Posts from the ‘Legal’ Category

Feb 8

Advanced Mixology: The Strategic Use of Retirement Assets

(Or How to Thwart the Taxman, Maximize your Retirement Dollars and Sleep 18% Better)

When talking to with retirees, wanna be retirees or children helping their older parents manage their nickels, dimes and c-notes, it’s almost certain that the best way to deplete retirement assets will be part of the conversation. And, that’s exactly as it should be. A well-thought-out retirement strategy can lead to staggering tax savings, greater flexibility and, most importantly, the ability to sleep that much deeper at night knowing that you’ve done as much as reasonably possible to achieve your financial goals, which seldom means making unnecessarily large contributions to our friends in Ottawa.

I’ve written about many different aspects of retirement planning in previous articles, including a series on RRSP / RRIF withdrawals, but I wanted to pull a bunch of different ideas from my previous efforts together, along with some new points to help anyone faced with these conundrums.

What This Article Can’t Do

Despite my strong wishes to the contrary and no matter how pretty or detailed any cashflow projections may look, retirement planning remains a series of educated guesses, many of which will ultimately be off the mark, often within days. How many people predicted the huge spike in inflation following Covid? What about the changes to capital gains taxation in the last Federal Budget? Or the changes to small business taxation over the last 10 years? These examples do not even speak to the more obvious unknowns, like lifespan, income needs and investment returns. Moreover, on that last subject, those of you that have read my previous article on how the “sequences of returns” generated by your portfolio affects your long-term results, you’ll also know that all 7% average portfolio returns are not created equal – bad returns early in retirement can have a disastrous impact on later portfolio sizes, particularly if forced to liquidate capital during the downturns, regardless of later market corrections.

Accordingly, despite my wishes to the contrary, I cannot provide a one-size fits all roadmap, nor can I guarantee that any perfectly plausible plan I prepare today will still be the best way forward if one of life’s surprises strikes you squarely between the eyes. On the other hand, there are a lot of common-sense principles, mixed in with some basic math, that I think can help tilt the odds in your favour. Moreover, the larger your nest egg, the shorter your expected timespan wandering this wonderful world, and the more pessimistic your projections of things like investment returns or spending needs, the smaller the chance of things going drastically awry. Accordingly, despite my dire proclamations, I firmly believe that the benefits of proper planning can usually help you cope with future surprises, provide wiggle room if you need a little more or earn a little less, and hopefully still save a lot of taxes along the way. Although we can’t predict the future, making reasonable assumptions, taking proactive steps and regularly reviewing your numbers are far better than merely shutting your eyes and hoping for the best.

Basic Philosophy

Noting all of these caveats and qualifiers, here are some of the things to consider when constructing your retirement funding plan.

Be Inflexible About Flexibility

As the future is impossible to predict, it’s vital to build flexibility into your plan. Flexibility can take many forms, such as:

Having enough liquid assets that can be accessed without triggering a huge tax bill in case of emergencies, or you don’t want to necessarily wait until you’re pushing up daisies before helping your kids and grandkids. It’s even better if these are in addition to a max-funded TFSA, as using the TFSA to pay for emergencies can carry a huge opportunity cost, since this is the one retirement account that both grows and pays out completely tax-free. In some cases, as you’ll see when I throw some math in your general direction, it might even be better to bite the bullet and pull money from your RRIF instead or borrow.
A HELOC is a great insurance policy. Even if you have the money to pay for big expenses personally, it can sometimes make sense to borrow instead. For example, for a big expense coming due in December, borrowing to pay some of the cost so you can spread out and minimize the tax hit by triggering gains or withdrawing RRIF dollars over multiple years can save you far more in taxes than you pay in interest. The HELOC also provides you with some breathing room while waiting for a market recovery before selling or waiting to sell real estate.
If a couple, plan for what finances will be like if one of you is on their own for many years. A lot of couples minimize their taxes and keep both their OAS pensions while both are above ground, but the survivor is often left dealing with a double whammy of less retirement income if all or most of the deceased’s pensions disappear, but a higher average tax rate on the reduced income since it is taxed on a single tax return. In many cases, it’s worth considering pulling out more RRIF money while you’re both hale and hearty so it can be split across two tax returns if concerned about the survivor being forced into higher tax brackets, or dealing with OAS clawback if you have accumulated significant RRSP/ RRIF savings.
Be willing to adjust your plans if a butterfly in Asia flaps its wings and throws off all of your previous plans off kilter. That means reviewing your situation from time to time and ensuring that you’re up to date with any external factors, like changes to tax rates or law that might mean that it’s now better to zig than to zag.
Be a pessimist. Run any projections on the basis that your investments just might not average 10% per year, you live to 100 and all of those dream vacations cost a little more than you expect. CFPs are required to run retirement projections using rates that might not top 5% and I suggest running one batch of retirement projections on this basis. At the very least, when making assumptions regarding investment returns, run projections using a range of assumptions and, if possible, use a Monte Carlo simulation rather than assuming your investments earn a constant yearly rate of return. A Monte Carlo simulation will randomize each year’s investment returns around your target return, with the maximum yearly high or low capped by how much you estimate returns might vary. The program might run 1,000 different projections, graph the results, and let you know what percentage of these projections didn’t result in you moving into your children’s basement and subsisting on cat food.

Income is Wonderful Thing, Particularly if Tax Efficient

I previously mentioned the impact of your sequence of returns on your retirement portfolio, particularly if you don’t own a yacht. The more income your portfolio generates, the less capital you’ll need to liquidate to pay for golf and groceries. This goes hand in hand with a well-diversified portfolio that is designed to minimize volatility. That said, all types of income are not created equal. Interest income can be taxed at over 50% in some provinces in the hands of the well-to-do. Investing in interest-paying investments in a non-registered portfolio can accordingly come at a steep price, compared to other types of investments that can compound tax-free until needed. Instead, investments that pay eligible dividends are almost tax-free until your taxable income approaches the OAS clawback threshold in some provinces, which is around $93,000. In fact, if in the lowest tax bracket, eligible dividends can actually reduce your tax bill unless you’re receiving GIS, in which case, earning eligible dividends can be a financial disaster.

There are also investments that pay regular distributions through capital gains, such as covered call funds, and, even better, other investment that pay “return of capital,” which is treated as a return of your original investment dollars and is thus tax-free, although it will increase your eventual capital gains bill when selling down the road. Private Real Estate Income Trusts (“REITs”) can provide return of capital distributions in the mid to high single digits and, since they are not initially taxed, they don’t need to generate as much income as less tax efficient investments to pay your hydro bills since, until you sell or are a long-time owner, what you receive is what you keep. Moreover, their tax efficient nature also allows retirees wishing to draw down their RRIFs the opportunity to withdraw more than would otherwise be possible at lower rates or without triggering OAS clawback.

Turning to Registered Plans, I suggest owning more of the interest payers, such as GICs, Mortgage Investment Corporations, bonds or bond funds, and Structured Notes, in those accounts. All types of income are treated the same in these accounts and these types of investments are generally very low volatility. Accordingly, since you’ll eventually be forced to make withdrawals from your RRIFs at one stage, regardless of your need or market conditions, owning these steady eddy investments in your RRIF also minimizes the impact of sequence of returns, particularly if you can increase withdrawals during bad times while you give your stock portfolio the time to recover.

And, if your investments don’t generate enough after-tax money to cover the life you wish to live, having a portion of your portfolio in low volatility, non-registered safe investments that you can use in a downturn can minimize sell low scenarios. Although I hate the opportunity cost having too much money in low, tax inefficient investments and would suggest not overdoing this unless you’re a very conservative investor, having some safe money to draw on when your stock portfolio is down 15% makes sense if your last name isn’t Musk.

Prioritize your TFSAs over your RRIFs

Although there are exceptions to this rule, particularly if the plan is to quickly replace any TFSA withdrawals the next year, I really like continuing to fund TFSA throughout retirement and instead draw down RRIFs. Returning to my mantra of flexibility, having a pot of money that can be accessed tax-free and later replaced is a wonderful thing. And if one spouse dies with a fully loaded TFSA, it can continue to grow tax-free in the survivor’s hands. Moreover, if the survivor never needs the funds, prioritizing preserving TFSAs over RRIFs can ultimately mean more after-tax dollars for future generations, particularly if tax rates continue to climb.

I was puzzling through the issue of trying to best explain the benefits of pulling money from a RRIF instead of a TFSA for living expenses despite OAS clawback for retirees who will likely pay tax at the highest rate at death and came up with an easy comparison. Assume you need $55,000 per year to fund lifestyle and can either draw $100,000 from your RRIF, which assumes a 45% tax cost, or $55,000 from your TFSA for free. In both cases, also assume that all your investments will double by the time you die in 10 years and you currently have $100,000 in both your TFSA and RRIF.

If you withdraw $100,000 from your RRIF but leave your TFSA intact, you’d have $200,000 after tax at death in your TFSA even though your RRIF is kaput. On the other hand, if you left your RRIF intact and withdrew $55,000 from your TFSA, you’d be left with $45,000 in TFSA dollars which will grow to $90,000 at your death, plus $200,000 in your RRIF. If you have to pay tax at 50% at death on that RRIF, however, you’d only be left with $100,000 after taxes. Adding the two accounts together, this totals only $190,000. In other words, if you are able to get the money out at a lower rate now than at death, I suggest taking in from your RRIF rather than your TFSA. My example has the TFSA hoarder passing on an extra $10,000 (5%) to his heirs on the last death. If able to withdraw RRIF dollars at less than 45% during life or paying more than 50% at death, the advantages of melting down the RRIF are even greater. Accordingly, consider funding your TFSA during retirement, even if it means pulling extra money out of your RRIF to do so, if you expect to be in higher tax bracket at death than right now.

As a first aside, it’s important to factor in OAS clawback to these calculations. Although retirees lose $.15 of their pension per dollar for each dollar their income exceeds the clawback threshold, they would have had to pay tax on that $.15 anyway, so the true impact isn’t quite so high. For example, if in a hypothetical 33.33% tax bracket, a retiree would really be out of pocket $.10 (33.33% of $.15) after taxes for every dollar clawed back. Accordingly, the total tax impact of this retiree losing some of her OAS in this scenario is 43.33% (33.33% marginal tax rate +10% extra in OAS clawback.) In some cases, after losing their entire OAS pension and no longer dealing with clawback, some retirees actually pay less tax per subsequent dollar of income until pushed into the highest tax brackets. Ultimately, unless your income is already so high that you consider your OAS pension a lost cause, it’s vital to consider the impact of the OAS clawback when creating a withdrawal strategy.

As a second aside, if comfortable with your own financial situation, consider using some of the extra RRIF money to fund your children or grandchild’s TFSAs or FHSA, or helping them fund another common tax-free growth investment – their home. If the kids are going to get what’s left anyway and you’re confident that you can’t spend all that you have, paying some tax now to fund their TFSAs or homes can make your money go further than waiting until death if you can access the money now at a cheaper rate than down the road. Moreover, gifting with warm hands rather than cold ones allows you to actually witness the fruits of your generosity and, in many situations, a smaller gift now can actually be more impactful than a larger gift later when your kids or grandkids are no longer living in basement suites or struggling with barely affordable mortgages.

As a final point, if you expect to outlive your RRIF, noting that the tax rules currently require 20% annual withdrawals from age 95 onward, you may not need to be in as big a hurry to liquidate your RRIF. Let’s change the previous example to assume that the tax cost of withdrawing the RRIF early remains at 45%, but that the tax cost at death is only 40% because your RRIF is a lot smaller by that point. Using the $100,000 TFSA and $100,000 RRIF scenario discussed earlier, an untouched TFSA would still be worth $200,000 at death, but the smaller TFSA and untouched RRIF would be worth a combined $210,000 net of taxes because of that lower tax bill at death on the RRIF. Ultimately, the right amount of extra money to withdraw (or not withdraw) from your RRIF is extremely situation specific. Crunch the numbers, make honest assessments of your situation and be willing to make course corrections if your investments over or under perform or if you no longer feel confident that you will be tap dancing on your 100^th birthday. If in doubt, my bias is to lean towards the solution that provides you with the most financial flexibility.

As a postscript (yes, I know I promised that the previous paragraph would be my last,) if there aren’t enough dollars to maximize one spouse’s TFSA or if it necessary to make TFSA withdrawals, consider playing the odds. At death, the deceased’s TFSA room vanishes, whereas any TFSA they pass along to the survivor can continue to grow tax-free. Accordingly, if there is a big age between spouses or one of you is looking decided more peaked, consider prioritizing funding or preserving the older / less healthy spouse’s TFSA. On that spouse’s death, the survivor would still have their own unused contribution room to use up if funds permit, plus the deceased’s fully loaded TFSA. I’ve even suggested drawing down the healthier spouse’s TFSA to fund up their partner’s account in extreme situations, such as when that spouse has a terminal diagnosis.

RRIFs vs. Non-Registered Dollars

Assuming your TFSAs are already at capacity, and you’ve already helped your descendants as much as is prudent and affordable, whether it makes sense to accelerate your RRIF withdrawals versus melting down your non-registered portfolio involves more convoluted cogitations. While both RRIFs and TFSA allow tax-free compounding, the same is not true for non-registered portfolios except if a buy-and-hold investor that focuses exclusively on capital gains, thus receiving no dividends along the way. In other words, if your TFSA or RRIF portfolio might double before death, a non-registered portfolio owning the same investments might only grow at 75% due to the increased tax drag resulting from rebalancing and income generated and taxed along the way. Moreover, don’t forget the tax cost of withdrawing money from a RRIF in the first place, which means that much less to reinvest, which might encourage you to draw down the non-registered account first in some cases.

I’ve talked about this issue in previous articles and suggest diving into my article archives if looking for more information on the subject. The magic mix of RRIF withdrawals, whether to fund lifestyle or to merely reinvest the funds in a non-registered account, varies from situation to situation, but some of the things to consider when mulling over these matters are as follows:

What is the tax cost of getting RRIF money out now vs. leaving well enough alone? If you’re expecting to pay a lot more per dollar in the future, including through OAS clawback or in your terminal tax return, paying the piper ahead of schedule may still be your best option even if you don’t look as wealthy on paper at the end of the current tax year and your non-registered money won’t compound as quickly as your tax-sheltered loot.

What types of investments would you sell inside your RRIF and what is their tax treatment if repurchased in a non-registered account? Dividend paying stocks owned inside a RRIF don’t benefit from either capital gains treatment or the dividend tax credit. Accordingly, selling these assets inside a RRIF and repurchasing them with what’s left after appeasing the tax man might eventually allow you to come out ahead. For example, a BC resident earning $80,000 per year would pay less than 2% tax on dividends from her non-registered portfolio each year vs as much as 53.50% at death if those dividends remain in the RRIF, continue to compound, and are eventually taxed at the highest rate. Although those dividends aren’t growing tax-free in the non-registered portfolio in this example, paying a token amount of tax each year along the way is a far better alternative than the estate having to pay through the nose when the grim reaper makes a house call. By the same token, if the same investor is the buy and hold type, (s)he might avoid paying any tax on the growth for many years or even until death, where the tax hit if in the highest tax bracket might be as little as 50% that tax payable on the RRIF balance, depending on how capital gains are taxed at that time. Although this retiree’s investment portfolio may not look as sexy during his lifetime as a neighbour who hangs onto her RRIFs until the bitter end, his heirs might ultimately be the ones able to afford the bigger casket.

Using my earlier hypothetical $100 RRIF and assuming both neighbours had identical RRIF investments and died at the same time, if the parsimonious neighour’s RRIF doubles prior to death but is then taxed at 50%, her devastated descendants would only net $100. If the savvy gentleman down the road withdrew the same $100 from his RRIF while in a 30% tax bracket to reinvest in a non-registered account where it compounds by only 75% until death, where the $52.50 gain is taxed at 26.75%, his initial $70 investment would be worth $108.46 net of tax at his passing. Conversely, had he instead invested his $70 in a GIC, the numbers wouldn’t look nearly as good, although perhaps still acceptable. Assuming his $70 GIC portfolio grew by only 50% prior to death due to the increased tax drag, he’d still have slightly more than $100 at death, which would be the only year when taxed in the highest tax bracket.

What is the tax hit from selling some of your non-registered portfolio? Although you won’t pay as much tax per dollar on capital gains vs. RRIF withdrawals, if you’re up big in your non-registered portfolio, you might be better off letting those investments continue to flourish, depending on some of the other factors in this list. Of course, don’t let tax considerations block out investment considerations – if the signs suggest that it’s time to sell a stock despite its past performance or it represents too large a share of your portfolio, don’t be afraid to pull the trigger despite the resulting tax hit.

How much is flexibility worth to you? Slowly pulling out RRIF funds over time to build up a non-registered war chest to provide more wiggle room for larger expenses later or to allow more gifting during your lifetime may eventually be worth your while even if there are no immediate benefits, other than perhaps a bit more peace of mind.

What would you do with extra RRIF withdrawals? What is the after-tax return or savings if using the cash to pay down or avoid incurring debt, buying life insurance that grows and pays out for free or helping future generations? If planning to reinvest in your own name, early withdrawals to purchase GICs is far less appealing than paying down high interest credit card debt.

How much longer do you expect to remain above ground? The shorter your remaining lifespan, the smaller the opportunity cost of triggering taxes ahead of schedule, particularly for RRIF withdrawals that will ultimately be fully taxable at death.

When looking to sell non-registered winners, don’t forget to also harvest losers as well to negate all or some of the taxable gain. Moreover, if triggering a large gain will push you into the OAS clawback zone or a really uncomfortable tax bracket, consider selling in stages over multiple tax years to reduce the tax pain if there isn’t a compelling investment reason to sell the entire investment now. If approaching the end of the year, selling some in December and more in early January might make a big difference to your bottom line in some circumstances.

Conclusion

There are myriad moving parts to take into account when strategizing how to draw down income during retirement and, as is so common, one size does not fit all. Knowing your options, how the tax system works and using somewhat pessimistic assumptions that are fact-checked regularly can go a long way to making the most of your retirement assets and improving the quality of your sleep.

I will have more to say on these matters in future articles, particularly for those you who also have corporate savings to draw upon during your golden years.

Apr 10

Making the Right Call: The Ins and Outs & Ups and Down of Covered Call Funds

As I’ve said many times before, few things in the investment world make me happier than receiving nice fat deposits into my investment accounts on a regular basis. I may have never been to Mississippi, but I strongly suspect that I’d have a strong affinity to the Show Me State.

I get even more excited when I know that I won’t have to share too large a portion of those juicy payments with the government come tax time. As I have been known to repeat ad nauseum, it’s not what you make, but what you keep after fees and taxes that really matters. Inside registered accounts, all distributions are treated the same. Accordingly, it’s irrelevant how you make your money in such accounts, so long as it’s an appropriate investment for your temperament and circumstances. On the other hand, how you get paid inside a non-registered account, whether in your personal or a corporate account can matter a heck of a lot. That’s where covered call mutual funds or etfs (I’ll use “funds” to describe both hereafter) might really shine.

Background

Put in simplest terms, a fund that “writes” or sells covered calls trades some of the potential upside from the stocks they are selling call options on in exchange for an upfront payment called an “option premium.” Using an example, if you own a stock worth $100, you might sell someone the right or option to purchase that same stock from you for $103 any time over the next month in exchange for an extra $.50 right now. If the stock never hits this value, the option will expire as worthless and the person purchasing the call will be out $.50 with nothing to show for it. You, on the other hand, will get to keep the stock, any dividend income paid on it, plus the up-front $.50 option premium payment. And, if you’re so inclined, you can start from scratch and sell another call option the next month.

Conversely, if the stock soars to $105 prior to the option expiring, you will be required to sell at $103 (or buy back the option) and miss out on that extra $2 of profit. So, although you are stuck selling a stock worth $105 for $2 less than market value, you still realized a $3 on the increase of value, any dividends issued, plus the $.50 option premium. Accordingly, although you didn’t do as well as if you hadn’t sold a call option or the person who purchased it who and made a 300% profit, you still have a lot to smile about. And, if you’d been collecting options premiums on that same stock for several months before it was “called away,” (forced to sell your stock at the price stipulated or “strike price”), you still might still be ahead of the game compared to simply buying and holding that stock.

Finally, if the stock goes down over the call period, although you’re probably not too happy about this, at least you’re $.50 better off from receiving the call premium than the guy down the street that owed the same stock but didn’t write a call. And, if you were a retiree on tight budget, the extra $.50 in call premium per share may mean not having to sell as many shares during a setback to pay for groceries. In summary, covered call funds usually underperform typical funds in a rising stock market but the higher income they generate vs. owing a similar basket of individual shares might be very attractive to more risk-adverse or income-hungry investors more interested in monthly payments than growth.

Option Pricing Basics

In the example I provided, I arbitrarily pulled numbers out of the air in order to explain the general concept. The value of any call option is highly variable and is affected by the following:

The prospects and volatility of the underlying stock: A stock that goes up and down like gymnast on speed generates a higher premium than a staid blue chip special, as the upside if the riskier stock catches fire during the option period is that much higher and, thus, enticing.

General Market Volatility: As you might expect, not only does a specific stock’s volatility affect what you can charge for an option premium, but so does that of the stock market as a whole. For example, options premiums will be a lot higher during an event like a global pandemic than when all is sunbeams and moonshine.

The Length of the Option Period: If you write an option that lasts 3 months, you should be entitled to a higher option premium than writing one that lasts a single month, since whoever purchases the option has three times as long to strike it rich and for a hot stock to keep on climbing.

The Difference Between Strike Price and the Stock’s Current Value. In my example, the “strike price” of the option was $103 for a stock currently trading at $100. If the strike price was only $102, the option premium will be higher since there is that much better price of the option eventually “being in the money” and rewarding the buyer. Likewise, as you’re agreeing to surrender more of the upside if pricing the strike price close to the current value, it only makes sense if you’re paid more in exchange. Finally, the increase in the option premium as the difference between the strike price and market price decreases can increase significantly as buyer risk goes down and seller opportunity cost rises. Accordingly, if the seller in my original example was selling a call option for $101 or even one that is already “in the money” such as a $100 call option, they should expect to get significantly more than the $.50 option premium from my example.

Advanced Lessons

As you might expect, things are not quite as simple as the example I’ve described above when looking at this strategy inside a fund versus on a single stock basis. Different companies have different strategies, so it’s important to understand how the various funds differ from each other before deciding on what does (or doesn’t work) best for you. Here are a few of the things to consider:

Do you believe in that market sector? In basic terms, if you don’t like the sector, don’t chase the income stream on the related covered call funds, or at least limit your exposure. And, even if you like the sector, beware of too much of a good thing in case your hunch doesn’t pan out. Consider a basket of different covered calls funds with different holdings or look into funds that do this for you rather than merely buying sector specific funds.

On what percentage of the fund are they writing calls? Most covered call funds don’t write calls on the entire fund. Accordingly, the more shares that aren’t optioned, the more potential upside in a rising market vs. a fund that has written calls on a higher percentage of its holdings. When comparing funds, take this into account rather than merely focusing on yield. The higher portion of a fund’s shares that aren’t optioned, the better the upside in a rising market.

What is the maximum percentage of a fund that can be optioned? Many funds target a set yield and will write just enough options each month so that the combined dividend and covered call premium yield generates the desired yield. Accordingly, in more volatile times, a fund may not need to write as many call options to hit their yield targets if each call option pays a higher option premium than during a quieter market. That said, funds may also restrict the maximum percentage of shares optioned at any one time. One way or the other, it’s good to know both what’s going on right now and the limits on how much can ultimately be optioned away if circumstances change.

What is the fund’s typical spread between the market value of the shares optioned and the strike price of the options and how variable is this? As explained earlier, the tighter the spread, the higher the option premium. In fact, some funds have recently started selling call options that are “in the money” or where price for exercising the option equals the market value of the share. I’ve seen funds like this generate income of the mid-teens but it’s important to remember that you will be giving up the entire upside on all optioned shares in that scenario, which may sting in a rising market. Conversely, when the market hits the skids, these funds should outperform similar options-free funds. Returning to the previous bullet, it’s also vital to know what percentage of the underlying stocks are optioned, as the non-optioned portion of the fund can still appreciate during a rising market. Accordingly, unless the market has gone gangbusters, to use a technical term, such funds may still hold their own when the market enjoys modest but not monumental gains.

Do the funds use leverage? There are several covered call funds out that borrow to purchase perhaps 25% more of the underlying shares, using the extra dividend yield from the extra shares and covered call premiums to cover the borrowing costs. This might allow the funds to more fully participate in rising markets if it means less of the underlying shares are optioned but are more likely to take it on the chin when the market falls. I would also expect that as interest rates decrease and the fund’s borrowing costs decline that such funds would not need to write as many options to generate the target distribution, further increasing their performance against their covered call peers in a rising market.

How long has the fund been around and what’s its track record? The new breed of covered call funds that issue “in the money” options has captured a lot of interest but it’s really hard to gauge their performance against both other covered call funds that employ less aggressive option writing strategies and against more traditional funds that don’t employ options at all. The high yield is amazing and may be answer enough for some, but it’s hard to make an accurate basis of comparison without the necessary historical data. The study I discuss later in this article raises some concerns regarding traditional covered calls. Although a juicy yield is a wonderful thing, keep an eye on the fund’s overall performance. Even better, look at its long term track record if one exists.

Fees! What does any fund charge compared to its peers?

How is the fund’s target distribution typically taxed? In a non-registered account, the distribution from a covered call fund is likely a mix of things. The options premium portion is taxed as capital gains. Depending on the underlying assets in the funds, some of the income may also be eligible dividends, interest income, foreign income or tax-deferred return of capital. Although interest income is usually the least desirable, a lot depends on your tax bracket, as eligible dividends may be disastrous for investors relying on the GIS, nirvana for those with slightly higher tax brackets and not nearly as good as capital gains for investors making the really big bucks. While an investment’s raw yield usually grabs the headlines, knowing what you’ll ultimately get to keep after taxes can help you make a more informed choice. That said, it’s a dangerous thing to make investment choices solely by focusing on taxation.

Additional Thoughts and Arguments Against

There are concerns in some quarters that the chase for option income can actually reduce total returns, such as identified in Larry Swedroe of Alpha Architect’s November 24, 2023 article (A big thanks to Moneysaver reader Dave Reid for sending this along!) That article compares the performance of some covered call funds vs. similar funds that don’t use this strategy and cited another study that concluded that over the study period (1999-2023) that a Nasdaq-focused covered call etf didn’t do nearly as well as a standard, cheaper etf tracking the same index. It also pointed out that a standard etf may be more tax efficient since more of its return translates to deferred capital gains. Finally, it also concluded that the smaller the spread between the option strike price and the stock’s trading price at issue, the worse the fund’s overall performance. In other words, the income from the call options didn’t fully compensate investors for surrendering upside.

This article raises many good points, although I would have loved to have seen a Canadian-based example. In an example where the underlying Nasdaq stocks averaged over 16% annual growth, it is no surprise that the covered call version drastically underperformed.

In defense of covered calls, I think that merely focusing on the total return can also lead to “sequence of return problems” for investors dependent on their portfolios to pay for their daily bread. As I’ve written about previously when discussing the “sequence of returns,” or when an investment has its good vs. bad years rather than its overall performance, having to liquidate stocks during a correction to pay the internet bill can have a disastrous impact a portfolio’s long-term performance, as it forces investors to “sell low.” Such investors may not have the luxury to wait until the stock market cooperates and might instead appreciate a higher income along the way, particularly if they don’t need to shoot the lights out to stay on track for their ideal retirement.

Conclusion

Ultimately, like in so many areas of life, there are pros and cons to every decision. Although wealthier clients with a long time horizon, higher risk appetite and no need to generate extra income may do better with more traditional funds, more income-dependent or conservative investors may look at their investment options very differently. And, if you are one of them and are considering covered calls to help ensure that you have enough to fund your monthly premium peanut butter habit or to sleep soundly at night, I hope this article has helped in your investigation.

Dec 11

Is Mortgaging Your Future Necessarily a Bad Thing – Investing in Morgage Investment Corporations

Over the last 2 years, the economic landscape has undergone a seismic shift. Interest rates and inflation have both spiraled to levels not seen in decades – the last time Bank of Canada interest rates reached current levels was prior to the 9/11 bombings. And, although inflation has dipped from its peak, we have still been dealing with inflation not seen since I was in high school, a period long since vanished into the mists of time.

These enormous changes, coupled with recent stock market declines and concerns over further market retreats have left many investors befuddled and bewildered, particularly those looking for fixed income returns that actually do better than inflation after paying off the tax man. Although GIC rates have also risen to the occasion, when both inflation and tax are factored into equation, their buying power is at best treading water and at worst, submerged by the waves. Consequently, many investors are clamouring for higher yielding investments that don’t make them feel like they are plunking their money down at a craps table, hoping not to roll snake eyes.

I’ve recently written on a type of structured bank note with significantly higher yields that GIC with some downside protection but want to spend today talking about another option: Mortgage Income Funds or “MICs.” For the rest of this article, I’ll outline what they are, how they work, and key factors to consider so that you can decide for yourself whether they are worthy of a special place in your life – inside your retirement portfolio. Thanks to Russ Mortgage, mortgage broker extraordinaire, and both Thomas Tsiaras and Wail Wong, portfolio managers at Aligned Capital, who regularly incorporate MICs in their client portfolios, for their valuable input.

The Basics

Background and Basic Features

MICs are investment funds created by the Federal government in 1973 that hold a pool of mortgages and which are required by law to pay out their yearly after-tax earnings to their investors. In return, the government doesn’t make MICs pay tax directly, which means more for investors, unlike most other types of investments, where companies have to pay taxes on their earnings and can only distribute whatever is left (although the dividend tax credit on eligible dividends can admittedly ease the pain in non-registered accounts.)

On the other hand, even though MICs may describe their distributions as “dividends,” they are taxed as interest or income by our friends at the CRA. As a result, MICs are not tax efficient and are often better owned inside registered accounts like RRSPs and TFSAs.

MICs play a surprisingly large role in the lending business. One recent article suggests that there are between $13 and $14 billion invested in MICs in our country and that they account for about 1% of the mortgage market. Another, slightly older, article suggests that there were over 200 MICs in Canada as of 2018. In other words, there are more MICs in Canada, and they are collectively worth far more, than most of us realize.

As you might expect, all MICs are not created equal. Each has its own investment mandate and strategy. Some may lend across Canada, while others focus on distinct geographical areas like the Lower Mainland of BC or Greater Toronto. Some only lend against residential properties while others lend to commercial developers. Perhaps most importantly, some seek higher returns by issuing second or third mortgages while others focus primarily on first mortgages. Different MICs also have different loan to equity rules – more conservative MICS may lend $.65 or less per dollar of collateral while other MICs may be willing to lend as much as $.85 per dollar, and as a result, paying higher distributions. Yet another recent article ranged expected returns across the MIC universe this year between 6 and 12%.

Finally, there is one more significant difference distinction between MICs– some trade on the stock market and are subject to fluctuations in value like a stock, ETF or mutual fund, while private MICs generally maintain a fixed value of $10 per unit so that investors’ total returns will be limited to interest earned. Private MICs are not nearly as liquid as public offerings and don’t have the same reporting requirements, but each investor’s ultimate returns are not dependent on the whims of the stock market on the day he or she decides to cash in. As in so many areas of life, there are pros and cons to any decision.

In summary, all MICs are not created equal and each of us needs to carefully look into the different alternatives before deciding whether or not to invest and, if so, which MIC or which basket of MICs offers you the best mix of safety, returns and quality sleep.

The Business of Private Lending

As you’d expect, people usually turn to alternative lenders when they can’t qualify for a traditional bank mortgage or the banks won’t give them as much as they want. Although poor credit history is always a reason why some people bail on the banks, it isn’t the only one. Here are a few other types of typical MIC borrowers:

Recent Immigrants Recent immigrants may not have been in Canada long enough to establish a sufficient credit history to fit within the bank’s lending box and may need to work with an alternative lender until they have been here long enough to build up the necessary track record.

The Self-Employed and Commissioned Salespersons. The self-employed are generally seen as a big risk, particularly if they have unstable earnings. Likewise, commissioned salespeople are often viewed through a similar lens. Moreover, regardless of how much money someone with a private company may be banking up in a holding company, the banks focus on personal income, ignoring additional corporate earnings that could have been paid out but were not, generally for tax reasons. In some cases, these clients may simply need to bump up their own salaries, work with a MIC in the short term and then circle back to the banks in a year or so. In some cases, the big banks are actually the ones that refer clients to alternative lenders in the expectation that the clients will return to the banking fold in the not-so-distant future.

Quicker Approval. In some cases, property developers may choose to work with private lenders, particularly for shorter term loans because it is easier and faster.

The Mortgage Stress Test and Its Impact

The stress test was introduced in 2018 and has resulted in many potential borrowers previously on the side of the banking angels no longer qualifying for a traditional mortgage, despite solid credit scores. As alternative lenders, such as MICs, aren’t bound by the stress test, they can adopt their own flexible lending policies and fill the gap when the banks say no. Ultimately, this increases both the size and quality of pool of borrowers MICs can choose amongst. On the other hand, many MICs have been growing like gangbusters since 2020, which might erode some of this benefit.

For those of you who are normal people (i.e. aren’t up to speed on all things stress-test), the basic rules are as follows. Borrowers working with the banks must be able to qualify for a mortgage at whatever rate is higher: 5.25 % (this rate is reviewed yearly) or 2% more than what their bank is offering them without using:

More than 39% of their pre-tax income to cover the mortgage and other housing costs, like utilities and property taxes; and

More than 44% of their pre-tax income to towards all personal debts, including the mortgage.

To put how much interest rates have climbed into perspective, the 5.25% is so out of date (borrowers have to be able to sustain mortgages between 8 and 9% as of early December 2023) that most people successfully applying for a mortgage will be paying actual interest that is higher than preset stress-test rate. The rate surge that the 5.25% minimum rate was designed to insulate has now arrived in full force and now seems to have stalled. Accordingly, the stress test has saved many borrowers from a world of hurt or will at least reduce their pain when it is time for them to renew over the next few years by capping how much they were able to borrow when the getting was good. On the other hand, if you believe that we are primed for interest rates to finally start falling or at least not to grow by another 2% over the next 5 years, then you may feel that the stress test is now getting in the way people and banks’ ability to think for themselves. That’s where MICs play a role.

Factors to Consider When Comparing MICs

Although I’ve already discussed some of the key differences between various MICs in passing, here is a more detailed summary:

Type of Mortgages. Different MICs lend against different types of real estate. Some may lend to developers or other investors, while others restrict their loans to homeowners. I personally prefer residential mortgage MICs in the belief that homeowners will move heaven and earth to protect the place where they and their family sleep at night vs a corporate developer that is protected from personal liability if things go wrong.

Geographic Considerations. Some MICs focus on Canadian real estate while others will also lend outside of the country. Moreover, within Canada, some MICs target specific areas, such as BC’s Lower Mainland or Toronto, while others sprinkle their loans further afield. There are different benefits and risks to each approach. For example, a MIC focusing on a specific geographic area may be able to understand that market better than a MIC with greater geographic diversity and may be able to build up better connections and quality of borrowers than a MIC without a homecourt advantage. On the other hand, as all of us investors know, diversification has its own advantages.

Downside Protection / Loan to Value Ratio. How much does the MIC lend per dollar of equity in the property? And, how much extra does a higher paying MIC generate for taking on this additional risk? I generally restrict myself to MICs who lend no more than approximately 75% of a property’s equity, but each to their own.

Priority of Mortgages. Some MICs (often called “Prime Mortgage Funds”) only issue 1^st mortgages while others may blend in some 2^nd and 3^rd mortgages. Determine the mix (see what I did there) of different mortgages in each MIC and how much fits into each category. As well, how much (or how little) yield do you give up by investing in a fund that only provides first mortgages?

Average Loan Size and Number of Mortgages. I believe that the greater the total number of mortgages and the smaller the size of the average mortgage, the better the protection.

Average Value of Borrowers’ Property. I prefer MICs that focus on starter homes, as I see them as more resistant to market drops than swanky luxury pads. As the value of a starter home in Halifax is a fraction of Toronto number or Vancouver values, it’s also a question of knowing what a starter home costs in that MIC’s target area so you can determine if the MIC is focusing on entry level residences or palatial estates.

Leveraging? Some MICS boost returns by borrowing from banks or other lenders at one rate and then lend the money out to borrowers at higher rates. The bank or other financial institution working with the MIC will have done its own due diligence before agreeing to this arrangement and will continue to monitor things closely, but you will need to decide for yourself whether you’re okay with this. I also suggest determining how much a fund is currently leveraged and the maximum amount it can borrow.

Liquidity Restrictions. Private MICs usually have a minimum holding period and only offer redemptions monthly or quarterly, which means waiting another month or two at least from when you want your money back. If a minimum holding period applies, determine the penalty for cashing in your chips early in case your plans change. Private MICs, like other exempt market investments, can also can “gate” or restrict redemptions in exceptional circumstances, such as if too many people want to redeem at once. This is potentially one of the biggest disadvantages of private MICs.

On the other hand, it’s also important to keep things in perspective. Although public MICs can’t gate redemptions, if there is a run on a public MIC, expect to sell at a significant discount. A private MIC that gates redemptions may ultimately allow cooler heads to prevail so that investors ultimately get do better in the long run. In any event, doing your homework prior to investing can go a long way towards avoiding things going wrong later.

Term to Maturity The shorter the duration of a MIC’s portfolio of loans, the less time for things to go wrong and less time for the value of real estate to decline enough for my equity to be at risk if it does. Many MICs focus on 1-to-2-year loans, although the average duration of loans may be even less than a year.

Public vs. Private. The typical pros and cons of public vs exempt market investments apply to the MIC world like they do public or private REITs. As I’ve mentioned the key issues earlier in this article, I won’t rehash them now. For those of you who have never purchased an exempt market investment, however, you will ultimately need to sign the standard acknowledgement that states that you know you could lose all of your money, regardless of its track record and downside protection. Strangely enough, there is no such requirement when purchasing a penny stock on the TSX.

Track Record, Management Team, etc. Like any investment, you’ll want to look at how long they have been in business, who is calling the shots, the company size, the continuity of their management team, whether they have missed any payments and ever gated redemptions.

Deal Flow and Growth. I like to know where a fund gets the majority of its clients and how quickly a MIC has grown. I also want assurances from MICs that have grown quickly that they aren’t scrapping the bottom of the borrower barrel simply in order to deploy funds. It’s actually a good sign to me if a fund refuses to accept new money from time to time if they don’t feel they can deploy it prudently, as this shows a responsible management team.

Average Credit Rating. Although this won’t tell the full story, it’s useful to know the average borrower’s credit rating and how this has changed over the life of the fund, particularly over the last few years if a MIC has been growing on steroids.

Default Rate and Loan Loss Provisions. How many mortgages are in default or trending in that direction, what is the fund’s typical default rate and what sort of default assumptions are baked into their projections when calculating their yearly distributions? A Portfolio Manager friend of mine has a personal favourite that has never had a single mortgage default in its 14 years of existence, although that doesn’t mean they shouldn’t continue to plan for the worst. A healthy MIC will have a low default rate well below the rate used for its forecasting. As different provinces and states have different foreclosure rules and timelines, knowing how things work in that MIC’s prowling grounds can give you an idea how long it will take to convert real estate into hard cash so the money can be reinvested.

Minimum Purchase and Qualification Criteria. For private MICs, some require at least a $5,000 initial purchase, while others may require significantly more. There are also restrictions on qualified investors, based largely on their income and / or net worth.Moreover, not all MICs have the same minimum investment limits. In some cases, investors may need a sizeable income or over $1m in investable assets, while others may be accessible for those with a lower income and over $400,000 in investable assets. Once more, although anyone can buy a penny stock and invest as much as their heart desires, not everyone is eligible to invest in a private MIC or allowed to invest as much as they would like.

Information Flow. For private MICs, determine how often they will provide you with information updates and what sort of information you might receive. Some provide monthly newsletters.

Variable or Fixed. MICs that only issue variable mortgages have been able to raise distributions in lockstep with increase in the Bank of Canada’s lending rate, which is also a great inflation hedge. One of my MICs with variable-only mortgages literally increased distributions within an hour of the B of C rate decisions on many occasions. Those with fixed rates aren’t as nimble but will likely be able to sustain rates for longer once the Bank of Canada changes direction. Accordingly, a fixed rate portfolio with a longer average loan duration might sustain higher rates longer if interest rates decline, assuming their borrowers meet their commitments.

Fees. Although distributions from MICs are net of fees and I have no problem with good people getting well compensated, I still want to know what I’m paying. Moreover, sometimes, the management fee doesn’t tell the whole story, as MICs also typically charge borrowers a loan origination fee. Some MICs pocket this themselves in addition to their ongoing percentage management fees while others share the revenue. Accordingly, sometimes the basic management fee doesn’t tell the whole story.

CHMC Insurance. Most MICs do not have their mortgages insured with the CMHC.

Timing of Payments. If you are looking or needing monthly cashflow, then funds with monthly distributions are likely the ones for you. If this isn’t as vital, there are other funds that pay less frequently, such as quarterly.

Conclusion

Although MICs have been around almost as long as we’ve been taxing capital gains, many investors have never heard of this particular acronym, let alone added it to their investment portfolio. Like all categories of investments, there are the good, bad and the ugly. If you’re looking for a higher yielding investment and are looking for alternatives to traditional options such as bonds and GICs, MICs might be worth a second look. And, if that second glance turns into a desire to invest, please be sure to ask the tough questions so that you ultimately end up with the MIC (or the basket of MICs) of your dreams.

Jan 15

Playing with House Money: How to Maximize Your Savings When Saving for that First Home

Playing with House Money:

Ways to Save for that First Home

It’s not exactly a newsflash that buying a first home in today’s Canada is only a pipedream for many. Prices soared to new highs across the nation during the heights of the Covid pandemic and, although we are now well off of those highs, the subsequent rampant run-up in interest rates has vastly decreased how much potential buyers can and should borrow. Making things even worse, 2022’s stock market decline chipped away at many potential down payments and the current stratospheric level of inflation means that a portion of many pay cheques earmarked towards home savings have been diverted to things like gas and groceries. The reality is that for many young Canadians, their only chance of getting into the housing market any time soon is from either playing the lottery or with a little help from someone else.

While reading this article will not create a down payment out of nothing or magically reduce mortgage payments, a little strategic financial planning, a lot of patience and a healthy assist from the investment gods may ultimately see you or your loved ones finally in a place of their own. Whether you’re saving up for your own abode or a parent / grandparent looking to give a youngster a leg up, here are a few ways suggestions to help achieve this lofty goal.

What This Article Won’t Do

I don’t plan on talking about any provincial programs that focus on saving property transfer tax, nor any federal or provincial programs that rebate any PST, GST or HST when buying new or substantially renovated homes. I will say in BC that if a couple is purchasing a home and one has already owned a home previously, it’s worth getting legal advice to discuss potentially having solely the first-time buyer on title initially.

I also don’t plan on providing any specific investment recommendations, other than a few quick comments that I’ll make now. First, just like when setting up any other investment account, picking investments that match your time horizon is vital, as is also adjusting this mix as you get closer to the finish line. Although swinging for the fences can pay dividends if you capture a market upturn, the reverse is true if the market swings the other way. If you’ve already saved up enough for that down payment, it’s time to take risk off the table and reduce volatility. This is particularly important for savers already shopping the market or waiting to close on a property, but also applies for those of you perhaps still a year or two away, waiting for prices and / or rates to drop before putting a toe into the property market. This opportunity might instead pass you by if your investment portfolio suffers a similar decline.

You’ll also need to make your own investment decisions or get professional advice, but a couple types of investments I currently own might not be things many of you have considered before. I currently own both some private mortgage funds (MICs) geared towards residential mortgages and some structured notes that provide both a healthy income and downside protection. There are downsides and risks to both, as there are for any investment, but both of these minimize stock market risk, although you’d also need to confirm that minimum holding period isn’t too long for your purposes, and whether you have sufficient income or savings to meet eligibility requirements. And, neither of these options are appropriate for all savers.

Setting the Stage

For many, the best path to their first front door will combine several of the different strategies I’ll discuss below – there are contribution or withdrawal limits to some of the government plans meant to assist with first home purchases, which means having to fund more than one type of savings or investment account. Moreover, savers may also need to pick from different government plans, as using one type of government-assisted plan may disqualify them from using some others. Finally, if other family members are also hoping to assist youngsters, they won’t have access to all of the same government assisted savings plans. Ultimately, if purchasing that home requires a combined family effort, the best strategy may involve different people saving or contributing in different ways.

Furthermore, just to make this all that more confusing, one size will not fit all, as we all have different financial realities, timelines and goals. Your job after reading this article will be to cherry pick what options best fit your reality and take whatever steps are required to move forward, either on your own, with the rest of your family or with the assistance of whatever advisors you need to make things happen.

I will also wait until next time to discuss some of the considerations parents and grandparents wishing to contribute can do to protect themselves and the lenders in lieu of gifting, such as lending, guaranteeing mortgages or co-owning.

So, with no further delays, prevarications, or qualifications, here we go . . .

Tax Free Home Savings Accounts (“FHSA”) – Coming April 2023 to a financial institution near you

Key Benefits:

Tax- deductible contributions.
Tax-free withdrawals with no repayment requirements.
No cap on the amount that can be used for a down payment, although there is a cap on yearly and total contributions.
Flexibility to transfer back and forth into RRSPs.

Key Disadvantages:

$8,000 annual funding limit and $40,000 lifetime funding cap.
Limited carry-forward room if you don’t maximize each year’s limit.
A higher income spouse can gift a spouse the money to fund the spouse’s contribution, but the lower income spouse must claim the deduction.
Although initially, savers were forced to choose between either using the RRSP Homebuyers’ Plan or the FHSA, recent changes now allow them to use both options. Accordingly, this disadvantage no longer applies!

This account combines the best features of both RRSPs and TFSAs. Starting in 2023, everyone over 18 (or likely 19 in provinces with a higher age of majority) who hasn’t owned a home in about 5 years can contribute $8,000 each year if maximizing their yearly contributions into this account, with a lifetime contribution limit of $40,000. Like a TFSA, contribution room is based on age rather than income. As well, all qualifying withdrawals are tax-free, with no repayment requirements, unlike when borrowing from an RRSP. Even better, there is no cap on how much you can eventually withdraw, other than you can only keep your account open 15 years. In other words, although you can only put in $40,000 and will have to wait at least 5 years to squeeze in your last dollar, you could potentially withdraw hundreds of thousands tax-free if you corner the stock market and / or get a little lucky, particularly if the money has many years to compound. Of course, swinging for the fences can also mean watching your contributions vanish, so make your investment decisions with your eyes wide open.

As is true for RRSPs, contributions are tax-deductible, which allows investors to invest more, since contributions either reduce how much they have to set aside for taxes or will result in a tax refund to refill the coffers. And there is no need to deduct contributions in the year they are made if expecting a big bump in salary next January (and thus a bigger refund) or that first real job is many years away. It’s even possible to transfer RRSP money to your FHSA to fund contributions if money is tight one year, although you won’t get any RRSP contribution room back. The reverse is also true if you ultimately never enter the housing market – you can transfer FHSA money into your RRSP without triggering tax and the amount transferred will not affect your regular RRSP contribution limits.

That said, my suggestion is to investigate funding the FHSA if not already attending open houses and schmoozing with mortgage brokers. The funds can always be transferred to the RRSP and used towards that down payment option if HBP ultimately turns out to be the best way forward. And, if that first purchase is delayed a few years and / or the investments in the FHSA do well, the saver can simply fund the down payment from the FHSA. As an added bonus, since money deducted under the FHSA doesn’t count against RRSP contribution limits, if the funds are ultimately transferred to the RRSP anyway, the saver will have more RRSP contribution room for use in the future compared to someone who instead put the same amount into an RRSP instead.

If maximizing FHSA contributions, the next question is where to put your next dollar of savings – a TFSA or RRSP. Generally, savers in a lower tax bracket with a longer time horizon before purchase are often better off putting extra funds into their TFSAs after maximizing FHSA contributions if hoping to eventually save the highest down payment possible –since the HBP caps withdrawals at $35,000, putting the extra cash into a TFSA after funding the FHSA could eventually mean a far larger down payment one day, since both the TFSA and FHSA allow the full account balance to go towards that first home should the investments inside the TFSA grow like gangbusters. Moreover, the saver can always withdraw funds from the TFSA at a later date to make catchup RRSP contributions if that ultimately looks like the best way forward, particularly if the saver is now in higher tax bracket and, accordingly would get a bigger tax refund per dollar contributed. And, if the money has grown inside the TFSA, the saver might actually have more dollars to contribute to the RRSP in the future anyway, which can mean an even higher tax refund and even more money for the pending purchase. Accordingly, as you can see, some savvy savers might actually use all three registered savings plans to maximize their downpayment dollars.

Changing directions, there is one major drawback to the FHSA – this plan offers minimal catchup contributions. Savers cannot carry forward any unused contribution room unless they’ve already opened a FHSA. Moreover, even after a plan is in place, savers who don’t take advantage of their yearly maximum contribution can only carry forward a combined $8,000 to use later, capping out yearly contributions at $16,000. In other words, if you don’t open an account in 2023, you will have no carryforward room for 2024 and can contribute only $8,000. And, if you do open an account in 2023 and contribute $1,000, you’d be able to contribute $15,000 in 2024. One matter I still want clarified is what happens for a saver who has not made any contributions for many years after opening an account – are they stuck with a single $8,000 catchup contribution when they do have the funds, plus that year’s regular $8,000, or do they get to do the same thing the next year as well until they hit their $40,000 lifetime contribution limit?

Due to this limited carryforward room, regardless of the answer to this question, if looking to use the plan, it makes sense to start sooner rather than later, even if making only a minimal contribution or perhaps transferring money from an RRSP directly to the FHSA to come up with the necessary cash. One final question that still remains in my mind is whether money in a spousal RRSP (i.e., one funded by presumably the higher income spouse for that other loved one’s benefit) can be transferred to the receiving spouse’s FHSA. Finally, if you are still unable to make your contribution but your spouse has a few extra dollars kicking around, (s)he can lend you the necessary funds, which is an exception to the normal tax attribution rules.

Registered Retirement Savings Account Home Buyers Plan (“RRSP” or “HBP”)– Borrowing from tomorrow to help pay for today

Key Benefits:

Contributions are tax-deductible and unused contribution room can be carried forward indefinitely.
Higher earners or those with lots of unused room can maximize funding far sooner, which can be important for savers close to purchasing.
Flexibility to transfer back and forth with FHSAs.
Potential tax savings if higher income saver can contribute and write off contributions to a lower income spouse by funding a spousal RRSP, which can be used to increase the down payment.

Key Drawbacks:

Withdrawals capped at $35,000 and must be repaid within 15 years starting from a couple years post withdrawal in yearly increments.
Takes away from growth of retirement savings.
Income-based, so starving students may not be able to contribute until employed and have qualifying income. Savers with defined benefit pensions will have limited RRSP contribution room.
Borrowing from your RRSP to fund a down payment disqualifies that saver from also using the FHSA. – No longer true!

Although RRSPs are designed primarily to save for retirement, there is an exception for anyone who hasn’t owned a home in essentially 5 years or, regardless of how long the gap between homes, if you’re recently divorced. You can borrow from yourself interest-free, but you need to start repaying your RRSP account a couple years later according to a 15-year repayment schedule. If you don’t make a repayment, you’re taxed on that year’s minimum repayment amount as if you’d made an RRSP withdrawal of that amount. On the other hand, you don’t get any new tax deduction when repaying yourself, as you already got your discount when contributing in the first place, which makes repayments more onerous than regular deductible contributions. For couples in different tax brackets, it’s possible for the higher income spouse to make contributions to something called a “Spousal RRSP” and for the receiving spouse to use that money towards the down payment. The contributing spouse uses up their own RRSP room and gets the tax deduction, but the money goes into a separate RRSP that the receiving spouse can use to come up with all or some of their own $35,000 in eligible withdrawals. Ultimately, most couples using this strategy aim to have $35,000 each to put towards a down payment, whether each funds their own plan or if the one in the higher tax bracket helps the other come up with all or some of the necessary funds through spousal RRSP contributions. Using the Spousal RRSP option if there is a big disparity in taxable incomes and the goal to only contribute enough RRSP dollars to max out the HBP, then the Spousal RRSP option can be a gamechanger.

The spousal contribution option is one perk that is exclusive to HBP – the FHSA allows us to only deduct contributions to our own accounts (even though we can lend a spouse the cash for their contributions.) As a result, the HBP is more tax-efficient for couples in wildly different tax brackets, since the higher income spouse can essentially contribute for both of them and have the tax deductions based on that spouse’s income.

Moreover, unlike the FHSA, RRSP room is based on taxable income. Savers without work pensions can contribute 18% of their qualifying income to next year’s RRSP to a yearly cap that will be $30,780 in 2023, plus all previously unused contribution. The result is that savers that are late to the game can potentially put in and deduct a lot of money in a hurry to fund a HBP withdrawal, unlike the pending FHSA, which is a longer-term play.

Unfortunately, savers with work pensions earn far less RRSP room but might still be able to play RRSP catchup if they have lots of unused room from the past. As a result, although the HBP might not be ideal for some savers with significant work pensions and microscopic RRSP room, all is not lost if they already have a sufficient RRSP, a spouse that could make a spousal RRSP contribution, or enough RRSP room from the past to get there on their own.

Tax-Free Savings Account (“TFSA”)– Maximum flexibility, but no write-off

Key Benefits:

Maximum flexibility, as this account can be used for any other purpose without triggering tax if plans change.
Not income-based, so savers over 18 or 19 can start funding contributions even if not working, should other family members wish to lend a hand.
Any withdrawals can be recontributed in the next tax year onward.
All unused contribution room can be carried forward indefinitely, which can allow large initial contributions for older savers.
Can be used in conjunction with either the FHSA and the RRSP HBP, or both.

Key Drawbacks

No deduction for contributions.
Limited annual new contribution room (i.e., $6,500 for 2023.)

The TFSA is a general-purpose savings account with no deduction for contributions, but both tax-free growth and tax-free withdrawals, regardless of how the money is used. Everyone 18 or older earned $6,500 in new contribution room for 2023 and can contribute any unused room from past year whenever the heart desires and finances allow from the year they turn 18 onward (or 19 in places like BC.) Moreover, any withdrawals may be recontributed in later years, which is an important benefit to this program that I’ll say more about later.

The major advantage of the TFSA is that it can also be used in conjunction with either or both of the other two options, either to augment savings after maximizing contributions to either RRSPs or FHSAs, or as way to build savings until the saver has enough taxable income to benefit from either of the other plans. In other words, rather than funding an RRSP initially when in a low tax bracket, the money could instead grow tax-free in a TFSA first before eventually going towards RRSP contributions when the saver can actually benefit from claiming the RRSP deductions. Even better, when the money is eventually contributed to the RRSP, hopefully the amount that can be contributed will have grown due to savvy investing while the money was in the TFSA, which means a bigger tax refund that would have been possible if the money had gone straight into one of the other two options.

The same applies for FHSA contributions as well if the saver isn’t in a high tax bracket, although savers would likely want to max their $8,000 per year contributions to that plan asap and only use the TFSA for the excess. That’s because the $8,000 that goes into the FHSA is tax deductible (unlike TFSA contributions) and the saver can wait until in a high enough tax bracket to make claiming the deduction worthwhile.

Finally, unlike HPB, there is no maximum withdrawal limit on a TFSA, nor any repayment option. An investor maximizing both TFSA and FHSA contributions could hypothetically fund the entire purchase using these plans if they hit an investment grand slam or didn’t live in a place like Vancouver or Toronto. And, the previously mentioned ability to recontribute any withdrawals will increase how much (s)he can shield from tax in the future if they strike it rich or want to tax shelter some of their inheritance one day – someone contributing $50,000 to a TFSA but later withdrawing $150,000 would be able to shelter $100,000 more when their ship comes in later in life than someone who never used their TFSA in the first place! When the tax savings from having that extra hypothetical $50,000 grow for perhaps decades are factored into the mix, the TFSA starts to look better and better.

Family Trusts – Are the hassles worth the tax savings?

Key Benefits:

Potential massive tax savings if the contributor is in a high tax bracket.
Can allow purchase funding to start far earlier than most other options.
Can be used to augment a youngster’s other savings vehicles or to provide the money to fund those plans.

Key Drawbacks:

Setup and annual costs, plus the headache factor, make this option only really attractive in Wills or when there is perhaps $500,000 plus to contribute at once or over a few years.
Current minimum trust loan rates (Jan 2023) are 4%, which is far less attractive than the 1% loans offered until July of 2022, with rates increasing to 5% in April.
May require faith that money allocated to youngsters will ultimately be used responsibly when they are adults.

Trusts either created in a Will or funded during life by gifts or interest-bearing loans at the minimum government rate then in effect are an incredibly valuable tool for families with enough non-registered money to make the costs and effort worthwhile. If set up correctly, they can transfer income that would have been taxed at far higher rates in the hands of older generations to their spouses as well as younger and poorer family members, including minors in some cases. The benefits of a decade or two of extra money left to compound these yearly tax savings can almost seem magical and can make massive difference to junior’s later housing prospect.

As an added benefit, although there might be a sizeable chunk of change in the trust that is used to create taxable income and capital gains, trusts can be drafted so that the original capital loaned or gifted to the trust doesn’t necessarily have to pass to the child. Perhaps just as importantly, how much of the income or gains get allocated to the various family members can be discretionary, so that no funds get distributed to a child or grandchild who hasn’t got their act together quite yet. The trust can also lend the youngster funds on an interest-free basis so that the family has some control over at least that amount if the child goes off the rails or perhaps as a way of providing a bit of protection in the event of a divorce or creditor concerns.

On the other hand, trusts can allocate money to youngsters but keep the funds invested inside the trust, issuing the child an interest-free promissory note. Over time, if the value of the note continues growing, this can eventually be the down payment. Once that child is an adult, however, they can call in the note to use any way that they like. Accordingly, each family would need to determine their own comfort level. Rather than issuing these promissory notes, the family can simply use each child’s annual allocations to pay that child’s expenses or reimburse their parents. This still leaves the family with far more money than it would have otherwise had if the investments perform as expected but reduces the risk that junior might spend 2 decades worth of Promissory Notes on a really big truck as soon as (s)he officially becomes an adult.

Obviously, a trust funded by a living relative is not something that every family can afford and the dramatic increase in the minimum interest that must be paid on borrowed funds also eats into some of the profits. Moreover, for trusts created in Wills, it is usually impossible to know exactly when they will be funded. In many cases, although they may still be an invaluable tax saving vehicle for future generations, the money going into the trust may only arrive after a child or grandchild has already purchased.

Life Insurance – Living benefits from an asset meant to pay out at death.

Key Benefits:

Provides later protection for the child’s family while also creating a side savings account that will grow tax efficiently which can be used as needed later in life.
Money can be accessed in a variety of ways.
Ensures insurance for the child even if their health later changes.
Provides protection to the family if a child passes away, particularly after incurring significant medical costs. Allows parents time to grieve.

Key Drawbacks:

Requires funding many years in advance and a parent / grandparent who is willing to assist.
Annual payments are required for at least 10 years in most cases.
Some withdrawals in the child’s hands may be partially taxable.
May not direct as much money towards a down payment as some of the other options, as some of the premiums go towards the life insurance benefit.

Permanent life insurance with a cash value is another all-purpose savings tool that can lend a hand when junior wants to get his own pad. The purchaser of the policy is usually a parent or grandparent who gets things going before the toddler has started to crawl. They purchase the policy for typically a combination of reasons:

Ensuring that the child will have protection for their own children one day even if their health later makes insurance extremely expensive or impossible;

An intergenerational wealth building strategy that allows excess allowable contributions to the policy to compound essentially tax-free until it eventually produces a tax-free death benefit; and

Most importantly for the current discussion, a savings strategy to accumulate a pot of money the child can use during life in various ways, such as purchasing a home.

Interestingly enough, even though the death of a child, particularly after a long and expensive illness, can have a profound effect on family finances, most people don’t purchase policies on children with this risk in mind.

The typical strategy involves purchasing a “participating whole life policy” (although other policy options are available) and paying the maximum amount allowed under the tax rules into the policy each year, which is usually many times more than the minimum required payment for at least 10 years, although 20 is better. The excess cash grows virtually tax-free in the policy at a set rate each year determined by the insurance company that usually increases when interest rates increase. After contributions stop, some of the annual income (called “policy dividends”) on the accumulated cash value is used to pay that year’s premium and the remainder is reinvested Moreover, some policies also have guaranteed annual increases to the cash value as well, which further grows the war chest that junior can tap into in later life.

Still others are “paid up” in a set number of years (usually 10 or 20), which means that no further premium payments are required or deducted from that year’s policy dividend payment. For safety-minded investors, a participating whole life policy is ideal, as it works a lot like a savings account — all policy dividends and the cash value are locked in once earned and accumulate like compound interest. The only way the cash value will ever decrease is if the owner makes withdrawal or to pay the annual premium or policy fee. At this point, policies typically pay about 6% per year, although the expectation is that this will increase due to the drastic increase in interest rates this year, although increases inside the policy usually lag interest rate increases.

Relating all of this to home purchases, the process works as follows. The (grand)parent(s) buys and own the policy and maximizes allowable contributions each year for 10 or 20 years. Eventually, they transfer the policy to their child or grandchild. The youngster can then withdraw all or some of the cash value, some of which can come out for free and some which will be taxed as income. The money can be used towards that first home either directly or perhaps to fund contributions to one of those government accounts mentioned earlier, particularly the FHSA, in order to offset any potential tax owing on the withdrawal.

There are other potential ways of accessing the money, such as “borrowing” your money from the insurance company through what is called a policy loan, so the cash value continues to accumulate inside the policy or, for policies with larger cash values, using them as collateral for bank loans. And if youngster isn’t attracted to the allure of home ownership, the money in the policy can always be used for other purposes, like educational funding, or continue to grow inside the policy until the time is right or add to the eventual death benefit used to protect that youngster’s own family.

Conclusion – A hopefully spellbinding conclusion commingled with a call to action

Buying a first home in Canada has never been more difficult and, until today’s combination of high prices and high interest rates abate, things will not be changing any time soon. For that reason, knowing how to make the most out of what you can do is critical, as options and strategies do exist. Your job is to review the information I’ve provided, plus what you find elsewhere to make every dollar go as far as possible, whether you’re saving for that house yourself or helping someone get a place to call home. Next time, I’ll write a bit more about some other ways parents or grandparents who have already accumulated the funds can lend a hand while minimizing risk.