Inheritance to help East Coast couple

They have a house worth $400,000 on which they have a $100,000 mortgage that is scheduled to be paid off in 10 years; monthly payments are $1,400. The couple have one car and expect to spend $10,000 in today’s dollars on a replacement every six years.

The couple have been focused on paying down their mortgage and paying for their three children’s education — all are now finished university or college — and haven’t made any RRSP contributions for the past 20 years. As a result, David has only $100,000 in RRSP assets; Susan, $20,000. David’s unused RRSP room is $200,000 and Susan’s is $36,000. The couple have no tax-free savings accounts, but have $20,000 in a traditional savings account.

David is in the process of inheriting $350,000 following the recent death of his mother and wants to know what he should do with these assets as well as the $10,000 a year the couple think they can save now that they no longer have education expenses. David and Susan also want to know what their priority should be: paying off the mortgage, making RRSP contributions and/or maximizing TFSAs?

The couple want to retire when David is 65 and would like to leave $50,000 in today’s dollars to each of their children. The couple also want to know how much they can reasonably plan to spend in today’s dollars each year in retirement to age 95, and if they should purchase critical illness and/or long-term care insurance.

The Recommendations: Both MacFarlane and Stewardson say David and Susan can expect to spend almost $50,000 a year in today’s dollars in retirement until Susan is 95 without using any of the value in their home. MacFarlane uses a 6.5% annual average return, after fees, in his projections; Stewardson, 6%. Both assume annual inflation of 3%.

MacFarlane puts his projections in terms of monthly expenditures, excluding mortgage payments, saying there is a 75% probability that the couple could spend $4,000 a month ($48,000 a year) and an 85% probability that they could spend $3,600 a month ($43,200 annually, their current spending). These figures are reduced by only $100 a month if the couple take out the CI and term life insurance he recommends.

Stewardson puts his projections in terms of rounded annual numbers — specifically, expenditures of about $50,000 a year in today’s dollars, also excluding mortgage payments and not using any of the value of the house.

The advisors take different approaches to the inheritance, however: Stewardson recommends paying off the mortgage but MacFarlane suggests it be kept.

Stewardson ran various scenarios and found that paying off the $100,000 mortgage in the next year made the most sense: paying off the mortgage would free up $1,400 a month ($16,800 a year) that could then be used for RRSPs, TFSAs and other non-registered savings.

However, MacFarlane thinks that as long as interest rates remain low, David and Susan will be further ahead if they continue with the mortgage and invest all the inherited assets — the 6.5% annual average return he uses in his projections is much higher than the 2.5% variable rate they could get on their mortgage. Even if David becomes disabled, MacFarlane would still suggest keeping the mortgage because David has disability coverage at work.

However, if interest rates rise sharply, MacFarlane would suggest considering paying off the mortgage; and if David should die in the next 10 years, MacFarlane would recommend using David’s life insurance to pay off the mortgage.

Stewardson recommends that David and Susan each set up a TFSA immediately and put $15,000 from the inheritance into each. Stewardson also recommends that the rest of the inheritance plus the $26,800 a year in annual savings — $16,800 from what is not being spent on the mortgage and the $10,000 in expected additional savings — be committed over the next three to four years toward the couple’s unused RRSP room. An accountant can advise how much the couple should each contribute to their RRSPs each year for maximum tax efficiency.@page_break@Stewardson notes this use of the inheritance would make the money into matrimonial property. He urges the couple to get legal advice about whether inherited assets should be comingled.

MacFarlane also suggests both spouses set up a TFSA immediately, with $15,000 from the inheritance put in each account and put the rest into a balanced portfolio. Then, on each Jan. 1 for the next 10 years, David should transfer $20,000 to the RRSPs — ideally, split 50/50 between his RRSP and a spousal one, in order to equalize the two RRSPs eventually — and $5,000 into each TFSA.

MacFarlane’s projections show that $20,000 a year in annual RRSP contributions will provide the maximum tax savings for David. The advisor doesn’t suggest using up Susan’s $36,000 RRSP room because the couple will have enough savings with David’s RRSPs — and there wouldn’t be much tax savings, given Susan’s low tax bracket.

Both advisors note that the equity in the house remains untouched in their projections, so that will more than provide for the $50,000 in today’s dollars per child for the estate goal — assuming the value of the house goes up at least in line with inflation. Nevertheless, both advisors suggest that David and Susan buy a joint last-to-die universal life insurance policy for $150,000 to ensure that goal is reached. As inflation will erode the value of the policy’s payout, the policy can be topped up periodically.

Stewardson says such a policy with a rider providing an additional $150,000 of term-10 insurance on David’s life would cost a onetime premium of $36,000.

MacFarlane suggests the joint last-to-die policy for $150,000, with a premium of $3,000 a year paid over 10 years — and a joint first-to-die $500,000, 10-year term insurance, which would cost about $2,100 a year.

In terms of CI, Stewardson suggests a 10-year $50,000 policy for David at a cost of about $2,400 a year and a 17-year $50,000 policy for Susan at a cost of $1,000 a year — both with return of premium. If unused, David would get back about $19,200 of the $24,000 he would pay in premiums; Susan, $13,600 of the $17,000 paid.

MacFarlane suggests $100,000, 10-year CI policies, which would cost about $2,000 a year for David and $1,000 for Susan.

Stewardson says buying LTC insurance at this couple’s ages means the premiums will be relatively low and they can be paid over the next 20 years, during which they will be working for 10. He suggests a policy for each providing $750 a week tax-free if the beneficiary cannot do two daily activities. The total cost for the couple is $3,300 a year for 20 years, equal to $66,000. Two years’ worth of benefits for one of them would amount to $78,000, so Stewardson thinks this is well worth it.

MacFarlane considers LTC insurance optional, noting that in New Brunswick, provincial LTC support is income-tested, not asset-tested, so the couple wouldn’t have to use their capital and home to pay LTC costs. He notes that this is a major reason to build RRSP assets equally using spousal plans because then the income, when withdrawn, is not almost all reported by one spouse.

MacFarlane suggests an asset mix of 70% equities in pre-retirement and 50%-60% equities thereafter for the couple’s RRSPs and non-registered assets; he also suggests 50%-60% equities for their TFSAs throughout. He recommends about 70% of the equities be large-cap Canadian, with the rest divided equally among U.S., Europe and emerging markets. For the fixed-income component, MacFarlane suggests two-thirds be in bonds or bond funds, and one-third in a real estate fund.

Stewardson recommends an asset mix of 60%-70% equities and 40%-30% fixed-income, depending on the couple’s risk tolerance. He suggests investing in an asset-allocation pool or mutual fund program that would target an equal split among Canadian, U.S. and international equities and also invest in foreign as well as Canadian fixed-income.

MacFarlane recommends using mutual funds and/or segregated funds and possibly using fund-of-funds asset-allocation portfolios to simplify decisions. He also suggests the couple consider putting up to half of their RRSP assets into a variable annuity with a guaranteed minimum withdrawal benefit.

Stewardson agrees that GMWBs could be a good idea, as they provide guaranteed levels of income as well as inflation protection as the assets grow and payments rise. He suggests the couple consider putting all of David’s RRSP assets into GMWBs now, then the same for Susan when she turns 50.

MacFarlane doesn’t charge for developing and monitoring a plan; he gets his compensation from mutual funds and/or seg fund fees and insurance commissions.

Stewardson doesn’t charge for his team to develop a plan if they will be overseeing the client accounts. Otherwise, he charges $165 an hour; a plan of this nature is likely to cost about $1,500. IE