Farming has been good to a couple we’ll call Horace, 50, and Betsy, 40. Their 3,500-acre grain operation has been consistently profitable. Now they want to plan their retirement and succession, but it’s too early to tell if their daughter, Moira, 10, will be interested in continuing to farm.
The couple plan to stay with their farm for the next decade and a half when Horace will be 65 and Betsy 55. Then they will either transfer it to Moira or sell.
The couple asked Don Forbes and Erik Forbes of Don Forbes Associates Inc./Armstrong & Quaile Inc. in Carberry, Manitoba, to work with them to plan their financial future. “This is a success story,” Don explains. “The issue is how the couple can make the most of their operation.”
At present, Horace and Betsy each take $60,000 as salaries with a $10,000 bonus going to each one’s RRSP. There is usually additional profit left in the corporation. If it is not reinvested, then they take it out as dividends for investment in their Tax-Free Savings Accounts or paying down their $550,000 house mortgage.
The mortgage at present has a four per cent interest rate and 24 years to go on the amortization schedule. If they add 10 per cent to their payments, currently about $3,000 a month, the mortgage would be paid in full in just under 15 years, Erik Forbes estimates.
It’s time for Moira to get a Registered Education Savings Plan. If the parents contribute $2,500 a year for the next seven years to her age 17, she can receive the Canada Education Savings Grant of the lesser of 20 per cent of contributions or $500 each year. That makes each year’s maximum contribution $3,000. There is a catch up provision as well, so the couple could add $25,000 plus $5,000 CESG for the past 10 years that they have not contributed and get the CESG to a maximum of $7,200 per beneficiary. If they invest at six per cent before inflation adjustment for the entire period to Moira’s age 17, she would have $64,000 with the $30,000 one-time catch up investment or $27,000 without it.
Horace’s RRSP balance, currently $160,000, with a $10,000 contribution each year, will grow to about $630,200 in 15 years. Betsy’s RRSP, with no significant present balance, will grow to about $245,000 – $247,000 in 15 years with $10,000 annual contributions. They can make a little more by contributing early in each year rather than waiting to the end of the contribution period 60 days after the end of each calendar year.
At age 65, Horace’s RRSP converted to a Registered Retirement Income Fund will provide him with an income of about $4,000 a month or $48,000 a year to his age 90 in future dollars without inflation adjustment while Betsy’s RRIF starting at age 55 would provide her with about $1,200 in future dollars each month or $14,400 a year to her age 100, Don. Forbes predicts.
Horace has $11,000 in his Tax-Free Savings Account. He should add $5,500 a year and fill the present space available, about $25,500, to make full use of the shelter, Don Forbes suggests. Betsy should open her own TFSA and fill its $36,500 spaced. The TFSA can be an emergency cash reserve. Over the next 15 years, the two accounts will grow at six per cent a year to $163,000 for Horace, recognizing his present $11,000 balance, and $136,000 for Betsy, who will have to start with a zero balance.
At age 65, Horace can expect Canada Pension Plan payments at 75 per cent of today’s maximum, $12,780, Betsy at 50 per cent of the maximum, each payable at 65. Inflated at three per cent per year for 15 years for Horace when he starts benefits at 65 and 25 years for Betsy when she reaches 65, the couple would have CPP benefits of approximately $27,160 when both benefits begin to flow.
They would also have Old Age Security benefits, currently $6,765 a year, when each is 67. Inflated at three per cent per year for 17 years for Horace and 27 years for Betsy, the couple would have combined OAS benefits before any clawback of $25,300 when Betsy is 67.
The sum of all these cash flows without any TFSA payouts would be $114,860 in future dollars.
To finance their future, the couple can continue to take money out of their farming corporation, but it should be paid as dividends rather than salary income, Don Forbes suggests. When they start to draw Canada Pension Plan benefits and Old Age Security and income from their RRIFs and TFSAs, they will be pushed into higher tax brackets and their Old Age Security benefits, currently $6,765 a year and perhaps would be clawed back quite substantially. The OAS clawback begins in 2015 at $72,809. With a three per cent annual inflation, it would start at about $110,000 when Horace is 67 and $127,400 when Betsy is 67. Using these numbers, the clawback would have little cost to the couple’s income, including OAS.
If Moira does not continue to farm, then all of its assets including land, machinery, and inventory would be sold. Unless its retained in the company, Horace and Betsy would assume all of the retained earnings as taxable income.
If the farm is sold, then its present estimated value of $8,836,000 would presumably grow. If we use a three per cent rate of return, which would just cover inflation, then the farm would be worth $13,182,000 when Horace and Betsy start their retirement in 15 years. At the same rate of growth equal to inflation, the capital obtained from sale of the farm would provide a pre-tax income of $395,000 a year before tax. The exact return would depend on the future accounting for the farming corporation and application of the $800,000 exemption on qualified farm property revalued, as it might be, in future.
The tax rate on this income distributed as dividends combined with the farm corporation’s tax rate would be about 38 per cent, leaving about $245,000 for living expenses, travel and investment, Don Forbes suggests. Total future income including all RRIF and government pensions would then be $624,720 per year. After tax at an average 40 per cent rate, which includes the effect of the clawback, they would have about $348,000 a year to spend in future dollars. That would more than cover present expenses of $10,000 a month or $120,000 a year inflated at three per cent per year to $194,000 in 15 years or $216,000 a year in 25 years, Erik Forbes estimates.
If the company were to continue to operate with cash, land, and other assets not generating active farming income, the Canada Revenue Agency would treat the business as a holding company or tax shelter. The result would be taxation of all non-business or passive income at the peak personal rate. Thus any land rent received by the company after active farming has stopped ought to be paid out each year and taxed in the hands of each person. Dividend paying stocks held inside a holding company would be eligible to pass through dividend income on a partially paid basis. That would further reduce the tax burden on Horace and Betsy, Don Forbes notes.
Horace and Betsy have tough choices to make, Don Forbes says. If they sell the farm and convert their land and equipment to cash, they will be faced with very high income taxes on resulting investment income. Continuing the farm as an active business, perhaps controlled by Moira, is the best tax plan. The family farm remains not only a good way to make money, but a good way to keep it.