Help clients keep windfalls

When Linda and John Wright* inherited $350,000 a few years ago, they thought they were set for life. They had two grown sons, a mortgage-free home and modest savings.

“Like many people, they saw the cash as a financial windfall,” says Jerry Olynuk, vice president and portfolio manager at Matco Financial Inc. in Calgary. The couple made major renovations to their home and loaned one son some of the inheritance to open a restaurant. Although he had a spotty work history, they felt he was going in the right direction.

But that initial loan was just the beginning. Soon the Wrights were fielding regular requests for cash to keep the restaurant afloat. To stem the draw on their savings, they made loan guarantees in lieu of investing. Their reasoning: in a pinch, the restaurant equipment could be sold to pay the loans back.

But when the restaurant failed, the hapless couple learned their son had already flogged most of the equipment. Left on the hook for the loan, they sold their home.

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Unfortunately, “the market did not place the same value on the renovations as they did,” says Olynuk, who counselled the Wrights after they sought financial advice. “They sold at a considerable discount and ended up delaying their retirement plans in order to make up the lost financial ground.”

Death and taxes

Many clients are surprised to discover inheritances are tax-free in Canada, says Cory Daly, a Regina, Sask.-based advisor. The estate’s executor ensures taxes and fees come directly out of the estate. But that doesn’t mean there are no issues associated with taxation on a bequest.

“The immediate tax is not an issue,” says Vancouver financial advisor Dylan Reece. “It’s the ongoing tax. The investment income that comes from interest, dividends or rental income can push up a client’s personal marginal tax rate. That may result in clawbacks to OAS or GIS payments, or a reduction in government subsidies for long-term care facilities or co-op housing, “where your rent is based on your income.”

To minimize the tax burden, consider the following strategies:

• Spousal loan. The higher-earning spouse loans part of his or her inheritance to the lower-income earning spouse at CRA’s prescribed rate of interest (currently 1%). The lending spouse then has to report the interest paid as income, and the lower-earning spouse claims the interest payments as a deduction. Ultimately, says Reece, “The lower-earning spouse has only to make a return greater than 1% for the couple to end up with a lower overall tax bill.”
• Inter vivos (living) trust. Clients transfer their inheritances immediately into this type of trust. “The trust files its own tax return,” says Reece. “Because it’s not reported on the individual’s tax return, it may not cause your client to use benefits.”
• Family holding company. Transfer the inheritance into a family business. Again, the corporation files its own income tax return. Explains Reece: “The client can allocate the income earned in the company to themselves, their spouse or even their children, who would be shareholders.”

Such scenarios are far too common

“As many as 70% of individuals who receive inheritances or windfalls fritter the money away in the first one-to-three years,” says Olynuk.

Advisors must intervene so clients can enjoy their newfound wealth while still improving their financial pictures for the long term.

That requires an in-depth understanding of where your client is right now. Cory Daly, owner of Daly Financial Group Inc. in Regina, Sask., says the best thing to do with an inheritance depends on clients’ ages, assets, dependants and financial goals, not to mention issues surrounding taxation, OAS clawback, estate planning and blended marriages.

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“When you receive a windfall, you really have to start from scratch,” he says.

The emotional factor

“The first thing I’d suggest to anybody who comes into unexpected cash flow is to do nothing,” Daly says.

He adds, “Don’t make any plans. Don’t take any phone calls. Don’t do anything until you’ve had a good chance to think.”

Dylan Reece, a financial advisor at Nicola Wealth Management in Vancouver, advises clients to park their money in a high-interest savings account or a short-term bond until they come up with a plan. They may be dealing with their own grief, as well as the emotional fallout from sudden wealth, and may not be financially savvy, he says. “That doesn’t always make for good decision-making.”

Other clients feel guilty about benefiting from death and resolve to preserve the nest egg for future generations at all costs. They may deal with the windfall ultra-conservatively, giving up the chance to reap decent returns on some investments.

Still others treat an inheritance as inexhaustible. “They’ll dip into it and just keep dipping into it until the core of it is gone,” says Olynuk. And, he contends, the bigger the inheritance, the greater clients’ tendency to spread themselves too thin.

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Consider Reece’s client. When he passed away prematurely, he left his two daughters a “couple million dollars,” says Reece. But the women, both in their mid-20s, weren’t working at the time, and now “they’re really not motivated to seek employment.” Instead, for the last four or five years, they’ve been racing through cash, each spending about $150,000 per year—an unsustainable amount if they’re to preserve the capital for the rest of their lives.

The initial number is often mind-boggling. “A million dollars was, and still is, a lot of money,” Olynuk says. “But clients may attempt to satisfy too many personal and family objectives—making major purchases and extending loans to family members—to a point where the principal is whittled down and not really critical mass anymore.”

But, as the story of the Wright family showed, that’s not always the case.

The power of projections

So how do you prevent clients from making flawed decisions in the wake of an inheritance?

Reece says the most potent tool at your disposal is the financial projection.

In the case of the two 20-somethings, “We tried to curb their behaviour by preparing income projections that show what their financial pictures look like if they continue spending at that pace,” says Reece. “Since then, they’ve been more inclined to at least reduce what they’re spending.”

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By contrast, the client who invests too conservatively can see the long-term effect when investment growth doesn’t keep pace with inflation. Even if he still wants to keep the inheritance in risk-free investment vehicles, “we might take on more risk in other areas of the portfolio to balance that out,” says Reece. “Or we might say, ‘If you just want to put that money in GICs or bonds you might consider using an insured annuity strategy.’ ” (See “Legacy for the future,” below.)

Olynuk advises clients to set spending priorities.

His go-to formula for allocating inheritances: first pay off high-interest debt, then low-interest debt; top up RRSPs and TFSAs; and finally increase non-registered investments and emergency savings.

Money left over can be allocated to children’s education expenses, purchasing lifestyle assets and donating to charities. As Daly points out, there’s nothing wrong with allocating a portion of the inheritance for a special trip or a new car.

“I certainly would want to have a little bit of fun and enjoy it,” he says.

When their ship doesn’t come in

“When we do retirement income projections, we generally don’t include inheritances, unless the receipt of it is imminent,” says Dylan Reece of Nicola Wealth Management. Elderly relatives may be funding health care and other needs for a long time, and that can quickly eat through capital.

But how advisors counsel clients and what clients actually do are sometimes different. So what happens if you have a client who’s not getting an inheritance, but has spent as if she will?

“The first thing we’d do is a detailed projection,” says Jerry Olynuk of Matco Financial Inc., “even if it’s not pretty.” Basic calculations include: time until retirement; current savings, spending rates and assets; projected rates of return based on risk tolerance; and the amount the client can afford to save yearly.

On the opposite side is the amount of income required in retirement. If there’s a gap, they can fill it by “either spending less and saving more now, or increasing earnings by generating a higher rate of return on investments, or by deferring retirement,” says Olynuk.

Reece encourages clients facing limited income streams in retirement to begin living on that budget several years before they actually quit working. “It makes the transition less abrupt,” he says. And, reducing spending now lets them put additional savings into their retirement accounts.

Legagy for the future

Let’s say a 70-year-old client invests $1 million from an inheritance in a prescribed life annuity. It generates pre-tax income of $79,356 per year (the annuity income based on current Cannex quotation) for as long as he lives, of which only $6,892 would be taxable.

Subtracting income tax ($3,012) and the cost of insurance ($41,327, based on a quote from LifeGuide) gives the client a net income of $35,017.

“When he passes away, his beneficiaries will receive the original $1 million directly from the insurance company,” says Vancouver financial advisor Dylan Reece. If the beneficiary of the policy is anyone other than the estate, the death benefit would not be subject to estate costs and probate fees, or the claims of the deceased’s creditors or action under B.C.’s Wills Variation Act.

The only catch: your client must pass a physical exam in order to qualify for life insurance.

Compare that to a GIC earning 3%. The gross income on that $1 million fixed-income investment would be $30,000 a month—all of it taxable. Subtract $13,110 in yearly income tax and the net after-tax income is $16,890; about half that provided by the life annuity.

What’s more, the $1 million would be considered part of the client’s estate and, as such, would be subject to probate fees.

Clients can also donate some of the inheritance to charity to honour a parent’s or relative’s memory, Reece points out. The donation will generate a tax credit that can be used over several years “to significantly reduce the taxes that individual pays,” he says, “so, on a net basis the cost of the gift is significantly reduced.”

*Names have been changed

Camilla Cornell is a Toronto-based financial writer.