is definitely advisable for Mrs. Purple to maximize her contributions to her Registered Retirement Savings Plan (RRSP). Unfortunately, Mrs. Purple never seems to find the time to photo copy her notice of assessment and provide this to her advisor. She was frustrated that last year, she missed contributing to her RRSP because her advisor did not phone.

Solution:   When Mrs. Purple came to see me I explained the benefits of the T1013 form. One of the main benefits is that I can go on-line and instantly obtain her RRSP contribution limits and unused portions for the current year.   I proactively contact each applicable client and advise them of their limits and recommended contribution level based on projections of current and future income levels.

Financial tips for blended families

Opening the communication channels is key when helping couples in blended family situations.   This communication should absolutely start on Day 1 for blended families, and should be part of the account opening process. A good advisor will ask probing questions beyond the checklist of mandatory questions to first open an account.  

With new blended families, it is not always easy to have open communication with both parties. Often, they have different advisors and different financial institutions.   If this is the case, then it is common for the couple to maintain the status quo with their separate finances.   I always encourage couples in blended families to come in together, even when they are maintaining separate finances. Once this happens, and once there is open discussion and communication, then progress can be made on a variety of financial decisions.

Often there is a disparity between the value of assets, or net worth, of each party. Rarely are the assets equal. One party may have more equity in real estate, while the other has more stock and bond investments.  

Making objective financial decisions can be challenged by the simple notion that “blood is thicker than water.”   For example, many parents want to provide for their children from a previous marriage. However, this can conflict with the many tax benefits provided for married or common-law relationships. This conflict is especially challenging when it comes to estate planning. Below I have listed a few common assets and basic challenges couples in blended families may face.

Non-Registered Account:  The term taxable account or non-registered can be used inter-changeably. Often young people do not have non-registered accounts as they are busy paying off mortgages and/or contributing to their registered accounts, such as RRSPs.   Older couples with adult children are more likely to have taxable accounts when they enter a blended family.   When a person has non-registered investments just in their name, this is called an Individual Account.   The monthly statements and confirmation slips have just the one person’s name on it, and the year-end tax slips (i.e. T5 and T3 slips) are in same one individual’s name.  

Couples in a first marriage, and who have built up equity together, will open up a taxable account called Joint With Right of Survivorship (JTWROS). This type of account has many benefits for couples, including income-splitting. The primary benefits of these joint accounts are probate is avoided, income tax continues to be deferred, such as for unrealized capital gains, and simplicity of paperwork after the first spouse passes away.  

Some couples have two JTRWOS with each person being primary on their own respective account. By primary I mean their name is first on the account and their social insurance number is on all tax slips. This enables couples to still keep funds separate, but it will still provide the same above benefits.

Tenants in Common:  Another option for taxable accounts is Tenants In Common. With Tenants in Common a taxable account is set up with two or more owners, where the ownership percentages do not have to be equal. Upon the passing of any owner, their portion represents part of their estate, and the other owners do not have the right of survivorship.   Many of the benefits of JTWROS are lost with Tenants In Common, but for some couples this may be the right decision. A couple that would like to combine their assets to pay household bills, could simply allocate the ownership based on the amount originally contributed. If Spouse ”A” puts in $300,000, and Spouse “B” puts in $700,000 then the allocation for ownership could be 30 per cent for Spouse A and 70 per cent for Spouse B.   If either spouse passes away, their Will would dictate how their proportionate share is divided.  

Registered Accounts:  The two most common types of registered accounts are Registered Retirement Savings Plans (RRSP) and Tax Free Savings Accounts (TFSA). RRSP and TFSA accounts can only be in one person’s name.  

However, with both of these types of accounts you are able to name a beneficiary. With couples in a first marriage and building equity together, your spouse is likely always named the beneficiary on registered accounts.   At the time of death, Canada Revenue Agency allows the owner of an RRSP (called an annuitant) to transfer their RRSP to their surviving spouse or common-law partner, on a tax-deferred basis. If there are financially dependent children because of physical or mental impairments, then it also may be possible to transfer the annuitant’s RRSP on a tax-deferred basis. Outside of these two situations, the annuitant’s RRSP is fully taxable in the year of death.

A person who has a spouse, and chooses to name an adult child the beneficiary should understand the tax consequences. If you name your spouse the beneficiary, your spouse receives 100 per cent of the value until the funds are pulled out gradually (taxed when taken out). If you name someone other than a spouse, the funds are deemed taxable in one large lump sum, so the marginal tax bracket of 45.8 per cent could easily be reached. Many people would cringe if they could see the amount of tax paid to CRA from RRSP accounts resulting from a lack of planning.  

Although the TFSA has no immediate tax issues on death, there are still some benefits to naming your spouse or common-law partner the beneficiary.   As an example, let’s look at a blended family with Spouses C and D. Spouse C has $48,000 in a TFSA and Spouse D Has $52,000.

Spouse C has the option of naming the Estate the beneficiary, naming Spouse D the beneficiary, or naming another individual such as a child or children from a previous marriage. If Spouse C names the Estate the beneficiary, then the account would likely have to be probated to validate the Will. The Will would provide us direction as to who the beneficiary of the TFSA will be. If Spouse C named Spouse D the beneficiary, then we can roll over the entire $48,000 into Spouse D’s TFSA account (without using contribution room). After the roll over, Spouse D would have a TFSA valued at $100,000 – all of which is fully tax sheltered. The roll over can be done once we receive a copy of the death certificate – and no probate is required for the transfer of assets. The only time individuals are permitted to put more into their TFSA accounts, other than their standard annual limits and replenishing amounts withdrawn in an earlier year, is when their spouse or common–law partner passes away and they are named the beneficiary.

If Spouse C named the children from the first marriage the beneficiary, then Spouse D does not get the additional room and the children could receive the funds but would not be able to roll this amount into their own respective TFSA accounts without using their available room.  

While there are many solutions available for blended families, it is important to talk about these options and then document the plan.   Gathering all the information and creating a plan that both parties are content with can take some time. A plan should include all standard types of assets such as personal residence and vehicles, as well as liabilities. One of my most rewarding moments as a Portfolio Manager is assisting my clients with their plan. A plan ultimately provides peace of mind for clients in what is often viewed as a complex situation that was either too sensitive to talk about or simply not addressed.

Tax tips for Americans in Canada

Recommendation No. 1: Seek advice on reporting requirements

Most countries, including Canada, do not tax on the basis of citizenship. For example, Canadian citizens who live in Canada pay tax in Canada on the taxable income they earn. If a Canadian citizen moved abroad a few years ago, with no continued ties to Canada, it is most likely this individual would be considered “non-resident” and would have no tax reporting obligation to Canada. In other words, Canadians are taxed based on residency.

The U.S. tax system is different as it treats all U.S. citizens as U.S. residents for tax purposes, no matter where they live in the world, including Canada. Many U.S. citizens live in Canada and are resident here. A U.S. citizen has to pay tax in Canada on taxable income if they are resident for Canadian tax purposes.   Canada and the U.S. have entered into various agreements (i.e. tax treaties) to address taxation differences and to largely avoid double taxation.  

The Internal Revenue Service (IRS) in the U.S. has been trying to crack down on American taxpayers using financial accounts held outside of the U.S. to evade taxes. For example, the U.S. introduced the Foreign Account Tax Compliance Act (FATCA), signed into law on March 2010, with the objective of identifying taxpayers evading taxes. To do that required co-operation from other countries to provide information.  

The U.S. effectively told Canada that if it did not comply, then all income from U.S. investments would be subject to a 30 per cent withholding tax. This threat of withholding was for both registered and non-registered investment accounts.

Previously, Canada was not required to withhold any tax on U.S. investments held in registered accounts. For non-registered accounts, the negotiated tax treaty had withholding rates on U.S. dividends at 15 per cent and nil for US interest income.

Earlier this year, Canada and the U.S. signed an Intergovernmental Agreement (IGA) regarding FATCA, in which Canada agreed to pass laws requiring that, primarily through financial institutions, that annual reports be made to the Canada Revenue Agency on specified accounts held in Canada by U.S. persons. The agreement brings Canada, via the CRA, into a reporting agreement to satisfy FACTA.

Under the agreement, the U.S. has agreed not to apply the 30 per cent withholding tax on registered accounts, such as RRSPs, TFSAs and RESPs, and to maintain the existing withholding rates for non-registered accounts.

Effective July 1, 2014, an amendment to the Canada Income Tax Act adopting Canadian tax regulations related to FATCA.   Also beginning in July 2014, financial institutions have new requirements to report to the CRA, not the IRS. Clients of financial institutions will be required to complete additional mandatory questions for all non-registered accounts. New account-opening forms will require you to state if they are a citizens of Canada, and if they are a citizen of the U.S. Another question is, “Are you a U.S. Person (Entity) for tax purposes?” Certain legal entities must answer a new classification question relating to active or passive entity.

For the purposes of FATCA, here are some examples of who is deemed a U.S. Person (Entity):

  • U.S. citizens, include persons with dual citizenship, U.S. residency,
  • Any person who meets the IRS “Substantial Presence Test of U.S. Residency,”
  • U.S. resident aliens (Green Card holders who do not have U.S. citizenship),
  • Persons born in the U.S. or who hold a U.S. Social Security Number (SSN) or U.S. Tax Identification Number (TIN) or a U.S. Place of incorporation or registration

Financial firms have a mandatory obligation to provide this information to CRA. CRA will begin sharing relevant information pertaining to the agreement with the IRS starting in 2015.

For the majority of Canadians, this is a non-issue. For the approximately one to two million people in Canada that would be deemed a U.S. Person (Entity), it reinforces the need to have all of your tax filings up to date with both the IRS and CRA.

Sharing information electronically between CRA and the IRS will enable the IRS to obtain information on U.S. Persons (Entities) that have not fulfilled their reporting obligations.

Other indicators must also be reviewed, including U.S. address (residence, mailing, in-care-of, or interested party), U.S. telephone number, standing instructions to transfer funds to an account held by the client in the U.S., a power of attorney or signatory authority granted to a person with a U.S. address.

Many snowbirds have asked me what their requirements are under FATCA. Reviewing the “Substantial Presence Test of US Residency” on the IRS website is a good starting point. A wealth advisor should have enough knowledge about FATCA to make sure your accounts are documented correctly and that they are asking you the right questions.

I recommend every client who is not sure if they have a reporting obligation to consult with an independent tax advisor to determine if they are a U.S. person for tax purposes. It is important that the accountant you approach has knowledge in these areas to be able to provide you appropriate advice.

Effective July 1, 2014, financial institutions are required by law to report annually to CRA on accounts where a client is unwilling or unable to provide documentation for FATCA, one of more U.S. owners are specified ”U.S. Persons,” undocumented account holders for FATCA purposes, and passive entity with one or more controlling persons that are specified “U.S. Persons.” The information that must be sent to CRA includes name, address, TIN/SIN and total account value.

If you are not sure if you have a reporting obligation, we encourage you to speak with your wealth advisor who should be able to communicate with your independent tax professional, and together ensure your financial accounts are documented correctly and you are fulfilling your reporting requirement, if any.  

This article is intended as a general source of information and should not be considered as personal investment, tax or pension advice. We are not tax advisors and we recommend that individuals consult with their professional tax advisor before taking any action based upon the information found in this publication.

Investments for retirement income key

Fewer Canadians can count on large defined-benefit pensions or fat nest eggs 

The Investment Industry Association of Canada (IIAC) issued a report on March 18, 2014 titled “Canada’s Investment Industry:  Protecting Senior Investors.”  The report noted the challenge of defining who is a senior.  Rather than picking a specific age, the IIAC used the term “senior investor” to include people who have retired or are nearing retirement.  The report also noted that there is only a limited number of Canadians who are not concerned about investment performance.  As time goes on, fewer Canadians will be able to retire with a large defined benefit pension plan or significant financial assets. 

Most Canadians who are retired, or are approaching retirement today, need to appropriately manage their investments.  Investment performance is composed of two parts, the changes in the value of the investments and also the income stream.  More and more people are looking for investments that generate an income.

The 2011 Census noted that almost 15 per cent of the population was 65 or older.  The first wave of baby boomers, born between 1947 and 1966, began hitting 65 in 2012.  The report noted that demographic studies indicate that one in four Canadians will be 65 or older by the year 2036.  

Seniors are living longer in retirement than ever before.  If a client retires at age 60 and lives to age 90 then their retirement time horizon is thirty years.  For most retired clients, it is a daunting task to try to map out an investment strategy to last the remainder of their lifetime.  Most seniors want to retire and not get bogged down by looking at their investments all the time. 

I have a few suggestions for seniors approaching retirement or those already retired.  First, find a qualified financial advisor who you feel has experience, but also one that you can work with for a reasonable period of time.  Together you can work on the suggestions below. 

The first step I take with new clients is ensuring that I understand their complete financial situation.   I suggest that a net-worth statement be prepared, listing all of your assets and liabilities.  The more detail you can provide, the better.  As an example, if you have certain assets listed, adding in the original cost of those assets helps an advisor map out the tax component for any future dispositions.   If you have a previously prepared financial plan, this is an excellent document to provide to your advisor.  Often, I see people bring in their previous financial plan, it is not so much a financial plan as a simple illustration or concept. 

A very important step is the preparation of a budget.  The best budgets are those that are prepared on a monthly basis.  Listing all of your incomes (i.e. Old Age Security, Canada Pension Plan, etc.) and all of your expenses will give you an idea of the monthly excess or shortfall.         

It is at this stage that an advisor can be invaluable for mapping out and explaining the various options.  Many seniors are looking for income.  In years past, income was closely associated with fixed-income investments (i.e. bonds, GICs).  As interest rates have declined, so has the income level for seniors relying on traditional fixed-income options.  It is still possible to create a good income portfolio but this often involves looking beyond traditional fixed income, at least for a portion of the investments. 

An advisor should be able to map out the various types of investments that pay income.  With each type of investment your advisor can explain the tax characteristics of the payments, frequency of payments, and risks. 

Creating a diversified income flow often involves using a variety of investments.  An income investor could have GICs, corporate bonds, debentures, bond ETFs, preferred shares, blue chip common shares, etc.  Many forms of income are tax efficient, including both preferred and common stocks that generate dividend income.  Many preferred and common shares have dividend yields that are higher than GICs and investment grade bonds.

There is no low risk option that generates high income. I frequently explain to clients that you can enhance your potential return by taking a little risk; however, the element of risk still exists.  Knowing that risk also exists in fixed income, and that life expectancies are longer, many seniors have opted to adjust their asset mix to include other investment opportunities that generate income within their portfolio. 

Historically, a senior could take a very passive fixed-income approach in retirement.  Today, seniors have to be more involved in their investments.  It is important for seniors to work with a financial advisor to design a portfolio that matches their risk tolerance and investment objectives, such as income and capital preservation.

Research ETFs before you buy

Exchange Traded Funds (ETFs) have become one of the fastest-growing areas of the financial market.   “Index Shares” is another similar term and many advisors use these terms inter-changeably.  Investors can participate in a broad variety of investment opportunities using ETFs. 

The original ETFs differed from traditional actively managed mutual funds as these are passive products.  For example, an investor could purchase an ETF of a well-known index such as the S&P 500 which holds the largest 500 U.S. public issuers. 

As their popularity has grown, so has the number of ETFs being created.  Some companies are creating a hybrid product with relatively low fees and some active management.  The water is getting a little murkier as new features are being added to these new products, so I caution investors to understand before they buy.

One reason for the growth in ETFs is the relatively low cost and transparency of the fees.  Investors do not want to be burdened with the cost of high fees, especially if these are hidden or embedded.   The management fee for the S&P 500 is 0.14 per cent through iShares by BlackRock (TSX symbol: XUS), and 0.15 per cent through Vanguard (TSX symbol: VFV).  These are just two symbols that track this common Index.  Other ETF examples trade directly on US exchanges and some that are currency hedged.  You should have full understanding of the tax component, risks and features before purchasing.

The annual cost of an actively managed mutual fund is significantly more than an ETF.  Mutual funds have a Management Expense Ratio (MER) that is embedded.  New regulations and rules are coming soon that will require full disclosure of all fees.  Trading costs are in addition to the normally published MER.  A passive ETF would have very little trading.  Like all services, fees are really only an issue in the absence of value. If an actively managed mutual fund is consistently performing better than an ETF, then the MER and trading costs may be fully warranted.

Some advisors may not recommend ETFs for a few different reasons.  It could be that an advisor only has a mutual fund licence and they are not permitted to discuss or provide ETFs as an option.  Mutual funds can be sold on a no-load, front-end (initial service charge) or a back-end (deferred service charge) basis. We recommend that investors ask their advisor what the initial commissions are, the ongoing trailing commissions, and the cost to sell the mutual fund investment.  Understanding the total cost of choosing an investment option should be done prior to purchase.

ETFs are very much an option that can complement a fee-based account.  Both cost structures are low and provide complete transparency.  ETFs are listed, and trade, on exchanges similar to stocks.  For transactional accounts, there is a cost to purchase an ETF, and a cost to sell them.  For fee-based accounts, there are no transaction costs to purchase or sell an ETF, however, the market value of the amount purchased would be factored into calculating your fees.

When a new client transfers in investments traded on an exchange, it is always easy to make changes.  Investors who have purchased proprietary mutual funds or mutual funds purchased on a low load or deferred sales charge may have fewer options.  In most cases, proprietary funds cannot be transferred in-kind and a redemption charge may apply to transfer in cash.  For example, say Jack Jones has $846,000 in a basket of mutual funds in his corporate investment account.  Jack is paying 2.37 per cent (or $20,050) annually in MERs to own his mutual funds.  I mapped out a lower-cost option for Jack that would decrease his cost of investing, to one per cent ($8,460).  The approach to investing involves a fee-based account with a combination of direct holdings and ETFs.  Annually, Jack would save $11,590 and have full transparency and liquidity.

ETFs can be used strategically to obtain exposure to various types of asset classes, sectors, and geographies.   Although the cost is lower, they are not immune to declines when markets get shaky.  An advisor can design a portfolio of positions that are lower risk then the market.  This is tougher to achieve with off-the-shelf  ETFs. 

Although the traditional ETF is a passive approach, we still feel that an advisor can provide advice with respect to the active selection of the ETF, tax differences, hedging options and more.   To illustrate using bond/fixed income ETFs, an investor could choose amongst many different types depending on the current environment (i.e. interest rate outlook, current economic conditions). 

An advisor can provide guidance on whether to underweight or overweight government bonds or corporate bonds and provide guidance on whether you have a short term, long term, or laddered bond strategy.  Based on your risk tolerance, should you stick to investment grade bonds or seek out greater returns with high yield bonds.  An advisor can explain some of the more complex fixed income ETFs including those holding real return bonds, floating bonds, or emerging market bonds.   An advisor can provide recommendations with respect to actively switching between these passive ETFs.

 

On having enough financial resources through retirement

Balancing living for today and not running out of money in retirement is perhaps the greatest financial challenge most people face.  Even financially well-off people wonder if they have enough for retirement.

In past decades, people with limited resources have received assistance through government funded programs, including subsidized residential care and extended care.  There is a general concern about how the government will be able to continue funding assistance programs for seniors and whether they will be able to offer the same level of assistance in the future.  This is a real concern given the rising costs of these programs, especially given increasing number of seniors as the population ages.

A baby born today in British Columbia has a life expectancy of 81.7 years according to Statistics Canada.  If you’re 65 years old this year, StatsCan suggests that your life expectancy is 85.7 years.  Both of these life expectancy numbers are at the highest levels they have ever been.  Although recent studies have suggested that babies born today may actually have a shorter life expectancy than their parents as a result of health issues such as increased obesity and diabetes.    

With financial planning, assumptions are made with respect to rates of return, inflation, income tax and life expectancy.  The younger a person is, the more challenging it is to project these assumptions.  Rates of returns have fluctuated significantly for both fixed income and equity markets over the years.  Federal and provincial governments can make future modification to various programs such as benefit payments, income taxes or credits that will have a direct impact on your retirement income.   One of the assumptions to consider in retirement financial planning is your life expectancy.  The chart below shows the required savings for different life expectancies and demonstrates how your life expectancy can make a material difference.

In all scenarios, the assumptions are identical where the rate of return is four per cent, inflation is two per cent, and income tax is at 30 per cent.   For illustration purposes, we will assume an individual requires $50,000 annually after tax.  The following table gives you a financial view of the capital required in a RRIF account at age 65 with the following different life expectancies:

Life Expectancy           Savings Required @ Age 65

            75                                $522,439

            80                                 $745,470

            85                                 $959,956

            90                                  $1,166,227

            95                                  $1,364,592

            100                                $1,555,361

Another variable is the type of accounts in which investors have saved funds.  If you have funds in a non-registered account or a Tax Free Savings Account then the numbers are lower than the table above.  Having a combination of accounts (non-registered, TFSA, and RRIF) at retirement provides you the benefit of smoothing taxable income and cash flows.

Building up sufficient financial resources before you retire takes away the reliance on government funded programs and the concern of running out of money.  Financial security is achieved when you have enough resources to dictate the quality of care you receive as you grow older.  Often at times in financial plans we factor in the assumption that the principal residence could be sold to fund assisted living arrangements.  I’ve never prepared a financial plan with the assumption that the government will be paying for a client’s long term care. 

I also advise my clients to understand the issue of incapacity and how to manage this should it arise.  When planning for the most likely outcome, many people will become incapacitated (mentally or physically) for a period of time before they die.   In some cases the period of incapacity can extend for a significant length of time.

I encourage clients to take appropriate steps to deal with the financial cost of incapacity and think about how their finances would be managed if they became incapacitated. 

While they are still able, clients should ensure all legal documents (will, power of attorney, representation agreement) are up to date.  Part of this process involves reviewing the beneficiaries on all accounts to ensure consistency with your estate plan. Simplify finances by closing extra bank accounts and consolidating investment accounts.  All government benefits such as OAS and CPP as well as pensions (RRIF and RPP) should be deposited into one account, which makes it easier to budget for excess or short-falls.  Most expense payments should be automated. 

If you lose capacity or interest, it is easier for your power of attorney to review one bank statement for transactions.  In many cases, a meeting with a client and the client’s legal power of attorney is necessary to set up a “financial” power of attorney.  This power of attorney allows a person the ability to request funds to be transferred from your investment account to your bank account, if funds are running low.  Clients can set up managed accounts where a portfolio manager can act on your behalf on a discretionary basis.  Financial mail can also be sent to the power of attorney.  When bank and investment accounts are consolidated, your power of attorney can easily review and monitor the accounts through monthly statements or online access.

 

Kevin Greenard, CA FMA CFP CIM, is an Associate Portfolio Manager and Associate Director with The Greenard Group at ScotiaMcLeod in Victoria.  His column appears every second week in the Times Colonist.  Call 250-389-2138 or visit greenardgroup.com

 

 

Benefits to early conversion of RRSP to RRIF

The Registered Retirement Savings Plan (RRSP) is for “saving.”   This savings and tax deferral within an RRSP can continue until the age of 71.  In the year you turn 71, you have to either close your RRSP by either taking the money out, purchasing an annuity or transferring it to a Registered Retirement Income Fund (RRIF). 

From a taxation standpoint, it is rarely advised to de-register 100 per cent of your RRSP in one year and withdrawal the cash.  This would only be advised when an RRSP is very small or there is a shortened life expectancy or financial hardship.   Purchasing an annuity as an RRSP maturity option is a final decision that can not be reversed.  Upon your death, the annuity option often leaves nothing for your estate or beneficiaries.  

For many reasons, conversion of your RRSP to a RRIF is the most popular and flexible method.  Most of your savings will continue to be tax deferred with a minimum withdrawal amount being determined annually based on the previous December 31 value.  In the year a RRIF is set up, there is no minimum withdrawal amount.   All RRIF’s set up after 1992 are considered non-qualifying.  The following minimum RRIF withdrawal amounts are the non-qualifying annual percentage by age on December 31st: 

Age                 Per Cent        

72                    7.48    

73                    7.59

74                    7.71

75                    7.85

76                    7.99

77                    8.15

78                    8.33

79                    8.53

80                    8.75

81                    8.99

82                    9.27

84                    9.93

85                    10.33

86                    10.79

87                    11.33

88                    11.96

89                    12.71

90                    13.62

91                    14.73

92                    16.12

93                    17.92

94 or older      20.00

To illustrate how the above schedule works, we will use 71-year-old Barry Campbell who has saved $1million in his RRSP.  Barry is single and he chose to convert his RRSP to a RRIF account in the year he turned 71 and he will begin taking annual payments next year.  Barry has had years of complete deferral but this is coming to an end.  Based on the above minimum RRIF schedule, Barry will be required to withdraw $74,800 ($1 million x 7.48 per cent) and have this amount included in his taxable income.   Unfortunately, Barry doesn’t have a choice at age 71.  Based on Barry’s total income with the RRIF, he is projected to have half of his old age security clawed back (required repayment) based on his high income.  If Barry were to pass away, the majority of the RRIF would be taxed at 45.8 per cent.  Unfortunately, Canada Revenue Agency (CRA) would receive nearly half of Barry’s lifetime savings within his RRIF.   

We feel it is important for clients to understand the taxation of a RRIF in a most likely scenario of normal life expectancy and shortened life expectancy.   RRIF accounts for couples greatly reduce the taxation risk of shortened life expectancy by being able to name your spouse the beneficiary and avoid immediate taxation of the full account balance.  In 2007, CRA introduced pension-splitting, which provides taxation savings for most couples with eligible pension income. RRIF withdrawals at age 65 or higher are considered eligible. 

Beginning in 2009, CRA introduced the Tax Free Savings Account (TFSA) that provides tax savings for individuals and couples.  The savings is a result of all income (interest, dividends, and capital gains) generated within the TFSA not being taxed ever.  There is no taxation upon your death.  The amount that can be put into a TFSA is limited by a relatively small amount each year. People who are serious about saving for retirement often contribute to both an RRSP and TFSA.

Given the introduction of pension splitting and the TFSA, many people should be looking at converting their RRSP to a RRIF before the age of 71.  When we are helping clients with the optimal time to convert their RRSP, we look at their marital status, health/genetics, and other investments.  With other investments, we create two baskets (A and B) to analyse what we call the “bulge.”  A bulge is when you have too much concentration in either basket A or B.  Basket A is the total amount in your RRSP accounts.   Basket B would include bank account balances, non-registered investments, and your TFSA – none of which will attract tax on the underlying equity if used.  Basket A may also include your principal residence if the intention is that this will be sold and the capital used to fund retirement.  

We caution investors not to create a bulge – having too much in either basket means you may not have the right balance as you enter retirement.  Taking advantage of deferral opportunities over time often makes sense.  Having too much in basket A means you may have very little flexibility if an emergency arises and you need cash (new roof, vehicle).   If A / (A + B) is greater than 75 per cent (a bulge) then we would recommend you speak with an advisor to determine in you should convert your RRSP to a RRIF early.  Above, we noted Barry has $1 million in basket A.   Barry also has $250,000 in basket B.  With these numbers Barry has a bulge percentage of 80 per cent. 

A financial plan prepared while you’re working largely results in savings strategies to reach your retirement and other goals.  In retirement, a financial plan is prepared to create withdrawal strategies that are tax efficient and smooth out your income during your lifetime.  They can also be prepared in conjunction with estate planning.   

Kevin Greenard CA FMA CFP CIM is an Associate Portfolio Manager and Associate Director with The Greenard Group at ScotiaMcLeod in Victoria.  His column appears every second week in the TC.  Call 250-389-2138.