George will pay tax on the taxable portion of the gain at his marginal tax rate of 35%. His tax liability will be: $ x 35% = $133.

Transcription

1 FILE 41: Taxation of Investments Taxation of Interest George Hammy invested in a Canada Savings Bond from which he received $765 in interest. George is in the 35% marginal tax bracket (federal and provincial taxes combined). He must pay: $765 x 35% = $ in tax. FILE 41 George keeps $ ($765 -$267.75). Taxation of Capital Gains If George s investment in a stock did not pay dividends he might decide to sell his shares. If the price of the shares has increased since he bought them and he earns $765 more than he paid, he will have to pay capital gains tax on 50% of the increase. $765 x 50% = $ George will pay tax on the taxable portion of the gain at his marginal tax rate of 35%. His tax liability will be: $ x 35% = $ in taxes George will keep $ ($765 - $133.88). Taxation of Dividends To determine the taxable dividend income from which federal tax payable for a public corporation in Canada that is subject to the general corporate income tax rate: If George received $765 as dividends from the Canadian corporation, he would include $1, in income for tax purposes ($ % = $1,109.25) The $ ($1, $765 = $344.25) is called the gross up. $1, is the taxable dividend income Total federal tax payable is calculated as the taxable dividend income multiplied by George s federal tax rate (note: not marginal tax rate). If the investor's federal tax rate is 26%: $1, x 26% = $ in total federal tax payable Copyright 2010 Oliver Publishing Inc. All rights reserved. +65

2 The dividend tax credit is 19% of the grossed up dividend income (not of the total federal tax payable) or 27.55% of the actual dividend received. $1, x 19% = $ is the dividend tax credit The federal tax payable is the total federal tax payable less the dividend tax credit: $ $ = $77.65 is the federal tax payable on the dividend received Provincial tax must then be calculated. There is also a provincial dividend tax credit and a provincial tax rate to be applied; both of which vary by province. Let us assume that in the province where the investor lives the provincial tax payable nets out at 8.5% of the taxable dividend income (after the provincial dividend tax credit and any provincial investment surtax). $765 x 8.5% = $65.03 in provincial tax payable Total tax payable is net federal tax payable plus provincial tax payable. $ $65.03 = $ George keeps $765 - $ = $ Conclusion By investing in a stock rather than a bond, in theory, George is ahead by $ ($ $ = $ the after tax dividends less the after tax interest from his Canada Savings Bond). However, dividends are not guaranteed while interest payments on a bond are. In summary, he pays the most tax on interest he has earned from his Canada Savings Bonds ($267.75), less on dividends from his stocks ($142.68) and the least on a capital gain when he sells the stock ($133.88). However, just as dividends are not guaranteed, neither is a capital gain. If Walter is a risk-averse investor, then the Canada Savings Bond is the best investment; if he accepts some risk, then aiming for a capital gain is his best bet. +66 Copyright 2010 Oliver Publishing Inc. All rights reserved.

3 FILE 42: A Comparison Chart of Mutual Funds and Seg Funds Mutual Fund Segregated Fund Benefits payable no the guarantees specified in the policy contract Consumer protection Insured by the Mutual Fund Dealers Association up to $1 million per client provided by Assuris up to $60,000. FILE 42 Creditor protection none named beneficiaries are protected; in case of bankruptcy, fund must have been held longer than one year Death benefit none 75% of initial deposit (less any withdrawals) as a minimum Disability waiver none if deposits are made on a periodic payment schedule to the fund, they will be continued by the insurer to a maximum amount if the contract holder is disabled Disclosure documents Distribution of income Estate planning issues prospectus: law stipulates that the document includes details on objectives, risks, sales charges, and calculation of the net asset value only to unit holders on record at end of calendar year proceeds become part of the estate and subject to probate fees information folder: can vary among companies; guidelines exist as to what the information folder must include but they are not governed by their provincial securities commission time-weighted so that income is received proportionate to the length of time during the year that units are held proceeds bypass probate unless estate named as beneficiary Frequency of valuation daily and possibly weekly monthly and possibly daily Maturity guarantees none 75% of deposits (less any withdrawals) as a minimum after 10 years; no maturity guarantee before 10 years Nature of units unit holders have rights to vote and receive distributions units are notional; they determine the value of benefits payable; no voting rights Ownership of assets assets are owned by the fund assets belong to the insurer Partial withdrawals yes yes Risk varies according to the assets in the fund; regardless of assets risk is greater than segregated fund RRSP eligibility yes yes Sales and licensing requirements & product approval & regulation Taxation of nonregistered contracts regulation and product approval through provincial securities legislation, license from the Investment Funds Institute of Canada required for sales income received as interest, dividends, and capital gains; capital losses are not received by investors until units sold varies according to the assets in the fund but risk is less than mutual funds because of the guarantee regulation and product approval through provincial insurance legislation, life insurance license required for sales income received as interest, dividends, and capital gains; capital losses are received by investors Copyright 2010 Oliver Publishing Inc. All rights reserved. +67

4 FILE 43: The IVIC Maturity Guarantee FILE 43 Your client signed a contract on April 15, 2002 to buy into a segregated fund. The payment that accompanied that contract is $10,000. On April 15, 2012, the investor will receive at least $7,500, if the maturity guarantee of the contract is 75%. On April 15, 2012, the investor will receive at least $10,000, if the maturity guarantee is 100%. On April 15, 2012, regardless of whether the maturity guarantee is 75% or 100%, if the value of the contract is greater than the guarantee, the investor will receive the actual value of the contract. For instance, if the value of the contract is $14,895, the investor will receive $14,895. In this case, the maturity guarantee is not invoked because the amount the investor will receive is greater than the amount guaranteed at maturity. +68 Copyright 2010 Oliver Publishing Inc. All rights reserved.

5 FILE 44: Creditor Protection in an IVIC Jim Morgan ran his own consulting business for 17 years from his home in Kingston, Ontario. During this time, he accumulated a portfolio worth $170,000 in Canadian shares and mutual funds. When Jim died suddenly, his suppliers came forward with outstanding invoices equaling $37,500. Jim s son, Mark, who was his sole beneficiary, saw his inheritance significantly eroded as follows: FILE 44 $170,000 - (minus) probate fees of $2,550* - (minus) creditors claims of $37,500 = $129,950 (*Probate fees are calculated before creditors claims are deducted; the probate fee in Ontario is 1.5%.) Mark s inheritance, therefore, was $129,950. If Jim had invested in segregated funds that had a value of $170,000 on his death, with Mark as beneficiary, Mark would not be required to pay either creditor s claims or probate; he would receive the full $170,000. Copyright 2010 Oliver Publishing Inc. All rights reserved. +69

6 FILE 45: Comparing Withdrawals from an IVIC FILE 45 Read these details and then use your calculator to determine the answers to the questions. Danny Warbachs bought 1200 units in a seg fund at $30 per unit. The fund guaranteed a 75% return on the initial deposit. In less than two full years, the increase on a per unit basis in the seg fund was $8.00. Following the increase, Danny withdrew $15,200 from the contract. a) How many units in the fund will Danny need to surrender to make the withdrawal? b) Using the linear reduction method, what is the value of the guarantee in the contract following the withdrawal? c) Using the proportional reduction method, what is the value of the guarantee in the contract following the withdrawal? d) Assuming the ACB of the contract was $36,000, what capital gain if any must Danny report as a result of his withdrawal of funds from the contract? Danny needs to surrender 400 units from the fund ($15,200 $38 = 400) Using the linear method of reduction, the new guaranteed value in his contract is the original value of the fund minus the amount of withdrawal multiplied by 75% ($36,000 - $15,200 = $20,800 x.75). Thus, the new guaranteed value is $15,600 The proportional method of reduction uses the new balance of units in the fund ( = 800). The new value of the fund is based on the new number of units divided by the original number of units multiplied by the original value of the fund ( x $36,000). Thus, the new value is reduced to $24,000. The guarantee is therefore $24,000 x 75% = $18,000. Since Danny disposed of one-third of the contract ($15,200 $45,600 =.333), he must report a capital gain of $3,196.80, which is one-third of the difference between the ACB of the contract and its market value at the time of the withdrawal ($45,600 - $36,000 x.333 = $3,196.80). +70 Copyright 2010 Oliver Publishing Inc. All rights reserved.

7 FILE 46: An IVIC Investment Shelley and Bob Palmer are 46 and 49 years old, respectively. They have struggled for years financially after Bob became self-employed twelve years ago, and failed to produce more than $5,000 annually in income from his business. Bob returned last year to the traditional workforce, and has landed a good job with an annual salary of $56,000. FILE 46 The Palmer s want to start saving some money for retirement but they have witnessed their friends lose vast amounts of money in the stock market, and equity-based mutual funds over 2001 and They budget $200 a month as an amount they can be comfortable putting aside. Their RRSPs each have lots of contribution room since neither has a private pension. Question: How should they invest their money? Situation Analysis Their time horizon is somewhat limited since, in theory, Bob might want to retire at 60. They cannot afford to risk their money at this point. They are prepared to make a commitment towards an investment. Their RRSPs are not topped up. Recommendation A segregated fund held in an RRSP will provide the guarantees they need in a tax-deferred plan. The Palmer s will have a contract with a policy-based guarantee. The maturity guarantee will return 75% of their initial deposits 10 years after the end of each year during which they are investing. The death benefit of the contract provides an insurance element. To ensure each is provided for, they should split their $200 into two contracts with a $100 deposit made to each. Each contract should name the other spouse as beneficiary. This means establishing both contracts within RRSPs. If they achieve growth that they want to lock-in, they can exercise the reset option and will be able to access their funds ten years after that date. Copyright 2010 Oliver Publishing Inc. All rights reserved. +71

8 Agent s Course of Action The agent completes Know Your Client forms for both Shelley and Bob. In doing so, she is better able to assess their risk tolerance which she finds to be quite low. She delivers the Information Folder, Summary Fact Statement, and Financial Statements for three funds: a balanced fund, a dividend fund and an asset allocation fund. Shelley and Bob must make the final decision between the funds available to them. The agent points out to the Palmers the websites where they can monitor the performance of their funds. The agent suggests the Palmers buy their funds on a deferred sales charge basis because over the intended period that the funds will be held, the sales charge will be eliminated. The Palmers are confident that Assuris will provide coverage if their insurer should fail. +72 Copyright 2010 Oliver Publishing Inc. All rights reserved.

9 FILE 47: Illustration of a Life Annuity Walter Burke is 70 years old. Like many of his generation, he invests his money carefully. He struggled and saved throughout his working years to acquire a very comfortable nest egg and the last thing Walter wants is to invest in stocks or mutual funds and run the risk that his capital will diminish. FILE 47 However, Walter is also a wise enough investor to realize he has a problem: his most popular investment is Guaranteed Investment Certificates. He is earning about 3.5% on his GICs. But, the inflation rate is close to 3%. Therefore, the real rate of return on his investments is only about 0.5%. Plus, he pays income tax on the 3.5% return at his marginal tax rate (38% last year). His capital is actually decreasing in real value. Walter has close to $1.4 million in capital. His family is very dear to him since his wife passed away four years ago after battling breast cancer. His daughter, Heather, though qualified as a tax lawyer, now stays at home to raise four precious grandchildren. Money is a bit tight in her family and it is very important to Walter to plan his estate in such a way that maximizes the amount of money his daughter receives. That day, though, is some time in the future. Walter is in excellent health. He looks 55, runs two miles every day, plays golf and tennis, and is learning how to snowboard. He spends two months every winter in Arizona, and every September joins a bike tour of the vineyards of Provence. He receives a handsome pension from his former employer, the South River Board of Education, and withdraws about $80,000 annually from his GICs to supplement his pension. With a little more income, Walter thinks he would buy a cottage where he could spend a month in the summer with Heather and the kids. Walter covered his cash and income needs when he was younger with a term life policy. He allowed the policy to lapse when he was 55 because the premium cost was becoming quite costly and, more importantly, his needs no longer required insurance. Walter s lifestyle requires a certain amount of income to maintain because he likes the way he lives. However, he is uncertain about what course of action to take with his investments. Question How can Walter protect his capital, maintain his income, and leave a sizeable bequest to Heather? Copyright 2010 Oliver Publishing Inc. All rights reserved. +73

10 Situation Analysis Walter s health is good none of his activities would require a rated policy he has significant capital with which to work Recommendations Walter will need to work with two life insurers. From the first insurer, he should purchase a prescribed life annuity for $1 million. He keeps $400,000 in GICs in case he wants to access a large lump sum of cash to buy the cottage. The annuity will pay an income of $70,000 annually. The taxable portion of the payment is $30,000 and he pays $11,800 in tax. His net income from the annuity will be $58,600. From the second insurer, Walter should acquire a term-to-100 policy on his life for $1 million. Given his health, there should be no problems acquiring the policy. Premiums will be about $25,000 annually. The policy names Heather as beneficiary. Term-to-100 is the best choice among the types of permanent insurance because the premium cost is the lowest. After these policies are put in place, Walter retains $33,600 annually. However, what he has accomplished is: a small increase in net income the ability to maintain his lifestyle more money left to Heather on his death than if he kept his money in GICs. Depending on the predicted future rates of return, Heather should receive approximately $1 million instead of the $700,000 she would have otherwise received. Walter with GICs Walter with Annuity Amount of capital $1,400,000 $1,000,000 invested Return on investment 3.5% 3.5% Dollar return $49,000 $70,000 Taxable income $49,000 $30,000 on prescribed basis Tax paid at 38% marginal $18,620 $11,400 rate Net income $30,380 $58,600 Cost of term-to-100 n.a. $25,000 premium Net retained $30,380 $33,600* *This amount is understated by about $8,600 because Walter continues to hold $400,000 in GICs. +74 Copyright 2010 Oliver Publishing Inc. All rights reserved.

11 Agent s Course of Action Agent A writes the term-to-100 policy with a face value of $1 million naming Heather as beneficiary. Agent B writes the life annuity policy for $1 million as a cash refund annuity so that Heather will receive the difference between the purchase price of the annuity and the income Walter received in the event he dies prematurely. Both agents document the decisions made by Walter if Heather should question their actions at a later date Copyright 2010 Oliver Publishing Inc. All rights reserved. +75

12 FILE 48: Illustration of a Life Annuity FILE 48 Nick Spanos immigrated to Canada fifty years ago with his parents. He is now 61 years old. When Nick was 29, he and his wife, Anna, bought a small restaurant. For thirty-one years Nick and Anna worked at the restaurant and earned enough income to put each of their children through university; one went on to become a lawyer, another proceeded to medical school to become a doctor. The Spanos paid off the mortgage on their house and then redirected the funds that had been going into the mortgage to their RRSPs. Two years ago, Nick and Anna decided that they had had enough of restaurant life; they sold the Eat and Run and netted $250,000 on the sale. At the time, Nick and Anna were both in good health but Nick s concern was that he would outlive his financial resources. Longevity is in Nick s genes: both his father and grandfather lived well into their nineties. Their retirement income would consist of their RRSPs, CPP retirement pensions, and OAS. Nick is suspicious of mutual funds and investment in general, and Anna defers to Nick in respect of family finances. Question How should Nick and Anna invest the proceeds of the sale of the restaurant? Situation Analysis They have considerable cash-in-hand to invest. They do not need life insurance since they have no debts and no dependents at this point in their lives. Investing is not in the cards since Nick retains an old world attitude towards saving and investing. Nick and Anna are the embodiment of dependability; therefore, a dependable income source will be appealing to them. Recommendations A joint and last survivor annuity, funded with the $250,000 from the sale of the restaurant, will provide an income for both their lifetimes. If purchased on a prescribed basis, they will know precisely how much income tax must be reported each year. +76 Copyright 2010 Oliver Publishing Inc. All rights reserved.

13 Agent s Course of Action Recommend a joint and last survivor annuity naming Nick and Anna as the annuitants with payments beginning immediately since they have no other income and they do not want to pay withholding tax to start accessing their RRSPs. Nick and Anna agree that the prescribed annuity is preferable so they know exactly how much income they will receive each month. Despite the fact that no payment will be made to their beneficiaries (the children) after death, the children will still be able to share the proceeds from the sale of Nick and Anna s home. Agent learns two years after policy has been delivered of Anna s death, so the annuity payments continue to Nick for the balance of his life. Copyright 2010 Oliver Publishing Inc. All rights reserved. +77