Don’t delay planning

More of your clients are near retirement, so they’re busy building wealth and paying off debts. Both are important, but this year’s IAFP case study showed advisors also have to tackle estate planning before clients stop working.

Case study

In last month’s AER, we examined an IAFP case study, which features a hypothetical Ottawa family. The article discussed how Jim, 42, Sarah, 40, and their three children might be affected if they move to Texas (Sarah’s been offered a work transfer).

The couple invests conservatively. Their two RRSPs, two TFSAs, RESP and open joint accounts are in mutual funds. Sarah also has $600,000 worth of employee stock options.

In this piece, we look at how Sarah and Jim should prepare for retirement and transfer wealth to their kids.

Jim’s retirement income

The couple can retire comfortably if they continue saving, says David Ablett, director of tax and retirement planning at Investors Group in Winnipeg. He tackled this topic at the IAFP symposium in October.

If Jim remains with the Canadian government, Ablett calculates he could retire at age 55 with a pre-tax, indexed pension of $84,361 per year until age 65. After that, he’d receive $70,176 per year. Jim has “a very generous plan that’s based on final average earnings,” adds Ablett.

What’s more, Jim’s contributions are currently tax deductible. And once he retires, “up to 50% of [his] pension income can be allocated to Sarah for tax purposes,” as long as she doesn’t acquire an IPP.

If Jim dies, Ablett says Sarah would continue to receive “a pension equal to 50% of the benefit earned, plus benefits for dependent children.” But if Jim’s laid off or chooses to go to the U.S., he’d have three options: an annual allowance starting at age 50; a deferred annuity of $39,060 starting at age 60; or the commuted value of his pension ($325,000), which would go into a locked-in RRSP.

If he retires in the U.S., he’d face withholding tax of between 15% (for periodic payments) and 25% (for lump sum payments) on any RRSP income, as well as tax on any worldwide income. He could, however, get credits for any Canadian taxes paid.

Jim also has his severance payout to consider, says Ablett, which would be worth $38,367, or 21 weeks’ worth of his current pay.

He’s getting this payout because a federal program used to allow government workers to accumulate a week’s worth of benefits for each year of work. It stopped in 2011, but workers kept their accumulated balances.

Jim could either take the funds now or wait until he retires, when his payout would take into account his weekly (higher) pay rate at that time.

A payout at retirement is preferable, says Ablett, since it would be considered “a retiring allowance. Rollover provisions would apply; Jim could transfer $8,000 of severance to his RRSP” under those rules if he has room.

According to the case study, Jim also has group life insurance worth twice his annual salary. The policy’s payout falls 10% every year starting at age 65. By age 75, he’d have a $10,000 paid-up life policy. If he moves to Texas, he’d have to find out how the IRS might treat it.

Sarah’s retirement income

Sarah could retire at 60 when her government benefits kick in, says Ablett.

She has no pension, but owns a $300,000 life insurance policy with a cash value of $5,500. Her annual premiums are $3,500. She also has a short-term disability policy that offers 66% of her present salary ($120,000) for two years and a long-term disability policy that offers 40% of her salary, or $80,000, until age 65.

In addition, Sarah has $600,000 worth of company stock options, which will be fully unlocked in 2017. Up until then, she has options worth $200,000. When she exercises them, says Ablett, “she’ll get a taxable benefit equal to the value of the shares purchased minus the cost of acquiring them.”

He adds, “A deduction equal to 50% of that taxable benefit can be claimed if she’s purchasing common shares and if the strike price wasn’t less than the [market] share price when the options were granted.”

Government benefits

Both Sarah and Jim are eligible for CPP and OAS payments; maximum CPP benefits are currently $12,150 per year and maximum OAS benefits, starting at age 67, are $6,600 per year, says Ablett. The couple may face clawbacks, however, since their combined retirement income may exceed $70,954 (the 2013 threshold).

The couple’s benefits would also decrease if they moved to the U.S., says Ablett. That’s because growth of CPP benefits stops once contributions cease—the upside is payments to non-residents aren’t subject to withholding tax.

Further, the couple would only get about half their OAS benefits, since you have to be a Canadian resident for at least 40 years after age 18 to receive the full entitlement. Jim and Sarah may also face recovery tax of 15% on OAS payouts from CRA if their net worldwide income exceeds the agency’s threshold for any year they receive OAS. For 2012, that threshold was $69,562.

Headed for comfort

The couple can also draw upon their TFSAs and RRSPs in retirement, currently worth more than $230,000, says Ablett. They’d potentially have 401(k)s and social security benefits if they move to Texas (see “U.S. retirement savings in Canada,” this page).

So long as they manage their investments well and take advantage of the room in their registered accounts—Jim’s RRSP room is limited (due to his pension) but Sarah’s isn’t—they can stay the course in terms of saving, says Ablett.

And in the U.S., the couple can still manage their RRSPs through an international firm or Canadian advisor. But they won’t enjoy TFSA tax benefits, since those accounts aren’t recognized in the Canada-U.S. tax treaty.

In either case, the couple should tap their TFSA savings first in retirement, adds Ablett. Then, they should use their government benefits, and finally, RRSPs or RRIFs. The couple could start withdrawing from their RRSPs before age 71, though, if they want to take advantage of income splitting.

“If they are indeed conservative,” he says, “they could also convert their non-registered savings into annuity contracts or GMWBs. But the biggest issue with annuities is you receive a fixed amount and there’s no inflation protection.” He suggests annuitizing only some of their non-reg funds, so they have both fixed and variable income.

Hidden estate-planning challenges

If Jim and Sarah die in Canada, probate fees are 1.5% in Ottawa and they already work with advisors who are familiar with estate laws. In Texas, however, tax and estate rules could be more complex.

Also, independent administration is most often used to settle estates in Texas, which means “executors and administrators are allowed to serve largely independent of court supervision,” according to an article by Houston-based Ford and Bergner LLP.

The article adds this kind of administration isn’t preferable when executors are trying to settle estates with liabilities or when heirs are fighting. Further, Texas estate laws are being altered as of January 2014.

Another challenge is they have to make sure Jonathan, Sarah’s son from her previous marriage, gets an inheritance. Stepchildren aren’t recognized as family unless they’re specifically mentioned in wills, says Christine Van Cauwenberghe, director of tax and estate planning at Investors Group in Winnipeg, Man.

If Jim were to die first, Jonathan’s share would be protected since he’s Sarah’s son—she’d be the surviving spouse and likely beneficiary of most accounts. But if Sarah were to die first, Jonathan’s share isn’t guaranteed, since Jim could gift his estate prior to his death or put everything in joint ownership with a new spouse, says Van Cauwenberghe.

To avoid problems, Jim should make sure his will explicitly leaves something to Jonathan.

Van Cauwenberghe also recommends an insurance trust for Jonathan. These trusts are helpful for people who find “there isn’t enough in the estate to leave a portion of the assets to the new spouse and also leave some directly to [their] children,” she adds.

She says Sarah should purchase a policy in her name (her son is a minor) and put it in a trust that names Jonathan as the beneficiary. She could make her brother the trustee to keep control on her side of the family.

If her brother dies, the trust could then be administered by a contingent manager or by the executor of her brother’s estate. Sarah should list alternative managers when creating the trust, says Van Cauwenberghe.

Jim and Sarah are still in their 40s, so they don’t have to decide on final strategies now, she adds. But Sarah would need to create that insurance trust before she becomes uninsurable.

If they move to Texas, they need to understand its family laws and re-do their wills.

U.S. retirement savings in Canada

If Jim and Sarah move to Texas, they may have U.S. retirement income, says David Ablett of Investors Group.

If they returned to Canada and gave up their green cards, their 401(k) income would be taxable in Canada and subject to U.S. withholding tax, which can be as high as 30%, adds Ablett. Lump-sum payments, however, can be tax-deferred in an RRSP whether people have room or not, so long as “the benefits were earned while individuals were non-residents of Canada.”

On the plus side, U.S. Social Security payments aren’t subject to U.S. non-resident withholding tax, and only 85% of the payments are considered taxable income in Canada.