Debt is more than a four letter word during your drawdown years

Written by Doug Dahmer  |  April 26, 2016

The month of April is always a particularly busy time for Retirement Income Specialists. One of our key roles is to provide each of our clients with a year by year drawdown recipe: outlining how much and where to source their annual cash flow needs. The ultimate goal is not to minimize the amount of income tax they pay on any given year, but instead to minimize the amount of tax they pay over the balance of their lives. Please note, these two goals are frequently confused, and seldom accomplished simultaneously as you will need to pay more tax sooner in order to pay significantly more later.

One of our many sources of insight for the guidance we provide, is found within our clients annual tax returns. At the same time, our clients’ previous years tax returns act much like a report card, keeping them informed as to how well we performed our role over the previous year, as we endeavor to accomplish this important long term goal.

The other day as I was reviewing Ben and Sharon’s 2015 tax returns, they shared a family story with me that spoke directly to the critical role a Retirement Income Specialist can play in helping those in their drawdown years make better strategic funding choices.

The moral of the story I am about to share with you is:
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The Story

Ben’s brother-in-law Sam, had recently returned from his accountant where he had been informed he owed close to $7,000 in taxes. Sam’s shock and dismay was aggravated by the reality that he had already sent the Canada Revenue Agency (CRA) an incremental $15,000 earlier in the year. Sam was anticipating a tax refund not a tax bill.

Ben and Sharon asked me to talk to Sam to help him understand how his cash flow funding choices ultimately created the problem he was faced with. They also wanted me to provide guidance of where to source the cash flow he now needed to fund this unexpected tax obligation. They feared that another poor choice would only further aggravate the problem Sam had inadvertently created.

From my follow-up conversation with Sam, I would like to lay out his story in the following order:

  1. the source of the problem,
  2. the symptoms of the problem,
  3. the ideal prescription, and
  4. the recommended solution.

The Source of the Problem

During 2015, Sam (age 67) decided it was high time to replace his dated vehicle. The total cost of the new car he selected was $35,000.

Unfortunately, like far too many Canadians, Sam’s only flexible source of savings were located within his RRSP portfolio. As a consequence, when it came time to fund this lump sum purchase, in his mind he had nowhere else to turn.

When Sam approached his financial institution to withdraw the required $35,000 from his RRSP portfolio he discovered, to his dismay, he would be required to withdraw a total of $50,000. The additional $15,000 was a CRA prescribed allotment to approximate the pre-payment of the incremental income tax this withdrawal would generate.

The Symptoms of the Problem

Sam is a retired teacher. He is also divorced. He shares his healthy teacher’s pension plan with his ex-wife. Sam’s portion of the pension is $40,000 per year. To this recurring pension income he adds his CPP of $8,000/yr. and his Old Age Security of $6,700/yr.

 

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With his typical recurring taxable income of $54,700, Sam lands smack dab in the middle of the Ontario/Federal combined marginal tax bracket of 32%. He has long grown accustomed to his annual income tax bill hovering around the $9,600 mark. Over the years, he has wisely learned to arrange to have the necessary taxes withheld at source to avoid the common aggravation of having to make quarterly tax installments.

Unfortunately, the incremental $50,000 RRSP withdrawal boosted Sam’s taxable income from $54,700 to $104,700.

At this lofty level of annual taxable income Sam was now, not only well above the OAS claw back line, he was also well into the stratosphere of the 42% marginal tax bracket.  The combined impact of OAS claw back and a higher marginal tax rate increased Sam’s annual tax bill by $21,700. This amount far surpassed the prescribed tax prepayment ($15,000) forwarded to CRA at the time of his RRSP withdrawal. This is what caused the incremental tax bill of close to $7,000.

The Ideal Prescription

As a Retirement Income Specialist, I cringe when I hear people claiming that all their annual cash flow needs can be met on the basis of a fixed repeating annual dollar amount. Reliance upon straight line income planning is my clue that I have met a household who is unconsciously ignoring and missing out on all future tax planning opportunities.

Similar to the first half of your life, issues continue to occur that require the expenditure of lump sums of cash over and above the recurring straight line number.  As in Sam’s case, it was the purchase of a new vehicle. For others it is the need to perform significant renovations like a new roof, a furnace or new windows. For others it is the funding of one of their bigger ticket vacations on their bucket list, like an African Safari or a journey to Australia/ New Zealand.

It is the forward knowledge of when these lump sum events are likely to occur, and roughly how much is needed to fund them, which provides Retirement Income Specialists the data they require to perform proper tax planning and strategic cash flow sourcing. The time and effort to complete the task is certainly worthwhile, as we have grown accustomed to identifying many opportunities which when accumulated over an average retirement of 25 to 30 years translates into tax savings that are measured in the hundreds of thousands of dollars.

What is unfortunate for Sam is that because he failed to plan for upcoming lump sum purchases he missed 12 years of opportunity, between the ages of 55 and 67, to set up the funding of his new car. In hindsight, Sam acknowledged that this car purchase was entirely predictable. Over his life time he had a long standing habit of replacing his cars roughly every 7 to 8 years. He had also grown accustomed to driving a car with the features and comforts of vehicles priced in the $35,000 price bracket.

Over these 12 years he had plenty of opportunity to draw incremental funds from his RRSP, even though they would cause him to pay higher taxes in the year and they were not immediately needed. If Sam kept the withdrawals low enough and did them frequently enough, he could keep his annual taxable income below the top of the 32% marginal tax bracket and accumulate the lump sum required for the car purchase. He would have been wise to pace these withdrawals with the annual TFSA contribution limit, moved the after tax proceeds to a TFSA, and allowed them to grow tax free until the date of the car purchase.

By consciously acknowledging and planning for an inevitable future lump sum purchase, Sam could have built a funding reserve that could be accessed when needed without forcing him into the punitive tax implications he ultimately inadvertently triggered.

 

 

 

 

The Recommended Solution

Despite Sam’s failure to forward plan for the funding of his car expenditure, he still had an alternate funding choice available to him. He could have used short term debt as a preferable tactical solution.

Unfortunately like most retirees, Sam’s belief was that taking on debt during retirement was a deed of the devil. Debt should be avoided at all cost. It is no wonder that financing the car over time was completely overlooked as a viable funding option.

Sam would have been wise to take out a line of credit secured by his house.

I recommend to all of my clients: ensure you have a secured line of credit in place before you retire. I am not asking these clients to gain access to flexible debt capacity in anticipation of needing it. Instead, it provides another arrow in the quiver of strategic alternatives to facilitate tax planning during their drawdown years. Remember, it is always easier to apply for and get access to debt approved while you are still earning employment income. This access to debt simply sits dormant in the background until it can provide useful strategic service. If we do all other things, it may never be needed.

Sam’s car could have been financed by drawing the $35,000 from this pre-approved line of credit. Sam could have amortized this loan over a four year period. This specific time frame for retiring the debt is selected to ensure that Sam kept his RRSP withdrawals, required to fund the loan payments, below both the OAS claw back line and the start of the 42% marginal tax rate. In total the interest cost of servicing this loan would have not exceeded $1,600.

I leave it to you – which funding choice would you have made?

  1. $1,600 in interest payments over a three year period.
  2. An incremental $7,000 tax bill caused by OAS claw back and jumping marginal tax brackets.

The cash flow savings of option one would have covered the cost of his upcoming Caribbean cruise.

Far too many retired Canadians believe that debt in retirement is a four letter word.

Whenever you are constrained to sourcing the needed cash flow from registered assets, the primary prescription to avoid tax traps is to employ debt to spread out the drawdown over several years. If done strategically, the interest paid is far less punitive than the incremental taxes paid by jumping marginal tax brackets and crossing the OAS claw back line.

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