In south central Manitoba, a couple we’ll call the Bretts have a 640-acre mixed farming operation. Jack and his wife, Martha, each 61, have a son, 30, with an off-farm job. Their son is not interested in taking over the family business.
It’s inevitable that Jack and Martha will want to leave their farm. It will be a complicated transaction, for the farmland was used as collateral for a $150,000 loan for Jack’s trucking business. He would like to accept a neighbour’s offer to purchase 480 acres of the farm for $800,000 and to rent the remaining 160 acres.
Farm Financial Planner asked Don Forbes and Erik Forbes of Forbes Wealth Management Ltd. in Carberry, Manitoba, to review Jack and Martha’s situation.
Jack’s accountant has verified that the sale can work. Jack and Martha can have the Qualified Farmland Capital Gain Tax Credit. If they take the $800,000, they will have to deduct the $250,000 Jack’s business owes for the truck loan, then put $50,000 into their respective RRSPs, $62,000 to top up their Tax-Free Savings Accounts to the maximum allowable contribution level, reserve $38,000 for home renovations and $400,000 for non-registered investments. With this allocation, they will have done just about the best they can with the purchase offer and sale.
The optics of the deal are a little complex, but the RRSP allocation will bring Jack and Martha down one tax level and provide a rebate just a little more than the anticipated retirement tax rate. Eventually, the couple will have to take the money out of their RRSPs, but there should be no need to do that until they stop working and earning taxable income. Waiting to convert to a Registered Retirement Income Fund no later than the year in which each partner turns 71 is ideal, for it will allow growth of assets within the RRSP without tax. But if they need to draw money out sooner, they can just tap it off the RRSP before RRIFing and pay the tax. Ideally, they should not draw down registered assets until they stop working. The best bet is for Martha to take income, for she is in a lower tax bracket than Jack, Don Forbes suggests.
Jack and Martha should each contribute the maximum allowable sum to their TFSAs, That’s $46,500 as of 2016. In January, they can add another $5,500 to each account. Jack has $39,000 of room and Martha $23,000 of contribution space.
Shopping for investments in today’s market is no easy task. It is never a cinch to make investments in stocks or bonds, but with interest rates low and perhaps near starting an upward trajectory, special care is needed, for as interest rates rise, bond prices fall — leading to capital losses. But stocks with hefty dividends in the 3.5 to 5.5 per cent range are available from solid companies like BCE Inc. and the chartered banks. Their prices are sensitive to interest rate changes, but rising dividends over time provide compensation for price declines. Moreover, the dividend tax credit means that payouts from public companies are taxed as a lower rate than ordinary earned income. If there are capital gains that the couple can realize, so much the better, for only half of gains are recognized as taxable income.
Timing the start of Canada Pension Plan benefits is tricky. Martha, who has no other income, can take CPP at 60 and pay little or no tax. Jack should not take CPP benefits until 65 after he has sold the trucking business and ceased active farming.
Each can take Old Age Security at $6,846 at 2016 rates at age 65, but if they like, each can defer starting OAS to age 70 with a premium for each year of deferral. That’s 36 per cent if they wait to age 70 when further deferral is not possible.
Similarly, each can defer taking CPP with a bonus of as much as 42 per cent if they wait to age 70. Playing the waiting game is profitable. Even allowing for a 25 per cent average tax, 36 per cent is 27 per cent after tax or an annualized, after-tax, non-compounded return of 5.4 per cent a year. The 42 per cent premium on CPP with the same tax rate works out to a 6.3 per cent annual simple return. These returns have no risk. No government bond pays such returns now. Some stocks may, but they come with a lot of market risk, Erik Forbes notes.
This strategy is simple, understandable, and tax-efficient. If Jack and Martha adopt it, then in 2016 Mack will earn $5,000 a month and Martha collect $700 from her RRSP, $300 from CPP (or less if benefits are deferred for future gains), and $500 from land rental. That’s a pre-tax family income of $6,500 a month before tax.
In 2020, when the retirement plan is in full effect, Jack, then 65, can take $1,000 from his CPP account or defer it as noted for higher future income, take $570 at 2016 rates from OAS, $600 a month from his RRSP, total $2,170. Martha can take $700 from her RRSP, $300 from CPP, $570 from OAS, $1,000 from taxable investments, and $500 from land rental. Family income at this point would be $5,240 per month or $62,880 a year. With splits of eligible pension income, they would pay average income tax of about 15 per cent and have $4,454 a month to spend. That would cover their modest way of life, Don Forbes says.
Jack and Martha can get more money out of their financial assets by setting parameters for what each of their asset classes may return. For example, stocks have traditionally generated a long run return of seven per cent a year before inflation adjustments and bonds three per cent before inflation adjustments.
If inflation runs at an average annual rate of two per cent, then the after-inflation returns are five per cent for stocks and just one per cent for bonds.
The conventional asset allocation is to set the percentage of bonds in your portfolio equal to your age. That would mean Jack and Martha would have 60 per cent low yield bonds liable to lose a great deal of market value if and when interest rates rise. The better allocation in today’s market leans toward solid common stocks like telecommunications firms, public utilities, a few major retailers and some foreign stocks with strong and diversified products and a history of raising dividends regularly. Jack and Martha can buy the stocks directly or use low fee Exchange Traded Funds that package indices and have very low fees Any investment decisions should, of course, be made with the advice of their advisor.
“Jack and Martha have done the right things in building their farming business,” Erik Forbes notes. “This is a plan for migrating away from the farm, generating income from government pensions and financial assets, and, if they are frugal, leaving a nice legacy for their son.”