RRSPs and the Government's Secret Tax Weapon

Jonathan Chevreau posted today on a BMO Retirement Institute survey finding that boomers expect to receive huge amounts of inheritance money to pay for their retirement.

A quick skim of the Passing it on study reminded me that in the case of inheritances "what you see is not what you will get". The example box on page four of the report shows how an estate worth $350,000 at death can be chopped in no time down to $223,500. That's even before lawyer and executor fees, or probate fees (taxes) get taken out. The reason is that instead of inheritance taxes Canada has a nifty little tax rule called deemed disposition, whereby upon death a person is considered to have sold all property at fair market value and to have cashed in all registered plans like RRSPs, RRIFs, LIRAs, LRIFs etc. There is an exception that a spouse can transfer the registered plans into his or her name without tax being triggered, but eventually the spouse too will die. Sooner or later there will tax to pay and since everything enters the person's income all in the same year, for almost everyone that will mean falling into a much higher, if not the highest, tax bracket.

Think about it, how many people die penniless, their registered plans depleted to nothing? You and I may withdraw RRSP money during retirement at lower marginal tax rates than while we were working but it is pretty sure that come death, our estate will be paying top rates. The government will end not only recouping its tax deductions but may well end up with more tax! That's the secret weapon. If you are dead, you may not care about paying unfairly high taxes on your estate and it is certainly difficult to complain at that point, or to vote against the government.

I've tried getting stats out of Stats Can and the Canada Revenue Agency about the extent of the issue - e.g. what is the average size of registered plans at death - but none seem to be readily available. (An indicator that this issue is real is suggested by Stats Can's table Private Pension Assets of Family Units, which shows that elderly families in 2005 had a median of $186,000 in private pension assets. Another table shows that the net worth of families 65 and older was a median $303,000, of which maybe half might be a tax-exempt principal residence, but the rest would mostly be in some form of taxable savings.) Better it not be too well known, I guess. People might get upset. The problem may get worse over the years as the decline of defined benefit plans means RRSP-type savings become more and more important.

This issue is one reason I am using my TFSA first since that account is "tax pre-paid" for contributions and any gains are tax free, even at death. It is also a reason to take money out of the RRSP when my tax rates are low.

Finally it is a good reason to donate money to charity since the tax credit effectively would mean no tax to pay even at the top marginal rate on the donated amount. Maybe that's why significant numbers of seniors are planning to donate parts of their estate to charity, not to bequeath it all to family.

The Living Will: a Case of Practical, Legal and Medical Overkill

Beginning with the very name, there is little to like about the Living Will (LW).

First thing wrong, it is a misnomer and has nothing to do with a Will, the document by which you specify what happens to your worldly possessions after you die. A Living Will is described as a document which states more or less what medical treatments you wish to have or not have if you become unable to make or communicate your own decisions and possibly who can speak for you in that event. It seems from this page on the Living Will and Values History Project that the term originated only in 1969, coined by a certain Luis Kutner whose motive appears to have been the promotion of the right to voluntary euthanasia.

This opportunistic piggybacking on the common and established word has caught on but confusion reigns supreme, as evidenced by the proliferation of other terms for the same thing - advance health care directive, advance directive, advance medical directive, representation agreement, mandate, authorization, personal directive, power of attorney for personal care etc.

Why so many terms? The answer reveals problem #1 - different governments have approved different versions and a LW valid in one place may not be recognized in another. Governments includes Canadian provinces, US States and countries of the world - yup, they all have their own since of course their logic and the needs of their citizens are unique. Funny how our needs change when we move from one place to another.... If everybody stayed put in their own little town the different versions wouldn't matter but go off on a work assignment or a holiday and you would need to have a whole series of LWs to paper your trail, all prepared with the help of a lawyer in each jurisdiction in order to ensure their validity there.

Problem #2 is the practical difficulty of letting everyone know who might need to know. Are you going to be able to provide copies to all the medical people who might conceivably need to have your instructions, wherever you might be?

Problem #3 is the one of changing or cancelling a LW, especially as you done what the experts advise (like Douglas Gray and John Budd in their book The Canadian Guide to Will & Estate Planning) and given out copies to your doctor, lawyer, proxy (person granted power to decide for you) and family members. You must go through a formal process, witnessed by two people, to revoke of change a LW. Forget who you gave copies to and you may have conflicting versions, or you might have people act on a version you revoked. Of course, if you stick the LW in a place unknown or not quickly accessible when the need arises, your carefully prepared LW may never get used.

Problem #4 is that your LW may not be followed anyway. The forces of medical officialdom may decide that your wishes are unreasonable or impractical and over-ride them. You may just be creating anxiety, guilt or bitterness by your family if your wishes cannot or are not followed. Can you anticipate every medical circumstance in which you might find yourself and address it comprehensively? There's a reason hypothetical questions are mostly useless.

I do not dispute the motives for making a LW - as expressed in the pdf Living Will within the University of Toronto Joint Centre for Bioethics (you must fill in a free registration to access the copy) - to gain control over your medical treatment and to relieve loved ones of the burden of decisions. (Incidentally, this version of the LW apparently can be valid in seven Canadian provinces so the multiple jurisdictions problem is somewhat mitigated.)

However, is a formal legal document the best way to do this? Wouldn't it be far easier merely to tell your family to follow your wishes and tell them your way of thinking about such matters, give them the latitude to use their judgement and reassure them that you trust their judgement. After all, who will the doctors ask, as ask they will?

If you don't trust your family, you've got real problems. Maybe then you must reluctantly opt for a LW.

The only other limited scenario in which I could see the LW being useful goes back to its origin. If you have a terminal illness so you know what lies ahead, maybe it will be useful and practical to tell others when to pull the plug.

Otherwise, the Living Will is definitely a case of the treatment being worse than the affliction. At least stop using the misleading name.

An Intriguing Free Book to Download plus a UK Mortgage Primer

Check out the Mortgages Exposed web page for access to a free download of the book In My Opinion by Michael Kelly, a successful retired entrepreneur. I've just skimmed through a few pages so don't have a firm opinion of it, but first impression is good: it looks quite readable and hey, it's free and it's the complete 110 page tome, not just excerpts. The style looks breezy and light-hearted, advice on what the grandfather has learned and wants to pass on to his grandchildren. The topics he covers includes some financial and budgeting advice, along with relationship advice (from a guy, no less!), education, children, running a business, being an entrepreneur, gambling and even death.

Here's a sample quote I can relate to: "You need not give self-created wealth away. Spend it first. But if you must give it away, do it when you are still alive and can directly observe and enjoy the happiness it might hopefully bring."

Another part of the website has an excellent series on mortgages as done in the UK, actually another short book that can be downloaded with working spreadsheets. The explanation starts from scratch, assuming little or no investment knowledge, and works through the various types of mortgages and related topics - fixed rate, variable rate, interest only, lifetime/revers/shared appreciation, buy-to-let, gearing, buy or rent - in short all the common situations with tips and tools for comparing and deciding between alternatives. There are a series of downloadable spreadsheets to work your own calculations, perfect for DIY types. There is a little bit of theory and lots of practical guidance. The perspective of someone who spent 30 years in the business shows through, who made his money, retired and is now giving back his knowledge to anyone who wants it. Overall, a gem of a resource.

Why an Emergency Fund? Part 1: Death

It seems to be a common truism or rule of thumb that everyone should have at least three to six months of living expenses in the form of cash. A quick Google search uncovers such advice at About.com, Bankrate.com, bloggers such as ChristianPF.com, TheSimpleDollar.com, the StingyInvestor, mainstream financial journalists like Jonathan Chevreau and professional financial planning guides like the CF1 Manual (unfortunately not available on-line) of the Chartered Insurance Institute's Certificate in Financial Planning in the UK. There is at least one dissenting voice at the Financial Blogger who states that one need only put in place a line of credit. But even he doesn't dispute the basic premise that there is such a thing as a financial emergency, an unexpected event that can provoke dire consequences without a fund.

Being the sceptic that I am, I will take a closer look at how unexpected and how dire such ''emergency events'' really are. Risk analysis and risk handling are a well established discipline in industry for project management (I knew that PM certification would serve me well some day...) so why not apply it to personal financial management? That involves identifying risk events, assessing their probability, the magnitude of the negative consequences, the alternative methods of dealing with the risk (which includes everything from preventing or actively reducing the chances of the risk occurring, transferring the risk to someone else at a price or simply doing nothing and accepting the chance).

Event #1 - Death
Probability - Nowadays, the life expectancy at birth is roundabout 80 years for men and women in Canada. That means it is unusual for people to die prematurely, much as we grieve for those unfortunate few. The younger you are, the less chance of dying soon. Insurance companies know this and charge less for life insurance for young people. In his fine book Insurance Logic (which I have reviewed here), Moshe Milevsky presents some data from Stats Canada that shows how rare is premature death. Though the data is from 1996, there probably has not been a big shift to today; if anything, I'd guess early death is a little less likely. Below is the table reproduced. It certainly surprised me.

What is the Probability of Dying Within the Next 10 Years?

Current Age	Female	Male
30	0.5%	0.9%
40	1.0%	3.0%
50	3.0%	6.0%
60	9.0%	16.0%
70	22.0%	35.0%
80	50.0%	66.0%

Cost - The first direct effect is the cost of the funeral and burial. Estimates range from $4,000 to $15,000 (e.g. Sandra E. Foster in her book, You Can't Take It With You, p.283). It seems the most common number is $5,500 to $7,500. This is a number which obviously can be controlled to a significant degree depending on the options one chooses.

The second effect is the possibility that the person dying may have dependents, for whom the disappearance of the breadwinner may have disastrous consequences.

Risk response -

1. First, note that by the age when death becomes a much more likely event, people will have reached retirement age and probably have accumulated savings or investments of other kinds to pay for funerals. Financial institutions will almost always allow the executor or family members to access such reserves of a deceased person for funeral expenses so it doesn't have to fall on you to pay for someone else before an estate gets freed up by probate. Investments can be sold within a few days and the money made available long before the bills come due.
   
2. Second, as noted above, death expenses can be kept at the lower end and that can decided at the time of the event.
   
3. Third, a person can avoid the problem by pre-paying for funeral expenses to a funeral home. The amount put aside can even grow tax-free waiting for your demise, a last comforting thought for those scrooges among us. Since for all but one person in history (and even that is disputed by some), death is a certainty, if you have the capability of putting money aside for an emergency fund then you can also direct that money to pre-paying your funeral.
4. Fourth, you can buy life insurance or just funeral expense insurance. This can spread the cost out in small monthly payments. Maybe you will even die early and get a bargain.

The response to the support for dependents should be dealt with through insurance, not an emergency fund. Death isn't temporary so a short-term fund of six months of living expenses won't do the job.

In short, death isn't a good reason to have a highly liquid emergency fund.

But there are other possible reasons that I will examine in the next posts: job loss, home repairs, injury or illness, car repairs, divorce/separation, legal problems, care for parents/relatives, pregnancy, wedding. And once all these have been reviewed we'll see where that leaves us overall.