Making the most of $250,000 windfall is this family’s top priority
PAY TAX DUE ON CAPITAL GAIN, THEN APPLY WHAT’S LEFT TO RRSPs, KIDS’ NEEDS, TFSAs
In a small town in Manitoba, a couple we’ll call Dave, 43, and Ingrid, 41, are raising two children, ages 13 and 14. Dave is a civil servant in local government and Ingrid is an administrator in a non-profit civic organization. Together, they bring home $6,828 a month. They are meticulous record keepers and have a net worth of about $658,000, including a $250,000 windfall from the sale of Ingrid’s share of a family business, due later this year.
“We need to decide what to do with the $ 250,000 legacy,” Ingrid says. “Should we pay off our $49,800 mortgage with a 2.75-per-cent interest rate? Or buy RRSPs, put some into our TFSAs, do a bathroom reno or buy a new car — one of ours is 12 years old — and get a $40,000 SUV? We have so many choices. How do we choose?” Family Finance asked Don Forbes and Erik Forbes of Don Forbes & Associates in Carberry, Man., to work with Dave and Ingrid. “They are good money managers. But the problem of making good use of the windfall turns out to be rather complicated,” Erik says. “Our job is to simplify the situation and help them make rational choices.”
THE WINDFALL
The $ 250,000 small- business legacy for Ingrid generated a capital gain of $116,000 after adjustments to its cost base. She borrowed $ 25,000 to make a charitable donation to reduce some of the taxable income; she has a tax receipt for the donation. The donation leaves $ 91,000 of the windfall as net taxable income. Income tax on that gain works out to $42,000 at the 46-per-cent combined federal and Manitoba rate Ingrid will have to pay. She does not yet have the cash from the transaction to pay the tax, so she can either borrow money for the tax owing or borrow $ 91,000 to put into RRSPs to fill her and her husband’s accumulated RRSP room. Interest on the $91,000 for the RRSP loan would not be tax-deductible, but the loan would be paid in full after the cheque arrives in the fall.
Dave can use $ 26,400 of RRSP space and Ingrid $ 64,600 of her RRSP room. If she loans Dave the money, a suitable note at the prescribed interest rate could be prepared.
Even if the money does not generate taxable income, just to be conservative, Dave should pay interest at one per cent per year for a few months to Ingrid. She would declare the modest interest income. The arrangement would work, since Dave earns $ 97,344 a year before tax. His marginal rate is 46.4 per cent in combined federal and provincial taxes. The total family tax bill will be reduced by the RRSP strategy, Don explains.
If Ingrid uses $ 25,000 of her $250,000 expected inheritance when received in a few months to pay off the loan and uses $ 49,600 to pay off their mortgage, $ 91,000 for their RRSPs and $ 20,000 for RESPs, they can add $ 61,400 to their TFSAs and then reserve $ 3,000 for taxes. The $ 250,000 will thus have been used very intelligently, Don says.
EDUCATING THE KIDS
Dave and Ingrid spend $ 4,500 a year for each of their two children to attend a private school. They also spend $ 4,140 a year for piano lessons, braces, summer camp etc.
The total, $ 13,140 a year, will stop in a few years when the kids leave high school and move on to university or other post- secondary pursuits. That money will then be available for other things, such as university tuition and the parents’ needs.
The children will have assistance with post- secondary education costs from the family’s Registered Education Savings Plan. The present value of the family RESPs — one for each child — is $ 11,846. The RESPs have been underfunded, but some catch up is possible, Don notes. The parents can put $ 5,000 a year into each plan for two years and get twice the maximum $ 500 Canada Education Savings Grant for two years. If the plans, with further contributions of $ 2,500 per child per year plus $ 500 each per year from the CESG, grow at three per cent over inflation until each child is 18, they will have about $ 37,000, or $ 18,500 for each child. That will cover tuition bills for fouryear degrees at Manitoba universities.
RETIREMENT
The couple can retire at age 60, when Dave can expect a $ 48,936 annual pension from his employer. If their RRSPs, currently $ 28,318, are enhanced with total contributions of $ 91,000 to a total of $ 119,318 and they continue to contribute $ 1,200 a year and if the plans generate three per cent a year after inflation, then they will have $ 224,111 in 2016 dollars when Dave is 60. That sum would generate $ 9,815 each year for 37 years to Ingrid’s age 95, Don estimates.
The c ouple’s TFSAs have a present balance of $ 12,279. If they put $ 61,400 from the legacy into the TFSAs and then continue to contribute $ 3,000 a year to each account, then with three per cent annual growth after inflation, the accounts would have a combined value of $ 256,400 when Dave is 60. If all income and capital is paid out in the following 37 years to Ingrid’s age 95, the fund would generate $ 11,230 a year.
At 60, Dave would receive $ 11,448 a year from the Canada Pension Plan. When she is 60, Ingrid will receive $ 7,200 from CPP. When each is 65, they would each receive $ 6,846 in Old Age Security.
Adding up their retirement income components, by age 65 the couple would have $ 102,232 a year before tax. If eligible pension income is split and TFSA payouts are excluded from income, Dave and Ingrid would pay 18 per cent average income tax and have $ 7,000 in 2016 dollars to spend per month.
If Dave and Ingrid want to fix up their house or buy a new SUV, they can take the money out of their TFSAs or just wait a few years until the kids have gone off to university, Don says. They can use the money currently funding their children’s activities for the bathroom reno or a new or newer SUV, Erik adds.
“With these allocations of the $ 250,000 legacy and the couple’s traditional frugalness, they should be able to provide money for tuition and books for their children in postsecondary education, pay off all debts and have a comfortable retirement income,” Erik says. “The key is following this plan and replacing any money taken out of the TFSA in order to maintain its growth.”