Debt is more than a four-letter word
during your drawdown years.
Most of us like to shy away from mixing debt and retirement.
When used properly thought it can bring big savings.
Spring is always a busy time for me as a Retirement Income Specialist as it is the start of tax season, and tax returns are like a report card for the cash flow planning process we do with clients. Our ultimate goal is not to minimize the amount of income tax our clients pay in 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 less later.)
While working on the returns for two clients (lets call them Sharon and Ben), 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 Story
Ben’s brother-in-law Sam, had recently been told by his accountant that 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.
The Source of the Problem
Ben’s brother-in-law Sam, had recently been told by his accountant that 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.
The Symptoms of the Problem
Ben’s brother-in-law Sam, had recently been told by his accountant that 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.
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.
Like 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, that gives 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, translate into tax savings that are measured in the hundreds of thousands of dollars.
What is unfortunate is that because Sam 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, typically with a vehicle priced in the $35,000 range.
Over those 12 years, Sam had plenty of opportunity to draw incremental funds from his RIF, 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.
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.
Here at Retirement Navigator™, I recommend one thing 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 and get approved for loans etc. while you are still earning employment income. This access to debt simply sits dormant in the backgrounduntil it can provide useful strategic service. Indeed, if things are planned properly, 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?
- $1,600 in interest payments over a three-year period.
- An incremental $7,000 tax bill caused by OAS claw back and jumping marginal tax brackets.
Had Sam chosen option one, the savings he would have enjoyed 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.eded without forcing him into the punitive tax implications he ultimately inadvertently triggered.