Last week’s post contained a real life Canadian couple’s financial dilemma on how to invest a surprised inheritance. I asked writers and readers of financial blogs to email me their suggestions. This couple is in their mid-fifties and are hoping to retire in 8 to 10 years. They are debt free, have poor paying jobs and only managed to save $55,000 for retirement. Unfortunately, my bullet point list of Canadian tax info wasn’t very clear.
Additional clarification of the Canadian Tax system
Canadians have three choices for saving for retirement if they don’t have a company pension.
Registered Retirement Saving Plan (RRSP)
- Contributions are limited to 18% of working income (max. $25,370 investment income not included)
- Tax deductible, refund based on your tax rate (lowest 20%, highest is 53%)
- Tax free compounding, withdrawals are 100% taxable at your personal tax rate (lowest 20%, highest is 53%)
- Government requires you to make withdrawals at age 72
- Not usually recommended for low income families
Tax free Savings Account (TFSA began in 2009), geared to low income families
- Personal contributions are limited to $5,500 per year, not tax deductible
- Unused contributions are carried forward indefinitely
- Tax free compounding, withdrawals are not taxable
- No restrictions on withdrawals, money can be taken out and put back in the following year.
Taxable investment account
- Interest income, foreign interest and foreign dividends are 100% taxable at your current tax rate (lowest 20%, highest is 53%) Plus there is 15% foreign tax withheld. If personal your tax rate 30%, foreign dividends of $100 minus $30 personal tax – $15 of foreign tax = $65
- Canadian Dividends have an eligible tax credit that increases the after tax yield. In theory, a Canadian could earn $40,000 in dividends tax free if they had no other income.
- Capital gains has the lowest tax rate because only 50% of the gain is included in income, so only $50 of a $100 gain would be included. High income earners (53% tax bracket) would only pay 26.5% in income tax.
I only received two suggestions and didn’t receive any input from any Canadian bloggers or readers. So, I asked a financial planner who works at one of my local bank branches to weight in.
From the United States, Bear with the Bull offered the following:
I am not sure I am most qualified to be a financial adviser and I really do not know Canadian tax laws. I would think they might want a mix of income, bond, possibly cash, and growth stocks. For my 401, I have about a 60/40 split of stocks and income/bond allocation. So if they are looking for more cash / income, maybe they would be more comfortable with something more 40/60 instead.
They probably would look to a portion to be cash or bond fund that could be used to maximize yearly retirement contributions and or have readily available should they need it. Since the Canadian real-estate market is seemingly doing well, how about investing in some Canadian REITs? It would have a short term growth opportunity and dividends as well. ETF’s also seem to be the latest investing vehicle and generally have lower fees than mutual funds.
- The 40% equities ($120,000) 50% Canada 40% U.S 10% Emerging markets
- The 60% fix income ($180,000) Perhaps a 1/3 split. $60,000 Bonds, $60,000 Reits, $60,000 Cash
Realize that this response and $5.00 will get you a good cup of Starbucks so take it for what it is worth.
From Belgian, Amber Tree Leaves offered the following:
Here is a potential solution, as I am not sure to fully understand the Canadian system, I will skip that part.
General comment: As they have not yet accumulated a lot of assets, it might be tough to retire in the next 8-10 years. It is reasonable to expect a severe correction in that period. As it seems that they have little investing experience, it might be better to go for an approach that generates cash from dividend stocks. The assumption here is that it generates higher yields than ETFs.
- allocation: 70 % stock and 20 % bonds and 10 % gold.
- The 70% equities 20% in Canadian dividend stocks, 50% world wide in dividend paying stocks
The gold is there as a hedge against the really bad times. It should be managed in a way that it needs to be sold and converted into stock/bonds when the price rises a lot. Timing this is hard, it is not the goal to get the absolute top.
Bank Financial Planner
First of all, I believe that money has different weights or “gravity” depending on how you acquire it. Inheritance money seems to have the most weight as often people feel they “owe” a higher degree of care of duty to it and are less likely to deal with it the way they would a lottery win or an insurance settlement.
Obviously, the first thing I would need to do is get a better understanding of their situation and their time horizon and risk tolerances. Let’s assume they are comfortable with a balanced approach. I would recommend 60% equity/40% fixed income. ($180,000 in equity and $120,000 in fixed income.)
I would recommend they start by contributing fully to TFSAs, which would account for $102,000 between the two of them. In the TFSA, I would use a ladder of market linked GICs to give them diversification, security of capital and the potential for higher returns than offered by traditional GICs. This allows them their only chance to earn interest without paying tax on every penny of it. It also means there are no fees to pay on almost one third of their investments.
For the non-registered account, I would recommend a core holding of a growth ETF portfolio ($100,000 with additional positions in our Canadian ($30,000), US ($15,000 and International ETF funds $25,000), with a portion in our US Dollar ETF $15,000) for additional diversification on currency.
After the initial investment occurred, I would want to have an annual strategy to move the maximum TFSA contribution for each of the clients. This would involve selling a position of the non-registered investments (unless there are additional savings available) and reinvesting in the same fund inside the TFSA to maintain the balance in the overall account. This would allow the gradual transition into the TFSA accounts, helping with taxes and probate fees down the road. A portion of capital gains (or losses) would be triggered each year, smoothing the tax impact on the clients.
I am not sure if this inheritance is big enough to bail out this couple’s retirement plan. A key element is understanding after tax returns when investing.