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A pre-emptive retirement

Farm Financial Planner: Preparing for life in town, a Manitoba farm couple prepares 
to pull an income out of their farm corporation assets

Central Manitoba grain farmers we’ll call Mel and Judy, 56 and 53, are in the process of selling their farm and migrating to town. They are making what you could call a pre-emptive move, for they have two children with off-farm jobs. Neither of the children has an interest in keeping the farm going.

Mel and Judy have 640 acres of farmland they own personally. They have already sold off the only assets in their farming corporation, machinery and various bits of equipment. The remaining parcel of land is rented to a local farmer for $36,000 per year.

Judy has a professional career position with a $65,000 annual salary — which will produce a pension — from a large industrial corporation. She intends to take early retirement at 55. Her pension will be $1,000 per month before tax at 55. Were she to stay at work to 65, it would be $1,500 per month. If Judy were to retire before 55, she could take her job pension and convert it to a Locked In Retirement Account. It’s a tough choice, for the company pension plan is underfunded and employees are being asked to contribute an extra one per cent of salary to make up some of its deficit. The LIRA would be hers, subject to tax on payouts. She would carry the investment risk and could give money to her heirs, charities or in trust to a pet if she wishes. The defined benefit pension shifts investment risk to an insurance company but can pay income to her for as long as she lives. She might appoint Mel as a survivor beneficiary, but cats and dogs don’t usually qualify as contingent beneficiaries. The choice is hers.

More from the Grainews website: Transferring ownership

Mel has stopped actively farming. Health issues complicate his outlook, but he still does seasonal work for neighbours in the spring and fall. That produces a $10,000 annual salary. He figures he can do this seasonal work for another three years until he retires.

What’s left now is $800,000 in a corporate account. They have lifestyle expenses of $36,000 per year and do not expect to spend a lot on travel. They plan to live frugally during their retirement.

For the moment, the problem is what to do with the $800,000. It is in a corporate bank account earning about one per cent interest. The book value of the farm assets in the corporation is $200,000, including all contributions to AgriInvest, the federal farm support program which matches investments dollar for dollar on eligible sales of commodities. Thus they have $600,000 of retained earnings that are vulnerable to being taxed as ineligible dividends — at a high tax rate of nearly 40 per cent when taken out of the corporation.

The recommendation

Farm Financial Planner asked Carberry, Manitoba-based Don and Erik Forbes of Don Forbes Associates/Armstrong & Quaile Associates Inc. to work with Mel and Judy. His advice: leave the balance inside the corporation and invest it. They have ceased active farming but intend to continue the corporation in order to shelter their retained earnings.

The corporation is no longer eligible for the small business tax rate of 11 per cent, so it will have to be converted to an investment holding company in which all interest and taxable investment income will be taxed at the highest personal rate, 49 per cent.

The first step in avoiding this prohibitive tax rate is to have the farm’s accountant pay out all investment income each year to be taxed at lower personal rates.

They can then invest in Canadian blue chip corporations. Their dividends will be eligible for the dividend tax credit and, with some combination of good portfolio management and luck, they will be able to generate capital gains, Don Forbes suggests.

The proposed stream of dividends will have been taxed at a higher rate in the hands of the issuing corporations, so it flows through to the investor with income tax partially paid. This structure will give the couple higher net after-tax retirement income and some future market appreciation than just leaving the money idle in a farming corporation account earning almost nothing and taxable to boot.

The total of the $200,000 personally owned and $600,000 in the corporate account asset base, if invested to produce three per cent per year, will generate $24,000 of pre-tax income and potential capital gains. The dividend tax credit on the dividend income alone will be about 28 per cent, making it equivalent to about $31,000 of ordinary interest income.

Mel and Judy should continue to make full use of their Registered Retirement Savings Plans and Tax-Free Savings Accounts for the tax shelter they provide. Money held in TFSAs is regarded as tax-paid and can be distributed with no tax liabilities. RRSP contributions are taxable, but they provide immediate tax shelter. The couple’s income will rise in the next few years, so deferral for 2013 and the next few years until complete retirement will provide effective tax relief.

Managing investment

The couple has a substantial body of financial capital, but they should not start off as do-it-yourself investors, Don Forbes warns. They can hire an independent financial advisor for one to 1-1/2 per cent of assets to be managed. The fee is deductible from tax. Some advisors use managed funds with concessionary management fees reduced from the customary 2-1/2 per cent on managed stock portfolios to just a fifth of that. On an $800,000 portfolio, the two per cent saving, $16,000, would more than pay for management fees of $8,000 to $12,000.

The couple’s future income will be the investment cash flow, $24,000 per year less tax cushioned by deduction of management fees, say $15,000 net plus Judy’s $65,000 salary, Mel’s $10,000 farming wages and other investment income which will push pre-tax income to $116,000. That income can rise with investment returns until the time Judy retires, say in 2016, when their pre-tax income would fall to $74,000 per year and hold fairly steadily until Mel draws CPP at age 61 at a reduced amount of $4,469 per year and he can begin Old Age Security at 65 and, later, Judy’s at 67.

When both are retired, their continuous income from all investment sources, that is, Judy’s company pension, Canada Pension Plan and Old Age Security, would be about $130,000 before tax. Allowing for splitting of pension income, such as Registered Retirement Income Fund payouts and Judy’s company pension, pension income credits, and personal tax credits, they would have $97,500 per year after average 25 per cent income tax. That works out to $8,125 per month, more than enough to sustain a modest way of life which consumes only $6,500 per month now and which, might decline a little if Judy no longer has to use her car and gas to commute to her town job and Mel quits driving around the countryside for his seasonal work.

“This is a model case for what successful farming combined with a reasonable lifestyle can produce,” Erik Forbes explains. “This couple ran a second generation family farm. Now, with no one to take it over, he is acting when he has choice and options. He can monetize assets by sale, boost returns and make them fairly secure by picking the right financial assets and generate what may be hefty capital gains down the road with an advisor paid up front rather than through the back door of commissions and fees on stock trades he recommends or products he sells.

The excess income the couple will generate in their 70s when all their savings and government and job pensions are flowing can go to their adult children and perhaps grandchildren to help them later in life. By selling assets now, they can ensure there won’t be a lot of loose ends. Moreover, by bringing an adviser into the picture, when there is a generational transition of assets and control, there won’t have to be a lot of hunting for stocks and deeds. This is a modest plan, but it will work, Don Forbes says.

About the author

Columnist

Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.

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