Special to The Globe and Mail
In Calgary, a couple we'll call John, 62, and Audrey, 63, are retired. Their gross family income in 2006 was $87,275, though they expect somewhat lower income in 2007. They have almost $2.3-million in assets, no liabilities, and a problem common to high-net-worth investors.
"I don't know when one should start withdrawing money so as not to be stuck paying great amounts of tax," Audrey says. Given the combination of taxable investments, registered retirement savings plans, pensions and real estate that they have built up, the question has to be answered. They have paid taxes all their lives and figure that it's time they designed a plan to keep as much of their money as possible for themselves.
The problem of designing an investment plan is complicated by the couple's strong preference for avoiding losses on their stock portfolio. They have invested 70 per cent of their financial assets in bonds. The bonds will probably not suffer if stocks plummet and might even gain in value, but investment-grade bonds have their own sensitivity to interest rate changes. If rates rise, existing bonds with relatively low interest rates become less appealing and therefore fall in price. Moreover, bond interest is fully taxable while stock dividends and capital gains are taxed at reduced rates.
What our expert says:
Facelift asked Derek Moran, a registered financial planner who heads Smarter Financial Planning Ltd. in Kelowna, B.C., to work with John and Audrey.
"The principal issue in this file is whether it would be smarter to draw money from registered plans early or wait," the planner explains. "The issue is complex, for it involves life expectancies, future health and income tax rates. There are also issues of taste - to have security or flexibility. But the bottom line is that retirement savings plans offer an exceptional opportunity to grow wealth. Now it is payback time."
Structurally, John and Audrey have $659,400 in RRSPs, $1.24-million of unregistered investments, a $283,000 house, a $90,000 vacation property and personal property. They are sophisticated investors, but they have made a fundamental decision to maintain a huge part of their financial assets in bonds regardless of implications for portfolio growth and tax exposure. Yet as long-term investors who spend less than they earn, they really do not need to be completely liquid, Mr. Moran says.
Audrey has a pension that currently pays her $974 a month. John will qualify for 74 per cent of the maximum Canada Pension Plan payment of $10,365 per year and Audrey 67 per cent of the maximum. Both will qualify for full Old Age Security, currently $5,903 a year.
John and Audrey have asked how to reduce their taxes, Mr. Moran notes. But that is the wrong question. Tax reduction is only part of the equation. They need to take a broader view, he explains.
The simplest way for John and Audrey to reduce taxes is to spread their pension income out over many years. The March 19 federal budget postponed the latest date for converting RRSPs to annuities, cash or registered retirement income funds by two years to age 72. They should be able to keep out of the danger zone of the Old Age Security clawback, which begins at $63,511 per person in 2007. The clawback imposes a tax rate of 47 to 51 per cent on income.
Spreading RRSP withdrawals out over more years forfeits tax deferral, the planner notes. The problem of whether to spread out payments over the most years or to defer withdrawals to maximize tax-free growth is nuanced by the province in which one lives. Alberta has indicated that it intends to lower income tax rates in future. The implication is to postpone withdrawals, Mr. Moran says.
It is also important to consider the types and amounts of assets one holds. Stocks and bonds that distribute their returns over time automatically provide a measure of income and tax averaging. In contrast, assets like growth stocks that have low or zero dividends defer realization of gains. Equities offer tax deferral without restrictions as to when income must be taken, unlike bond coupon payments and stock dividends that cannot be deferred. The couple are mainly fixed-income investors, so postponing withdrawals makes sense, Mr. Moran says.
John and Audrey have more income than they require for their present expenses. That also argues for postponement of withdrawals from RRSPs.
"What should drive the bus in this case?" Mr. Moran asks. "It has to be investment decisions first and tax decisions second. The couple is risk-averse and so has a high level of fixed-income investments. They have bought themselves more liquidity than they need at the cost of potentially forgone capital gains. What they have to do is reassess their risks and need for instant money. If they can reduce their insistence on liquidity, then they can shift to assets that produce capital gains. They can then postpone realization of those gains and wind up with potentially higher returns and lower current tax obligations," the planner says.