With some careful planning and good investing, this Manitoba farm couple can be ready for retirement
Paul and Emma Thompson, as we’ll call them, both 50, have farmed in central Manitoba for a quarter of a century. The couple, whose names we’ve changed to protect their identities, have 800 acres they own personally and another 960 acres of pasture that their farm corporation owns. The corporation also owns 200 head of beef cattle and all the equipment that they use on their 1,760 acres.
The last 10 years have produced a lot of problems for Paul and Emma. For a time, their operation suffered from market worries about BSE, which reduced the prices they obtained from selling their cattle. As well, Paul has health issues that make it harder for him to operate the farm. The recent surge in beef prices and the rising value of farm land has made it easier to consider selling the farm.
Paul and Emma have two children in their 30s, neither of whom are interested in carrying on the farm. Emma will have a defined benefit pension when she retires from her work in a hospital. Until the sale, Paul and Emma plan to rent their land for $20,000 per year. Paul figures he can also earn $20,000 per year before tax. They each have $20,000 of RRSP space to fill.
Winding up the farm and the farming corporation will be complex. Paul and Emma went to Don Forbes, head of Don Forbes & Associates/Armstrong & Quaile Associates Inc. of Carberry, Manitoba, to find a tax efficient way to maximize retirement income.
The challenge is to retire in 10 years, when Paul and Emma are 60, with an after-tax income of $40,000 per year. Backing that income will have to be a conservative and secure investment strategy.
Tax management is key to achieving their retirement income goals, Forbes says.
When the cattle are sold, the estimated $400,000 proceeds will be fully taxable at a 10 per cent rate for the first $400,000 of active business income. Above that level, the rate is 32 per cent on active income. When money is paid out of the corporation, personal tax rates apply.
Income splitting will be helpful as a way of managing taxes. If half the shares in the farm corporation now held by Paul could be transferred to Emma, it would reduce taxes payable, Forbes notes. An accountant will have to work on this problem, he adds.
The preferred shares in the farming corporation have a book value of $414,000. These can be redeemed by the corporation with cash on hand. Then part of the remaining mortgage for personally owned farmland, $30,180 in year two of the plan, as cash becomes available from the farm sale. This would save $7,000 of interest payments, Forbes says.
Any gain in the price of the land or the cattle can be attributed to common shares.
The corporation has paid income tax on profits, but gains in value of retained earnings will be taxable when they are distributed out of the corporation.
The common shares in the corporation can be liquidated in four ways: as salary, as dividends, as shareholder bonuses or as taxable capital gains. Each strategy has an upside and a downside. Salary adds to potential Canada Pension Plans benefits as well as the annual cost in CPP taxes. Dividends held within the farm corporation are taxed at a low rate until payout when they are re-taxed at a higher rate. Bonuses add to tax exposure. Distributable capital gains are taxed with the first half tax-free and the remaining exposed to tax.
Best bet: take salary at, say, $33,000 per year to increase CPP contributions. CPP will be the couple’s main indexed pension. The downside is that salary income is taxable at a higher rate than dividends. However, they can use RRSPs to shelter income. Paul can invest $18,000 in RRSPs each year for the next four years funded by his salary from the farming corporation. This money plus the existing $30,000 in RRSP accounts can generate sufficient income to pay $14,400 per year for 35 years from age 61 to their age 96.
Cash that becomes available from sales of corporate assets, preferred shares can be redeemed through preferred shares and put into Tax-Free Savings Accounts over several years at $5,500 per person per year maximum. Emma and Paul each have $25,500 of TFSA space as of Jan. 1, 2013. After this space is used up, additional savings can go into a fully taxable joint investment account, Forbes suggests. After 10 years, this fund, growing at three per cent after inflation, will have $65,000. This capital, while not needed in the plan, is available as an emergency fund. If it is not needed or drawn down, it can be part of the children’s legacy, Forbes notes.
For her part, Emma can put $10,000 into RRSPs each year for the next 10 years.
The income for these contributions will come from farmland rental outside of the farm corporation, Forbes says. This money will provide a retirement income of $12,000 per year for 30 years beginning 10 years from now. Her employment pension will add $12,000 per year for the rest of her life beginning in a decade.
Finally, farmland rental of $19,200 per year outside of the farm corporation after Paul’s age 60 will add to their income. To make the plan work, the couple will need at least $100,000 in cash from the farm corporation in 2013 to buy TFSAs and RRSPs and to cover potential tax due.
On top of these income sources, the couple can count on combined CPP benefits of $11,700 per year based on prior contribution and two Old Age Security benefits of $6,553 each beginning when each is 67.
Thus, when retirement is complete and each has passed the age of 67, their total income will be $84,356 before tax or, with pension splitting and a 30 per cent tax rate, about $4,920 per month to age 90. That will meet their target of $3,334 per month or $40,000 per year with money to spare. Thereafter, money not spent from the TFSA accounts and any residues of money saved and income still coming from rental of land they have not sold would go to their surviving children or grandchildren, Forbes says.
The plan and the forecasts of income are complex but not really that difficult to achieve. It is vital that the couple take advice from their accountant to ensure that they comply with tax law.
For testamentary purposes, Paula and Emma could reduce payouts of their retirement accounts so that all capital is not exhausted at age 90. They can achieve much the same thing by investing in stocks or other assets that produce capital gains that they can harvest at their discretion, dividends from public companies taxed at reduced rates through the dividend tax credit, and by ensuring that their wills are up to date with provisions designating one another as beneficiaries able to postpone deemed disposition of accrued but unrealized gains.
In retirement, it is essential not to take risks that may result in unrecoverable losses. In practice, that means diversification in stocks, bonds and commodities. Selection risk in any asset class can be reduced by use of exchange traded funds that track various indices, by purchase of low fee mutual funds with appropriate mandates and strategies, and by rebalancing at least one a year so that no asset class gets to be top heavy as, for example, the now insolvent Nortel Networks did when, a decade ago, it made up more than a third of the value of stocks on the Toronto Stock Exchange.
“With some careful planning and accounting, this couple can retire in security and comfort,” Forbes says. “If they follow the ground work I have laid out, they will have a financially viable retirement.”
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