Strategy: Cut the taxman’s bite
A widower we’ll call Philip, 78, is eager to preserve his wealth. He spent almost four decades working in the chemical industry, much of that time as a factory supervisor. A widower and a resident of Ontario, he wants to keep as much as he can of his nearly $1-million net worth for his two sons: Herb, who lives in Ontario; and Fred, who lives south of the border in Georgia.
Philip has no immediate financial problems, for his take-home income, about $5,500 a month, exceeds his allocations, other than savings, by $3,015 a month. He has no debts and is in good health. Yet he is focused on what he considers his adversaries: current taxes and probate fees after he dies.
“I would like ideas on how to reduce probate fees for my estate when the time comes and also how to reduce my exposure to the Old Age Security clawback, which eats up what I can give my sons,” he says.
Family Finance put these problems to Benoit Poliquin, a chartered financial analyst and financial planner who is lead portfolio manager for Exponent Investment Management Inc. in Ottawa, and Gregory Sanders, a lawyer and chartered accountant who heads the tax law group at Perley-Robertson, Hill & McDougall LLP based in Ottawa.
“Philip’s concerns are among the most common in financial and estate planning for persons approaching and beyond retirement,” Mr. Poliquin notes.
“It is very easy, even common, to fall victim to the OAS clawback when you have a work pension and several thousand dollars of Canadian-source dividends.”
WHAT PHILIP CAN KEEP
Philip’s taxable annual pretax income, $79,450, puts him over the 2013 clawback threshold, $70,954. The clawback takes 15% of the difference, which works out to $1,275 a year. What the clawback takes each year will rise, for his Registered Retirement Income Fund’s distributions, which are about 8.4% of his RRIF capital today, will more than double to 20% when Philip is 94.
The clawback is a double whammy for Philip. His income from his non-registered dividends is given special treatment by Canadian tax law, which makes everyone with such income add 38% to the cash dividend when calculating taxable income. This inflated income goes to the bottom line, increasing income vulnerable to the clawback before the dividend tax credit, about 20%, is applied to the grossed-up amount.
“The taxation process inflates income on which the clawback is calculated before any tax credit is applied,” Mr. Poliquin says.
“It is unfair to Philip and to every other person who has taxable dividends and receives Old Age Security. In Philip’s case, given that he spends less than his take-home income, it means his sons will inherit less.”
In the clawback range, which extends to $114,815, at which point all OAS income goes back to the government, the effective tax rate in Philip’s bracket, including provincial tax, is about 33% plus the 15% clawback. The total rate, 48%, puts Philip into a higher tax bracket than Ontario residents earning $500,000.
The irony of the clawback in Philip’s case is that he does not need the income the clawback partially takes away. When Philip’s wife, who passed away a few years ago, was alive, he could split his $28,000 annual corporate defined-benefit pension and his Canada Pension Plan and RRIF income with her, eliminating the clawback problem.
She is gone and so is the ability to split pension income, lowering tax and reducing vulnerability to the clawback.
It is a fact of life for every widow and widower. With no spouse, Philip’s strategy has to focus on restructuring his portfolio. He can reduce risk by swapping Canadian stocks, the dividends from which are inflated and knock down the amount of OAS he can keep, for GICs that do not have their interest grossed up. If done over a period of a few years as interest rates rise, he should be able to equalize what he gets now in tax-advantaged Canadian dividends, Mr. Poliquin says.
This process, if carried out for a few years to reduce his substantial stock portfolio, would eliminate much or all of the clawback. “Why take equity risk if you don’t need the money?” Mr. Poliquin asks. “At 78, asset protection means more than asset growth.”
WHAT PHILIP CAN GIVE
Anyone making a will should consider what a good executor needs — honesty, of course, a willingness to do the job of rounding up assets and paying bills before distributing what is left to heirs. Philip’s will appoints his brother and sister, who are in their 70s, as co-executors.
They could predecease Philip, so the will makes his Canadian-resident son, Herb, a secondary executor. Philip would prefer that the secondary executor be his U.S.-resident son, Fred, but Fred’s foreign residence would complicate the administration and cost of preparing the estate for probate.
Philip has several ways to eliminate potential probate issues, Mr. Sanders notes. He can make a gift of his Ontario home, a condo, to Herb, who lives nearby, and, if he wishes, crediting Fred with the value of the condo.
In his will, Philip can reduce probate costs by naming beneficiaries for his RRIF and TFSA so that these assets flow directly to his children without probate.
Holding property in joint name could also be employed to avoid probate and its Ontario fees, which are $15 per thousand dollars of property over $50,000. At worst, probate should cost Philip’s estate less than $15,000, so the legal fees and other costs used to avoid it should not cost more than the money to be saved, Mr. Sanders says.