Vancouverites we?ll call Samuel, 58, and Vera, 61, have built their lives on a small fortune they inherited a dozen years ago. Samuel gave up his small retail sales consulting business, Vera her work as an office manager, and both moved on to living on Samuel?s inheritance.
With $745,000 of trust funds based on inheritances ? Samuel is an only child and his father was quite successful in manufacturing ? they travel three months of the year and work about three months of the year.
You could say they have no financial problems. But their leisurely lives ? he works as a tax preparer in spring and she as a hostess in a posh hotel in summer ? have put an upper limit on the incomes they can expect for the rest of their lives. So far, with modest spending, their way of life is working. But they anticipate complete retirement at some point in the not-too-distant future and wonder if, without their salaries, it will be sustainable.
?Our issue is when we can stop working and retire completely,? Samuel says. ?Do we have enough wealth to retire comfortably, that is, to maintain our way of life as it is??
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Samuel and Vera. ?This is an unusual case, for the couple has chosen to live within their ample means rather than to strive for more wealth and more income,? Mr. Moran said. ?They are beneficiaries of not just money, but of good tax planning. The money is taxed in separate hands, for each trust files its own return. Therefore each hand pays less tax.?
Financial Foundation
The base for the couple?s income is a pair of trusts established from money they inherited from Samuel?s parents. They now have a total of $745,000 in capital and generate 5%, or $33,628, a year before tax. To that, they add $42,750 they earn in a few months of work each year. The trust income, all dividends, is taxed at an average rate of about 4.0% courtesy of the dividend tax credit and the fact that Samuel, Vera and the trusts are all taxed separately. The couple?s average tax rate on their own salaries, the trusts and their taxable investments averages 10%. That leaves them with after-tax income of about $69,800 a year, or $5,818 a month. That?s more than their $4,518 of expenses, including allocations to their tax-free savings accounts. All figures are in 2012 dollars.
Our issue is when we can stop working and retire completely
If they quit work tomorrow, they would have their trust and investment income and could have Vera?s early CPP benefit of $3,402 a year, a 36% reduction of her age 65 annual benefit of $5,316. That would add up to total income of about $37,000 a year before an assumed tax rate of just 5%, leaving $2,930 a month for expenses net of all savings of $3,055 a month. It would work if they tapped their trust funds for the difference. In two years, Samuel could take early CPP at 60 at $4,785 a year, a 36% reduction of his age 65 benefit. When each is 65, OAS would add $6,540 to pre-tax income. But taking early CPP is not a good idea. They would lose a lot of benefit and they do not need it just yet.
If they defer applying until each is 65, assuming that both have retired from their part-time work, their incomes would be $7,476 annual CPP for Samuel and $5,316 annual CPP for Vera, $13,080 in combined OAS benefits, investment income from taxable stocks and their trust of $42,166, taken at a rate that will exhaust the capital by Vera?s age 95, and RRSP income of $14,333. That adds up to $82,171 before tax, or $6,300 a month, after 8% average tax based on a very low rate on their trusts. Even without their salaries, they would be able to support their present monthly expenses. They might then shift RRSP savings to travel or other uses.
Risk management
It is intrinsically risky to estimate investment income over a period of three decades to the point at which all capital will have been paid out of trusts and investment portfolios. The couple?s portfolios have 42% fixed-income assets that pay 2% a year. The balance of the portfolio ? stocks ? will have to generate a return of as much as 7% a year if payouts are to be sustained at projected levels. That is attainable but not necessarily sustainable, especially if the couple wants to reduce volatility by shifting toward bonds and perhaps preferred stocks or other forms of fixed income. They may find that preferred stocks give them both reduced volatility and higher income, even though preference shares are, in effect, low-quality bonds.
If investment performance were to fall seriously short of expectations, they would have a fallback asset, their home, which is inflation-linked and capable of being sold as a principal residence without any tax on gains, Mr. Moran says.
Samuel and Vera could stabilize their income and to some extent immunize their wealth from the ups and downs of capital markets by putting some or even all of it into an annuity.
The annuity would pay a guaranteed amount each year to the death of the second partner, with some number of years of payments guaranteed. It would work for the couple, but Samuel and Vera don?t need to tie up their money for three decades. They would do well to defer any decision to buy an annuity for at least five or 10 years until interest rates, which are the basis of annuity payouts, have risen by perhaps one or two percentage points and then revisit the subject, Mr. Moran says.
?The couple?s problem is to preserve their good fortune. They can eventually afford to give up their part-time jobs, but they should wait to 65 when they get their government pensions to do it. They should work till then so that they do not have to tap their trust funds prematurely,? Mr. Moran says.
Need help getting out of a financial fix? Email andrewallentuck@mts.net for a free Family Finance analysis
Source: http://business.financialpost.com/2012/10/26/can-this-couples-inheritance-and-good-fortune-last/
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