A couple we’ll call Liam and Sue, both in their early 50s, have farmed in southern Manitoba for nearly four decades. They have a big stake in the land, for they personally own 1,400 acres. Another 640 acres are owned by the family farm corporation they formed 20 years ago.
The operation has been successful, so much so that they have $346,000 of deferred income tax in the corporation. They utilized the 11 per cent low corporate tax rate to focus on aggressive growth. Looking ahead, they want a diverse stream of income for a more stable and sustainable retirement.
To cope with the tax due, Liam and Sue consulted Don Forbes, a farm financial planner with Don Forbes & Associates/Armstrong & Quaile Associates Ltd. of Carberry, Man. The issue is not only tax, but succession as well, for while the couple has two grown children, neither is interested in continuing the farm.
The couple’s plan is to continue farming for now but to slow down to semi-retirement in nine years. They will keep most of the farmland for retirement income and then leave it as a legacy for the children. Farmland rents for $50 per acre per year in their area.
They want to get the most income of out the farm by drawing salary income from the farm corporation at the upper end of the mid-tier rate. That will allow Liam to optimize his Canada Pension Plan (CPP) benefits and Registered Retirement Savings Plan (RRSP) payouts for the next nine years of work. A tax accounting simulation showed that a mixture of $36,000 salary and $12,000 corporate dividends would work best for their needs.
For Liam, estimated $8,000 RRSP contributions for the next nine years, added to his current RRSP balance of $128,000, will have grown to about $266,000 at rate of about 3.5 per cent over the rate of inflation. That would support Registered Retirement Income Fund (RRIF) payments of $1,500 per month for the next 30 years, Forbes estimates.
Sue’s $8,000 of RRSP contributions for the next nine years, added to her present RRSP balance of $97,000, would grow to $212,000 on the same basis. That would support RRIF payments for Sue of $1,000 per month for the next 30 years.
Liam and Sue should each continue to maximize their contributions to their Tax-Free Savings Accounts (TFSAs) at $5,500 per year, the new limit that applies beginning January 1, 2013. Contributions should accumulate to $100,000 in 10 years or $250,000 in 20 years.
The couple should continue to hold their non-registered joint investments of $142,000 in corporate class mutual funds so that any taxable capital gains will be deferred until units are sold during retirement when, presumably, they will be in a lower tax bracket.
For now, Liam and Sue aim to keep the farmland as a source of retirement income. They could decide to sell and invest the proceeds or they could transfer the land at current market value to their children. In either case, they are eligible for the $750,000 qualified farm land capital gains exemption. The farmland owned by the corporation does not qualify for this exemption as an asset sale, Forbes notes.
In retirement, it is important to be debt-free. Interest rates are likely to be higher in a decade. Therefore their present $114,327 of mortgages on their revenue properties should be paid before rates begin to rise. Given the announced plans of the Bank of Canada to keep rates in a low range until 2014, there is no need to hurry. Interest rates will rise, but it will be a slow process.
Liam and Sue currently spend $36,000 supporting their way of life. By the time they retire in 2022, inflation and additional travel will have pushed up their cost of living to $60,000 per year, they estimate. That expenditure will require $74,450 pre-tax income.
That income can come from CPP benefits for both of them totaling $11,784 per year at 65, RRIF payouts of $30,000 per year, $12,000 per year from rental properties, and $60,000 per year of farm corporation dividends for total pre-tax income of $113,784. When both are 67, they can draw Old Age Security (OAS), currently $6,540 per year. That would push total income in their late 60s to $126,864. If pension income is carefully split, reducing individual income to $63,432 before tax, they would avoid the OAS clawback that (in 2012) currently begins at $69,562. Income after average tax of 25 per cent would be $7,929 per month.
The couple’s income will have risen above what they currently earn. They will have the additional cash flow to pay down deferred taxes due on a gradual basis. The process of raising farm corporation dividends from their present level of $24,000 per year to $60,000 per year by issuing taxable dividends will achieve another tax saving.
Individuals are taxed on investment income at a lower rate than corporations. This will be very important when the farming corporation ceases to be active.
There are numerous variables in this plan and some cannot be forecast with accuracy. Tax rates may change in the next nine years and during the couple’s retirement. The OAS clawback rate is likely to rise at about two per cent per year to $86,180 by 2022, but if it rises more slowly, then some of the couple’s OAS would be lost to tax.
Rents charged by the farming corporation and the value of equipment the corporation may acquire or sell in the next nine years is uncertain. However, the couple plans to control capital costs by not buying any new equipment unless absolutely necessary. Existing equipment will be sold at retirement. At that time, the company will distribute the proceeds to the farm corporation’s shareholders.
Liam and Sue also face erosion from inflation. Only about a fourth of their total retirement income will be indexed. The 75 per cent balance of retirement income will come from investments and savings.
To maintain purchasing power for the 30 years in non-farm investments, the couple needs to maintain a stock and bond balance. Stocks that pay dividends of 2.5 to 4.5 per cent are readily available. The dividend tax credit adds about 25 to 30 per cent to the value of the dividend when compared to fully taxed interest income.
Government bonds pay very little at present and are likely to drop in price when interest rates rise in what may be a few years. But corporate bonds with ratings of single A to BBB+, which is in the lower part of the investment grade range, and with maturities of seven to 10 years, often pay 3.0 to 3.5 per cent. In a time of limited global growth, stocks and bonds from companies in consumer staples, such as grocery stores, public utilities, and telecom companies offer sustainable earnings and limited volatility.
The danger in building portfolios is that one tends to look backward and then assume that what worked in the last decade or other period should continue to work.
Today, the market favours large cap dividend paying stocks, though in the midst of the dot com bubble of 1999, dividend stocks were out and sheer growth was in. Capital markets are not immune to fashion trends.
Liam and Sue can avoid market fashions by buying broad market index funds. Exchange traded funds (ETFs) offer a way to buy whole industries, product groups, or entire exchange listings with no selection risk. Those exchange traded funds that equally weight every stock they hold avoid fashion risk — think back to when Nortel Networks was 30 per cent of the total capitalization of the Toronto Stock Exchange. Equally weighting every stock enables ETFs to dodge the problem of overweighted hot stocks.
If all goes well with the couple’s plans, Forbes suggests they may want to enlarge their legacy for their children and to make significant donations to good causes. †