“Financial Checkup” is an ongoing series that discusses financial planning options. In this issue, Investment Executive speaks with Jim Dennis, vice president and investment advisor with Richardson GMP Ltd. in Toronto; and Mike Lakhani, a senior financial advisor with Assante Financial Management Ltd. in Mississauga, Ont.

The Scenario: David is a 45-
year-old dentist in Toronto. His wife, Sharon, also 45, works part-time for the practice from home, where she is taking care of their children, aged 12 and 14. They have a house worth $800,000, with a $250,000 mortgage at 5%; the penalty for advance full payment is three months’ interest.

David’s practice was incorporated in January 2006: David holds all the voting shares, Sharon holds all the non-voting Class B shares, and the non-voting Class C shares are held in trust for the children. David’s take of $100,000 from the corporation was salary until 2008 and then became dividends. Sharon’s salary has remained at $35,000.

The remaining income is kept in the corporation and saved for David’s retirement. He expects to add $6,000 a month to the account, up to age 65. In addition, he expects to sell the assets in his practice for $650,000 in today’s dollars when he retires at 65. There also is $385,000 held in an investment account owned by the corporation, 60% in Canadian bonds and 40% in Canadian equities.

Neither spouse has an RRSP. David has $78,000 in RRSP contribution room; Sharon, $38,000. They also don’t have any RESPs.

David’s financial goals include: $100,000 in after-tax income in today’s dollars to age 95; paying the university education costs of both children (estimated at $20,000 per year in today’s dollars for four years for each child); new cars for both David and Sharon, costing about $35,000 each in today’s dollars, every five years; spending $150,000 annually in today’s dollars, including major trips with Sharon, when they are between age 65 and 75; and leaving $600,000 in today’s dollars to each child, excluding the house.



The Recommendations: The projections of both Dennis and Lakhani suggest that these goals can be met. Both advisors recommend that life insurance be purchased to ensure that the estate goal is reached. However, their approaches to meeting the couple’s income goals differ markedly. Dennis uses tax-efficient investments while Lakhani employs a more traditional tax-deferred savings program using an individual pension plan.

Dennis’s projections, which assume an asset mix of 60% fixed-income and 40% equities, average annual return of 5% and inflation of 2%, show an after-tax estate — not including the house — of $500,000 in today’s dollars when the couple reach 95. This projection assumes that the assets are invested in tax-deferred mutual funds, such as those offered by Toronto-based NextGen Financial Corp.

But the couple will run out of financial assets at age 93 if the assets are invested in fully taxable funds, in which 50% of the income would be interest, 25% in dividends eligible for the Canadian dividend tax credit and 25% in capital gains.

The difference in estate values over 50 years comes from the large appreciation in the value of the invested assets as a result of favourable tax treatment, which assumes total tax deferral in the first 20 years and then reduced taxes in the following 30 years.

Specifically, Dennis recommends initially investing all the assets in the corporation’s investment account in investments that generate no taxes or income, such as NexGen Compound Growth Tax Class fund, so all taxes are deferred. When David is 65, the assets would be invested in investments that pay a fixed monthly distribution of 6% a year, such as NexGen Dividend Tax Credit Class. That would cover the $100,000 in annual spending that David and Sharon desire, while the rest of the money remains in the compound-growth funds. The investments in these funds would be diversified by geography, sector and investment style, and the corporation would continue to hold them after David retires.

With this approach, David and Sharon will be able to access the income they need in a flexible way and at a relatively low tax cost. As a result, Dennis projects that the couple will be able to leave their children $500,000 after taxes in investment funds and $700,000 in life insurance proceeds, meeting the goal of $600,000 for each.@page_break@Lakhani’s projections, which assume an asset mix of 40% fixed-income and 60% equities, an average return of 6% and an annual inflation rate of 3%, show that the couple will have sufficient assets to last until age 95. At that point, their estate would be around $1.2 million in today’s dollars, primarily in life insurance proceeds. This would allow $600,000 for each child.

The strategy that Lakhani suggests is to set up an IPP, which would be turned into a locked-in retirement account when the couple retires at 65 and from which both David and Sharon can draw.

IPPs allow greater annual contributions than RRSPs, starting at about $45,000 combined for the couple, and rising to $200,000 when David is 65. By regulation, these plans must produce an annual return of 7.5%. If that amount is not achieved through investments, the corporate owner of the IPP must make up the shortfall. Such makeup contributions are tax-deductible for the corporation.

At retirement, a portion of the LIRA transfer would be taxable, which could be mitigated with proper tax planning. For example, Sharon’s income could be planned so that she has no other taxable income during the year of transfer, says Lakhani. Alternatively, some of the funds could be transferred tax-free to a life annuity, which would provide a guaranteed source of income as a hedge against longevity risk.

Lakhani recommends passive investments, such as bonds, for the fixed-income portion. He also suggests that these investments be held in a universal life insurance policy because interest earned within an insurance policy is not taxed until it is withdrawn. As for the equities, he suggests indexed funds or index-based mutual funds that are split equally among Canadian, U.S., European and a combination of emerging markets and real estate investment trusts.

Lakhani notes that David’s corporate structure allows for extensive income-splitting because the dividends for each share class can be set at whatever level is most tax-efficient. However, he advises, dividends should be paid to the children only when they are adults and should be limited to covering their education costs.

Lakhani also suggests paying off the mortgage immediately with a one-time dividend to Sharon. Without mortgage payments, the couple can contribute to tax-free savings accounts.

Dennis recommends extra mortgage payments of $25,000 every five years, which would result in the mortgage being paid off in 16 years.

Both advisors suggest critical illness insurance but don’t think long-term care insurance will be needed, given the expected growth in assets. Dennis recommends $150,000 in permanent CI insurance for David and $75,000 in term-10 CI for Sharon. He suggests a return-of-premium policy that could be triggered after 20 years. Lakhani suggests term-20 CI insurance of $150,000 for both spouses. He also suggests that the corporation set up a health-spending account to be used to pay medical bills for any member of the family,

In addition, Lakhani recommends a joint last-to-die life insurance policy for $700,000. This would cost about $10,000 a year, but would be fully paid up in 20 years. At that point, the death benefit would increase with the return on the underlying investments to $1.2 million at age 95.

Lakhani also suggests the term life insurance be raised to $3 million for David and $1 million for Sharon, and that all life insurance policies be owned and paid for by the corporation.

Because of the tax deferral in Dennis’ approach, there will be a material tax bill — about $318,000 at age 95 — to be paid by the children, so Dennis suggests joint last-to-die life insurance of $1 million, which would cost about $1,800 a year, to provide funds to pay that tax bill so that investments don’t have to be sold immediately to pay it. The insurance premiums would reduce the size of the pre-tax estate but leave the children with at least as much after taxes.

As long as Dennis is managing the assets, he would not charge a fee for developing and monitoring the financial plan. He would, however, charge a 1% fee for the tax-deferred funds.

Lakhani’s annual fee is 1.25% of assets if the assets are less than $1 million. His fee falls to 1% for assets of $1 million or more. IE