Leanne graduated with an honours chemistry degree from McGill in 1980 and has spent the last 34 years with the marketing arm of a private pharmaceutical company. She rose through the ranks and has been director of marketing for 10 years. The job requires extensive field sales work and comes with a $185,000 annual salary, plus annual bonus. Long hours and a travel schedule that kept her on the road for 234 days a year means she never married or had kids. She owns a studio apartment in Ottawa, Ont. free and clear, but has never thought of it as home since she’s rarely there. Her parents are dead and her closest family ties are her brother, sister-in-law and their two daughters. She dotes on her nieces, sending gifts from her travels, and says if there’s anything left to form an estate after she passes, it will go to the two of them. She’s never written a will.
One week ago, Leanne received severance notice from her employer, which included: an option to take early retirement; receive a lump-sum severance equal to 26 weeks salary and retain her DB pension (in which she’s fully vested), with a payout date starting at age 65; or receive a lump-sum severance payment and commute her pension. She was given a 60-day window to choose how she’ll be paid out.
Executive Director, Private Client Group & Portfolio Manager, HollisWealth
She also has significant vested stock options (6,000 shares) at a strike price well below what other executives sold the stock for recently. If she takes a lump-sum severance payout, her option to exercise the stock purchase times out in one year. If she takes retirement, that’s extended to two years. Her hectic working life meant she never had time to spend her earnings, so she has sufficient cash on hand to exercise on the options.
She also owns 2,000 shares outright, but has expressed ambivalence about increasing her share position because, she says, “the company kicked me to the curb.”
At her age, Leanne’s convinced she’ll never get another job. She met with three recruiting firms, had one job interview, and was consistently told her salary expectations vastly outstrip what’s being paid by companies today. So she’s frustrated, and presumes that what she gets from this package is all she’ll have to live on for the rest of her life.
She’s concerned about the tax implications of a lump-sum payout from both the severance and by commuting the DB plan, but is leaning toward that option because it provides the cleanest break from her former employer.
Planning for a longer life
GR: Let’s develop some assumptions. For instance, she might never go back to work. Or, perhaps, she works as an independent contractor so she can write off business expenses. All of this planning will help her think rationally.
JW: And since she can expect to live another 30 years, based on recent statistics, I’d suggest she hold on to her defined benefit (DB) pension, which will pay her for life. One of the concerns I think some people have with taking the DB pension is that, if they die early, there are no benefits for their survivors. But given that she’s single and has no direct dependents, she should take the pension. The question is whether she should start it now or wait until she’s 65. Most plans have a fairly punitive reduction, but not all do.
Let’s assume the plan has an early retirement reduction of 5% a year before age 65. If she collected early, she’d experience a 45% reduction in the pension she’d receive, which means she won’t have an adequate income replacement.
So she must find a way to postpone collecting her DB pension to age 65. If she does, she could probably get about 60% of her pre-retirement income from her DB plan—that’s taking the CRA pension cap into account.
Add to that government benefits, including CPP and OAS, and she might end up with about 80% of her pre-retirement pay. The problem is, how does she get from 56 to 65? Since she’s barely spent most of her income, she must have some savings, perhaps unregistered, so she could use that.
Also, if all she ever did was work and she has no family or dependants, then the worst thing for her to do is stop working completely, since she’s so used to it. Aside from the psychological benefits of a career, she’ll get an income too. She may not find a full-time job somewhere, but she could set up a consulting firm or find contract work.
PC: The tax issues are almost the same, irrespective of which option she takes. If she takes severance, there are provisions in the Income Tax Act to roll all, or a portion, of her retiring allowance into an RRSP. There are some rules around the mechanics. For instance, there’s a $2,000 limit she can transfer for each year of service before 1996. There’s also an additional $1,500 for each year prior to 1989, when her employer was not required by law to make vested contributions to a registered pension plan on her behalf.
If she transfers directly into an RRSP, she’ll be in a lower tax bracket, and she does not pay tax immediately on that severance amount. If she has the capacity to transfer her lump sum into an RRSP, then she could withdraw income from the RRSP over that nine-year period and spread the tax hit. Another issue is whether she has built-up RRSP contribution room. If she does, then in addition to the capacity to transfer all or a portion of the severance amount into an RRSP, she could also catch up on unused contribution room.
JW: But because interest rates are so low, CRA has capped how much you can actually transfer into your RRSP. So if she commuted her pension, there’d be a cap and she’d have to take part of it in cash, which would mean she’d have to pay tax. The tax rate is treated like income.
PC: Since the company’s private, there are no income tax consequences until Leanne actually disposes of the shares. So she can exercise the option and acquire the shares, and she doesn’t have to include the proceeds in income until she actually disposes of the shares. That’s because while public company shares have easy access to liquidity, private company shares do not. The tax rules are built around the assumption that private companies have limited liquidity. When the shares are actually sold, the difference between the fair market value of the shares at the time the option was exercised and the option price, will be taxed as employment income. And then there is the capacity to reduce that benefit by 50%, so that it mirrors the taxation of capital gains.
GR: And what’s the magnitude of disposing of those stock options? It could be a $10,000 gain, or a $100,000 gain. If it’s big, she may want to time the execution, so that it straddles two tax years.
PC: Yes, and she may also have the opportunity to utilize the lifetime capital gains exemption, which is $800,000. But I’m a bit concerned about the concentration of wealth in the ownership of her 8,000 shares. If they’re worth a considerable amount, there are probably some restrictions in terms of liquidity. She can’t wake up one morning and decide to liquidate a share interest in a private company, unless there are provisions, say in a shareholder’s agreement, that allow for that. She also needs to separate her emotions when making this decision. The shares are worth more than the option price, so even though she doesn’t like the company, why wouldn’t she take the opportunity to acquire those shares?
PC: She might think that, just because she’s single and doesn’t have any dependants, she doesn’t need a will. But there are many implications of not having a will. In Ontario, if she doesn’t have a will and her brother survived her, her estate would flow to him upon her death. If her objective is to have her wealth pass to her nieces, she must have a will.
GR: And when creating the will, she should consider whether she wants any of her wealth disbursed to her brother and sister-in-law. Are there any marital issues between them? If so, she must consider that her wealth could be attacked under family law if they ever split.
And since she’s leaving money to her nieces, how should the trust be handled? Have they reached the age of majority? Half a million dollars in the hands of an 18-year-old can be positive or negative, depending on the individual.
There could be some advantages to the proposed changes in legislation to testamentary trusts. Leanne can now reach from the grave, so to speak, and continue to control the trust if she establishes proper provisions. For instance, she could have her brother and/or sister-in-law as trustees, and then set up some mechanical formulas to allow the nieces access. Say they go to university—they’d get funds for that.
PC: Under the 2014 federal budget, the changes for testamentary trusts limit access to the marginal tax rates. However, I wouldn’t allow these changes to dissuade Leanne. There’s still a three-year window where the marginal tax rates will apply.>
*This is a hypothetical client. Any resemblance to real persons, living or dead, is purely coincidental.
Originally published in Advisor's Edge Report
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