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Should I Stay or Should I Go Now – Whether or Not to Refinance Your Mortgage and How To Ease The Pain

Covid 19 is the sort of financial tsunami that bowls over and swamps all but the most conservative of financial projections. As we slowly begin to pick ourselves up, dry out our wet clothes and figure what comes next, I am suggesting to many of my homeowner clients with fixed rate mortgages to look at their existing mortgages to see if there are any opportunities to turn at least some of the lemon that is Covid into perhaps a shot glass full of lemonade.

When diving down into the rabbit hole of mortgage refinancing calculations, many surprises may await. Accordingly, I strongly suggest that you arm yourself with the expertise of an experienced mortgage broker like my friend and fellow Moneysaver contributor Russ Morrison that has been around the block at least twice to help you maximize savings and minimize unnecessary bank penalties.  And, after crunching the numbers, if you believe that it does make sense to pay whatever penalties come with paying up your current mortgage, it’s just as important to ensure that your shiny new replacement mortgage provides you with as much flexibility and as many features as possible in order to hopefully help you continue to save for many years to come. Don’t worry – I’ll save that next topic for another article.

How it Works

Trying to understand the ins and outs of whether or not it makes sense to pay down your existing mortgage ahead of schedule is a lot like trying to read a book in a foreign language upside while not wearing your glasses – extremely frustrating, confusing and open to misinterpretation. I’ll talk about the details of how this is calculated in a second, but at the end of the day, these calculations determine whether the savings you’d reap under the new mortgage would be enough if you continued your current payments going forward to pay down the mortgage penalty that you’d be adding to your new mortgage by the time your old mortgage expired. Put another way, if your mortgage balance would be $500,000 after taking advantage of all the prepayment options I’ll discuss later to lower your penalty, with 3 years until renewal, and your monthly payments are $3,500, would a new mortgage for $515,000 (current balance plus an arbitrary $15,000 penalty) and $3,500 in monthly payments leave you with a smaller mortgage balance 3 years from now than would be the case if you just kept paying down your current mortgage? If so, and the hassle factor and any associated costs from making the change aren’t too significant, then you’d want to look at making that change. I highly suggest getting your broker to spell out any additional costs or other downsides in advance so that you’re not surprised later. For example, will there be any legal or appraisal costs and, if so, how much?

Furthermore, if you want access to a new secured home equity line of credit (“HELOC”) from your new lender, how do those rates compare to what you currently have? HELOCs are usually variable and are also based around the bank’s prime lending rate. It is quite possible that in these days of Covid that your new HELOC rate might not be as attractive as your old one. You’ll need to take the extra interest you might be paying on the HELOC in the future into account before making your final decision if you’re planning on using your HELOC extensively going forward.

If your new mortgage is fixed term, then the calculations to determine whether you’re better off refinancing your mortgage are relatively straight forward. If you opt to go variable, however, then these calculations will need to take into account how your variable rate might change over the remaining balance of your current mortgage.  Although in these days of Covid, it is hard to imagine when rates might start to climb again, I still suggest taking this into consideration and crunching the numbers to include at least a rate increase or two at different points of time during the period in question. Taking on a variable mortgage does mean taking on more risk.  Factoring in what things look like if rates do climb, however how unlikely that may currently seem, forces you to see what could happen if life throws us yet another curveball. If you’re still ahead of the game despite these more pessimistic estimates, then you can proceed with more confidence and certainty. If the numbers no longer work, you can either stay with the status quo or, if the savings if rates don’t change are too much to pass up on, then at least you’ll have made an educated decision with a better idea of the downside if things don’t go entirely your way.

Calculating Your Prepayment Penalty

If you pay down a typical fixed rate mortgage ahead of schedule, it’s going to cost you. The penalty is generally whatever is higher – the interest you would have paid on the remaining balance of the mortgage over the next three months, or what they call the “interest rate differential” or (“IRD”), which is allegedly based on the difference between what you would have paid in interest over the remaining term of your existing mortgage vs. what you would have paid in interest over this same period on a fixed term mortgage at current rates for the remaining mortgage term. For example,  if you had 36 months left on your existing mortgage, the IRD would look at the interest you would have paid over those three years under the status quo minus the interest the bank can get now lending out your current mortgage balance to someone else based on their current posted 3-year mortgage rate. In theory, you are compensating the bank for not being able to get as much interest on the money you’re returning to them ahead of schedule when they have to lend it out to someone else now at lower rates.

There is one very important exception to the IRD calculations just discussed. Banks are only allowed to charge an IRD penalty during the first 5 years of your mortgage. After that point, they can only charge three months’ interest. Although longer term mortgages (i.e. like 10 years) are not particularly common (they are generally priced higher than 5-year mortgages for several reasons, one of which is to compensate them for lost IRD payments if the borrowers do cancel beyond the 5 year mark), if you’re the exception to the rule and already beyond the 5 year mark, you should have your mortgage broker on speed dial. You’ll be able to avoid the sticker shock that I’ll be taking about in the ensuing paragraphs if you do refinance.

Calculating a typical IRD penalty sounds pretty straight forward, but all lenders are not created equal and the devil is in the details.  For the naive, if your current 5-year mortgage rate was 3.39% and the posted rate for a three-year fixed rate mortgage today was 2.39% on a remaining mortgage balance of $300,000, you’d expect that the interest rate used to calculate your penalty would be 1%. Not so fast. Your original 3.39% rate was very likely not the “posted rate” advertised to the masses but a discounted rate that is referred to as the “bank rate” or the “discounted rate.” That is also true for the 2.39% rate currently posted – it’s likely that because the bank truly loves you and values your business that they would be willing to go a little lower than the posted rate, but only just for you, of course. As a result, the rate some banks use to calculate the IRD is the difference not between the actual 3.39% 5-year mortgage rate that you are currently paying and that 3-year posted rate of 2.39%, but the posted rate when you took out your mortgage two years ago and that 3 year posted rate. The difference between the posted rate and the bank rate on your original 5-year mortgage may actually be 2% or more higher in some cases! Thus, instead of using 1% (3.39% – 2.39%) to calculate your IRD, some banks might use 3% or more using this example (5.39% – 2.39%). Alternatively, they might get to the same 3% result by subtracting the 2% discount you received 2 years ago from the current 2.39% posted three-rate. Never mind that shorter term mortgages don’t get discounted nearly as much as 5-year fixed mortgages, nor that banks aren’t discounting their rates nearly as much these days in these times of Covid. Put another way, how many lenders out there do you think would be willing to discount their posted 3-year rate of 2.39% by 2% to 0.39%? In the end, there are currently a lot of horror stories regarding some potential prepayment penalties, particularly for those poor souls who aren’t refinancing in order save money under new rates but who might be losing their homes due to the financial crisis or are forced to refinance purely for cash flow reasons.

It’s important to note that banks aren’t the only way to get a mortgage in Canada. In addition to banks, or private mortgages, your choices include monoline lenders (lenders who only do mortgages rather than the whole array of products banks offer) and credit unions.  Generally, banks charge the highest penalties on fixed mortgages, although it really varies from lender. Bottom line: it’s vital to do your research prior to entering into your next mortgage to determine how lenders calculate their IRD penalties, as well as other key considerations like portability (the ability to transfer your old mortgage to your new home) and penalty- free prepayment privileges that can reduce any penalty if you do need to get out of your mortgage at a later date.

In the end, as Russ Morrison, licensed mortgage god, advises, picking the right mortgage is a lot more than just comparing interest rates. That’s why I suggest working with a mortgage broker rather than going it on your own. It’s free, you get to shop the entire mortgage market and you also get lenders’ best rates up front rather than only after you’ve found a lower rate elsewhere.  Perhaps most importantly, however, a good broker will walk you through the other considerations I’ve just discussed so the mortgage you pick fits you like a glove and you know how to optimize its features.

If it still makes sense to prepay your mortgage, there are a few things that might minimize the pain:

  • Be strategic when picking the time to pay down your mortgage. Get your broker to calculate both the savings and penalty happen to be if you pay down at different points in time. One of the big things to keep in mind, however, is that you won’t know for sure what the posted rate for the period closest to your remaining mortgage term will be in advance, nor the rate that you’d be able to get on the new mortgage that you will actually take on. If you try to get too cute, you may not be able to get the same mortgage rate offered today, which could more than offset any reduction to your mortgage penalty you might get by waiting. As well, using our previous example, if you wait until there are only 2 years left in your current mortgage, the IRD would look at the 2-year posted rate rather than the 3-year one. It could well be that the 2-year rate is lower than the 3-year posted rate, which means that, although the calculations would only look at 2 rather than 3 years of lost interest for the bank, the rate used to calculate that penalty may actually be higher: for reducing the IRD, you usually want the posted rate offered for the remaining term of your current mortgage to be high, not low so that the difference between the two rates (and thus, the rate used to calculate your penalty), is as low as possible.
  • Prepay the pain away.  When calculating the best time to pay down, it’s vital to remember that the penalty is only applied against the outstanding balance at the time of paydown.  Thus, the less you then owe, the smaller the penalty you’ll incur when repaying the bank’s dough. This will occur naturally over the lifespan of any mortgage, although if you’re still 25 to 30 years before it’s scheduled to be paid down completely, each payment at this stage is likely mostly interest anyway. There are steps you can take, however, to hammer down your mortgage balance before you pay it out and, as a result, significantly reduce any mortgage penalty. Most mortgages allow you to pay a set percentage of the original balance loan (a range of 10 to 20% is pretty common) each year in one or more lump sum payments. You may also be allowed to increase your regular payments by that same percentage, too, often without this affecting how much you’re able to prepay in lump sum payments. I’ll dive into the ins and outs of prepayment rules in a separate article but here are the basic things to keep in mind when looking at these options:
  • The early bird gets the worm. The earlier you start prepaying, the smaller your mortgage balance when it’s time to calculate the penalty.  Each prepayment means that every regular payment you make thereafter will be directing more money towards the mortgage balance rather than in interest payments. Just like when looking at investment returns over the long term, the magic of compounding also casts its financial spell when trying to reduce your mortgage balance by making extra payments as soon as possible.
  • Read the fine print and use it against them. Different lenders offer different prepayment percentages and features. Some allow you to make as many lump sum payments each year over a small minimum payment amount as your heart desires, while others aren’t as generous. Others may even restrict when you make your annual prepayments to a set date, such as each year’s mortgage anniversary! Since you’re stuck with these rules and limitations, it’s essential know the hand you’ve been dealt so you can employ these rules to your best advantage. For example, are the prepayment periods based on your mortgage anniversary or the calendar year? If you’re planning to pay down your mortgage, you could save you a lot of penalty dollars if you diarize the earliest date you can make your next lump sum prepayment and time your mortgage paydown for after you’ve done just that. If you have a 20% yearly prepayment privilege, getting to make an extra 20% prepayment reduces your mortgage penalty by that same 20%!
  • Let your HELOC lend a hand. Although taking advantage of the prepayment privileges propounded in the preview paragraph may sound promising on paper, it might be another thing entirely coming up with the money to make this happen in the real world. That’s where your existing HELOC comes in.  If you use your existing HELOC or even arrange a new one in anticipation of paying out your mortgage early to fund lump sum prepayments or also free up the cash to also increase your regular payments as well, this can take a huge bite out of that future mortgage prepayment penalty. And, when it’s time to take out that cheaper, lower rate mortgage, you can borrow enough to pay down the balance of the HELOC. Even better, since the prime lending rate has fallen so fast so soon, the interest you’re paying on it in the meantime may actually be significantly lower than the rate that you’re paying on your current fixed rate mortgage anyway.  Not only will you be reducing the penalty you’ll pay the bank down the road – you’re doubling down your savings by reducing the rate of interest you’ll be paying along the way as well!
  •  Consider using your TFSAs to turn the tide. If you’ve got a lot of money already tucked away in your TFSAs and you’re still struggling to come up with your prepayment, consider dipping into your TFSAs to come up with a bit more cash.  You can always borrow back the money to fill up your TFSAs as part of your new mortgage, although you will have to wait until the next January before you can replace the money you’ve withdrawn. This option works best for investors who don’t expect a lot of growth or income from their TFSAs between now and then, as the opportunity cost for reducing the prepayment penalty using your TFSA loot is the tax-free income and growth you would have received had you stayed invested. If you’re one of those people who have calendar prepayment privileges and want to make that final penalty-free prepayment in January before refinancing your mortgage, consider pulling your TFSA money out in late December if you want to minimize potential lost investment growth. Your new mortgage can include enough money to restock your TFSAs and you can start earning tax-free TFSA dollars once again with minimal opportunity cost. Just don’t try to claim a tax deduction on the money used for TFSA purposes, as that’s not allowed.
  • Cash in your cash accounts. Another potentially useful way to prepay that mortgage is to sell existing non-registered investments to raise the cash. There will be a tax bill to pay on any capital gains, so you’ll need to take this into account before making this decision. If you were going to be selling some of the investments anyway within the next couple years and are worried about having to pay more tax on capital gains in the future like I am, this might be something you could consider doing anyway. Want to stay invested? Perhaps you can use your HELOC to buy back those investments. Not only will this reduce your eventual prepayment penalty and perhaps even lower your combined interest rate if your HELOC interest is lower than your fixed rate mortgage, you can now write off the interest on the money you’ve used to repurchase those investments! If selling investments at a loss, however, be sure not to repurchase the exact same ones or wait for at least 30 days after selling to do so or you won’t be able to claim that loss for tax purposes. When eventually getting your new mortgage, you’ll likely need to pay down the existing HELOC, which might mean having to sell your investments again, but you can take out a new HELOC at that point with whoever is issuing your new mortgage or even look at carving out a separate mortgage just for investment purposes if that gives you access to a lower interest rate.Either way, try to keep the investment loan portion of your mortgage or any HELOC as a separate mortgage or portion of any HELOC for tax purposes. Not only will this make your accountant far happier, it will also likely save you a bunch of tax dollars going forward. If the debts are kept separate, you can arrange your finances so that you pay as little as possible towards your deductible debts and direct more towards your non-deductible ones. As a result, more of your debt and more of your interest will be tax-deductible, which can result in significant tax savings.

Final Considerations

When refinancing your mortgage, there may also be some opportunities to reduce your current expenses if times are tight. Although the break-even calculations assume that you’d continue your normal payments under the new mortgage and keep your amortization period (i.e. the number of years before your home is completely mortgage-free) the same, you don’t have to do either of these things.  Under your new lower rate mortgage, your minimum regular payments will probably be lower despite adding the interest penalty to the balance. If your focus at this point is on keeping your monthly costs lower, you could likely reduce those payments slightly and still have the penalty paid down by the time your current mortgage would have expired. Or, if cashflow is particularly tight, you might decide to decrease your payments and increase your amortization period which could significantly reduce your regular payment costs to make ends meet until your finances improve. At that time, when funds permit, you could look at increasing your regular payments under the prepayment privileges provided under your new mortgage in order to get things back on track. For some of us, the decision to pay down our current mortgage may even be based purely on reducing our regular costs even if the size of the penalty doesn’t otherwise justify making the change. If you’re in that boat, you’ll just have to make sure that you still qualify for a mortgage or to see if you have any relatives willing to act as guarantors.

Conclusion

Although 2020 has caused many financial problems for far too many Canadians, there may at least be a few ways of easing the sting and helping us get our houses back in order. For some of us, paying down our mortgage early might be one such opportunity.

Free Online Presentation November 6, 12:15 pm

Once more the World Money Show and Canadian Money Saver Magazine have generously invited meme to be part of their 3 day Extravaganza of investing and financial planning running from November 4 to 6.

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To register and find out more, please click on the following link:Registration Link: https://online.moneyshow.com/2020/november/canada-virtual-expo/speakers/ffvcms0311172/colin-ritchie/?scode=051449

Even More Wills, Chills and Thrills – A Few More Things to Consider When Drafting a Will

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During these times of turmoil and Covidic confusion, many of my clients have had Wills on the brain. Although many Wills do a good job covering off the basics, I still often finish reviewing my new clients’ old Wills with a vaguely uneasy feeling that there are a few too many “what ifs” left floating in the wind for my liking. And when I also reviewing their beneficiary designations, I really start to get fidgety. Thus, in effort to stop my squirming, I am inflicting this article upon you today.

In law school, I was trained imagine the worst and to make you think about things that you don’t like talking about at cocktail parties. Fortunately, my job is also to provide you with safety valves and solutions to protect you and yours if the worst actually does come to pass. Admittedly, in many cases, this extra worrying will be unnecessary and any extra issues, tension and confusion left unresolved will eventually work itself out with few permanent scars. On the other hand, if life does come up snake eyes, a little extra planning can easily pay for itself many, many times over in terms of problems avoided, relationships preserved, and dollars saved. In my view, when you’re talking about the transfer of a lifetime’s worth of hard work, sacrifice and saving to the people and causes you love most in amounts that can profoundly their futures, this is one of those times when it’s worth sweating the small stuff. 

Noting all of this, here are a few of the extra things I suggest considering before you sign your Will’s back page:

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  • Not being able or getting around to update your Will and beneficiary designations on insurance or registered plans in the future. I am particularly thinking of clients who lose their capacity to make legal decisions due to disease or injury but may linger for many years after diagnosis or mishap.  Most people assume that they can just make changes to their plans if someone dies in the wrong order or life throws a curveball, but this isn’t always possible. To counter this contingency, I like to include:
  • Backup guardians and trustees and perhaps secondary backups.
  • Indexing cash gifts to inflation or making them a percentage of the estate instead so that they keep up with inflation or grow/ shrink with the size of your estate if it is larger or much smaller than anticipated.
  • Distributing assets like accounts, real estate and company shares as part of an heir’s share of the estate rather than a stand-alone gift. In other words, if the goal is to equally divide an estate amongst your 3 children but for your youngest son is to get the cabin, divide your estate evenly but specify that your son’s share includes the fair market of the cabin at death net of taxes. In that way, regardless of what the cabin is worth in the future, your boy still gets his mancave but the estate is divided equally. Worried about the cabin being worth more than his fair share? Either he can get a mortgage to buy out his sibs at death or you can provide other options in your Will like him paying out his siblings over time at an interest rate that is based on the market rate at that time.
  • Contingency planning for life insurance and registered plans if leaving these assets jointly to your children with descendants of their own or who might have them in the future. Without this planning, if a child with descendants predeceases you, it is very likely that your other children would just get a larger piece of the pie and the children of the deceased would both go hungry and might even be stuck indirectly paying for some of the taxes on some registered plans they never received. Although many clients accurately assume that children who receive this extra share would do right by their nieces and nephews:
  • Some of your kids may honestly believe that they are just following your wishes when keeping the extra share or may never understand that there has been an injustice in the first place;
  • If the recipient children have creditor issues or incapacitated, they might not be able to set things right even if they want to; and
  • If the grandchildren are still minors or even young adults, it could be messy and complicated to determine how to get the money back to the children, avoid unnecessary taxation and determine who is to manage the money in the meantime.
  • Including provisions to hold an inheritance in trust if your now-healthy heirs are incapacitated at the time they inherit or perhaps beset by other problems, like creditor issues or addictions. Why take the chance that an inheritance might end up managed by the government, squandered, used to feed an addiction or handed over to creditors rather than your kith and kin?
  • Flexibility to move any trusts created in your Wills to other jurisdictions if your children or other heirs end up living abroad. It’s also really important to get good advice if you have heirs with U.S. citizenship or living in the U.S to avoid your heirs pay far more taxes than necessary.
  • Contemplating potential money issues and uncertainties might arise amongst your beneficiaries and trying to head off as many at the pass in advance. Along those lines, I suggest dealing with the following:
  • Stipulating executor fees and ongoing fees for trustees managing trusts for your heirs directly in the Will. Although courts generally award fees based on a percentage of your estate and you can do the same in your Wills, this can cause problems. Either the person doing the work doesn’t want to rock the boat and claim a fair (or any) executor fee or perhaps they does claim a fee and the rest of your heirs feel (perhaps with justification) that it is more than you would have wanted, particularly if the executor is also an heir and doing some of the work for their own benefit. The size of the estate doesn’t often match its complexity so naming a percentage in your Will might over or undercompensate your executor. Ultimately, although this is not a perfect solution, I have landed on picking a flat fee and indexing it to inflation or, if using a percentage, including a minimum or maximum value that is also inflation indexed. I also suggest doing the same thing for trustee fees as well in order to ensure that they also get paid yearly if required to manage trust funds for some of your heirs in an amount that is fair, transparent and not open to creative interpretation.
  • Including a memo that distributes your personal effects and then stipulating a way to divide the remainder, with provisions for compensation payments if there is a significant disparity in the value of the assets distributed. Some people fight more about the picture albums and artwork than the bank accounts. Trying to head this off at the pass in advance or even sitting down with your children to get clarity who gets what and agreeing upon a process for divvying up your “stuff” can go a long way to eliminating sour faces at future family picnics. Some people even put masking tape labels on the back of contentious possessions with the name of the future heir on the back! Others have an auction between heirs to buy your velvet Elvis print and bobblehead collection, although others think starting a bidding war over the family heirlooms and assets is just a recipe for disaster.
  • Providing guidance or perhaps including even a guardian fee for the people caring for your children. It is often exceedingly difficult to quantify the extra costs your guardians might incur raising your children and it can be an awkward conversation if the person managing their money and the person managing your children are not the same. Providing a statement of general principals to your trustee, such as to take a liberal and expansive view of expenses and to clarify things like including your guardian’s vacation costs when travelling, or to with your children might make your guardian and trustee’s relationship far more comfortable and productive. It is also a great idea to provide guidance on the sort of lifestyle you wish to provide your children. See my earlier articles on “Voices from Beyond the Grave” that discusses this and other related issues in more detail on either my or the Canadian Moneysaver websites for more details.
  • Considering whether the same person should be trustee and guardian. This is often done without incident, but there is a significant conflict of interest if the person deciding how much of the guardian’s mortgage, cable bills and property tax should be paid from the a child’s trust fund is the same person incurring these expenses. Every now and then, we lawyers hear cautionary tales about guardians who may have dipped into their charges’ trust funds a little too liberally, perhaps so that the children can’t afford to attend university or don’t have that down payment for their first home that mom and dad anticipated would be there.  This may be due to fraud or overly generous accounting, but it also might due to picking people to raise your children who are not also good at managing an investment portfolio or budgeting for the future. Moreover, both jobs require significant time commitments. Perhaps picking different people to watch your money than those you’ve picked to watch your kids is actually doing your guardians a rather large favour.
  • Not automatically picking children or spouses as executors or trustees. Being an executor is a generally thankless task and it takes longer to wind up many estates that most people expect. Although it can be expensive and not without problems, picking a professional trustee or at least someone who isn’t one of your heirs to do the job might sometimes be the best solution. Do consider the following before naming family as your executors:
  • Do your children get along and work well together if you pick them to act as a team? Do you want to include tie-breaker provisions in case they can’t agree? Does it make sense to name children who now live in distant lands or to require that they also sign off on every decision?
  • Will any children feel excluded if their siblings are picked as executors and they are not? As well, siblings not chosen may have unrealistic expectations regarding how long an estate should take to settle and have been noted to unfairly hound executors for their piece of the pie far sooner than is reasonable. The excluded siblings may also often feel without justification that the chosen child has not done a good job at maximizing the value of an estate or overpaid everyone involved, from the estate lawyer down to the woman hired to clean out your refrigerator after you’re gone.
  • Does your new spouse really want to be executor if it means your old kids are breathing down her neck? Conversely, how would your children from prior relationships feel if the new spouse is your sole executor or perhaps managing trust funds for them or their children? How do they feel about your spouse even managing his own trust fund if whatever is left at his goes to them,  particularly if that spouse has unlimited spending powers?  Likewise, if the children are managing your spouse’s trust fund and deciding both how much to pay out each month and how to invest the cash, how would your spouse feel about that?  If the kids are to get what’s left down the road, there is also a real temptation for them to both be cheap when budgeting money to your spouse while also picking riskier investments that focus more on growing their own future inheritance than the more conservative income-focused portfolio that better ensures your spouse will never run out of cash. The expression “conflict of interest” was perhaps invented with these situations in mind. The expression “family squabble” certainly was.
  • Is there even the slightest chance of a Will challenge, particularly if you have a blended family or you don’t treat your children equally in some provinces? An inheritance is a once in a lifetime windfall and no matter how people get along until that point, big money can still lead to big problems, particularly if you are not around to make sure that everyone plays nice. Moreover, if your children are forced to wait until your new spouse dies before getting their inheritance, they may actually get legal advice telling them to challenge your Will since they will have little chance of challenging their stepparent’s Will at a later date, assuming that there is anything left to challenge by that point anyway.
  • Is there a reasonable chance that anyone acting as trustees of any ongoing trusts will have to act as “bad cops” to their siblings, nieces or nephews and thus wreck Christmas dinners for decades to come or who will ultimately cave to pressure in order save future Christmases? This is another great reason to consider a professional trustee, particularly if dealing with heirs with potential addiction issues, creditor problems or a money management handicap.
  • Determining whether it makes sense to pass on or sell family assets like businesses and cabins. Will passing along these assets in kind to your family mean starting a new family feud rather than continuing a family legacy. Issues include:
  • Treating children with sweat equity in the business or farm fairly while also providing for your other children.
  • Balancing your business children’s desire to potentially run and grow the business vs. non-business children’s desire for cash flow and safety.
  • Do your children have the experience to run your business and to work together? Is this a recipe for success or the ingredients for creating a family disaster?
  • Who gets to make business decisions? Equal voices can mean gridlock or non-business children having too much say in matters they don’t understand but providing control to one can cause resentment or to make unfair or unpopular decisions. Who sets salaries for the business children? Are profits to be reinvested or a set percentage paid out each year? What if the child you pick isn’t up to the task and ultimately squanders not only his inheritance but his siblings’ as well by running the business into the ground?
  • What if any of the children wants to sell their share of the business or cabin and the others can’t or won’t buy them out?
  • Are your children able and willing to pay ongoing property expenses and do their share of the maintenance for family cabins and cottages?  If one child really doesn’t use the place as much, should they be paying the same portion of costs? Does that child really want the place?
  • Balancing financial autonomy with financial prudence.  Except for smaller gifts, I generally recommend holding a youngster’s share of an estate in trust until they are at least 25 years of age and often suggest handing over the inheritance to those children in stages so that they can learn and make mistakes with only a small portion of the inheritance before being entrusted with the big bucks later. Some of my Wills even require the children to co-manage their trusts with the original trustee for a while so that they get on-the-job experience managing investments, budgeting and taxes before getting to call their own shots. Although there are horror stories about younger heirs burning through their legacies and many years of their lives when trusted with too much too soon, I worry almost as much about responsible, well-intentioned kids hiring the wrong financial advisors or trying to do too much on their own with insufficient experience. On the other hand, in Wills that hold a child’s share of the estate until they are in their mid-30’s or so on, I usually draft the trusts in such a way that the money can be handed over ahead of schedule if the child has proven themselves along the way if the trust is no longer worth the expense. For trusts with a larger dollar value or time line, also consider appointing a “protector”. This gives your heirs someone to notify if the trustee is not up to scratch and the protector can swoop in, fire the incumbent and appoint a new trustee if appropriate. Otherwise, getting rid of a bad trustee is as hard and frustrating as getting ink stains out of your favourite shirt and far, far, far more expensive.
  • Decoupling family finances. While money is probably not the root of all evils, I do see it as a major cause of many family spitting matches. Accordingly, I ask my clients to carefully consider whether or not to leave assets like private companies and real estate jointly to multiple family members for the reasons expressed previously. In situations where it is the right decision or the only practical choice, I encourage clients to take additional steps, like signing agreements or at having family discussions in advance to set up ground rules, particularly to cover what would happen if one of the children later wanted out, such as a buyout procedure, valuation formula and the appropriate timeframe for payouts. Do investigate life insurance in these situations as well in the hopes of paying some of the children out in cash rather than making them get shares in the family business instead. You might even make the children to get the business or cabin pay for this insurance in the first place!
  • Providing surety in blended family situations. Decoupling finances can be even more important for blended families. For first marriages, it is common for the surviving spouse to inherit all or most of the family assets and that usually makes sense. In second marriages, however a lot can go wrong if the children from your first kick at the can are forced to wait to inherit until your second dearly beloved is no more. This can poison relationships, result in those Will challenges I mentioned earlier in places like B.C. and might even result in your children missing out on any part of your estate if your new spouse outlives them, remarries, goes on a decade long spending spree or ultimately leaves  their inheritance to their favourite charity, the pool boy or their own children instead of yours.  If it isn’t possible to provide for your children while also protecting the surviving spouse (again, more life insurance might be a solution in some cases), many families leave the survivor’s share in a trust that ensures that the remainder flows to the children or their descendants eventually. While this situation isn’t ideal, picking the right trustee and providing sufficient guidelines in the trust can at least go a long way to minimizing family tension, particularly if the children at least receive something at the first passing, perhaps when they need a financial leg up the most.
  • Equalizing inheritances for children with large age gaps. If you’ve already put some of your older children through school, covered their spring break adventures, paid for 10 years of interpretative dance or tuba lessons, funded a closet full of must-have jeans,  two decades worth of pizza and so on, is it fair to leave your estate equally to all your children when the younger ones never received such benefits? In situations like this, I often use a general education and maintenance trust to cover all expenses for anyone in school or under a set age, with the remainder divided equally amongst all of your children, regardless of age, when the last of them no longer qualifies for payments. This might comprise 40% of the estate if no surviving spouse and is designed to provide the younger children with the support and extras that their older siblings received during your lifetime. The remaining 60% would be equally divided amongst all the children, with older children receiving their portion of the 60% immediately. When the dust settles, all the children have been provided with the same leg up and luxuries prior to get their university diplomas or reach adulthood but your older children are not forced to wait until their youngest sibling gets a diploma before having the cash to buy their first home.
  • Including provisions to gift over an inheritance on a child’s death.  Although most Wills contemplate what happens if a child predeceases you, most don’t deal with what happens if a child inherits but passes on while leaving behind a spouse. In most cases, your son or daughter-in-law would likely inherit and your grandchildren would only what’s left after (s)he is also deceased. If that spouse remarries, has additional children in the future or squanders the cash, then your grandchildren may end up with nothing, less than you would like or perhaps inherit it far later in life than you would have wanted. Leaving the money in a trust that names your child and their own descendants as beneficiaries can ensure that your grandchildren get what’s left on your child’s passing or can even gift over to your other children instead at that time if none of these grandchildren exist and you really don’t like your son /daughter-in-law. As an added bonus, this type of trust structure can actually save your child a lot of money along the way in taxes avoided by allowing gains and income to be taxed in your grandchildren’s hands at their rates, making any inheritance go a lot further. You might even name your child to be their own trustee in some cases in order to maximize flexibility and decrease both complexity and costs of running the trust.

Conclusion

My job as a lawyer is to find the dark cloud hidden inside the silver lining, no matter how small and unlikely.  Although many of the extra provisions I’ve just enumerated in copious detail may be ultimately be unnecessary in many cases, the downside is generally just a few extra dollars and hours “wasted.”  On the other hand, taking a bit more time now to think and plan for the unpleasant and unthinkable might be a game changer.

Covid Contemplations: What to Do If You Have Been Socially Distanced by your Finances

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In this eerie time of social distancing, medical mayhem and financial carnage, I feel like a background character in a cheesy made-for-tv movie starring B-grade actors from the 70’s. Unfortunately,  the chaos and risk are all too real, although the consequences and aftermath remain a riddle wrapped inside an enigma.

For those of you, however, who are trying make sense of their financial picture, I do have a few suggestions to lessen the financial pain and some things to keep in mind when you are deciding what to do next.

Consider Future Tax Issues When Making Your Financial Decisions Today

When reading some of the tax-planning options I discuss below, particularly those about harvesting capital losses, it’s also really important to consider how things might look a few years down the road when Covid19 is hopefully a distant and not particularly fond memory, like door-to-door salesmen and (fingers crossed) manbuns. I simply can’t imagine a future that doesn’t include significant tax hikes, particularly for those in the higher tax brackets or for most people in their year of death. I also worry if this might also include increasing the inclusion rate for capital gains from 50% or, for those of you not up on tax-speak, what percentage of any realized capital gains is actually included as taxable income and what part is tax-free. Keep in mind that this was something tax types were stressing about even before this all came down.

In the past, as much as 75% of capital gains were taxed on sale. If the inclusion rate goes to 75% again, this would mean paying 50% more tax on gains than we are right now! For example, if you had a $10,000 capital gain and were in the 40% tax bracket, you’d have to pay $2,000 in tax at the 50% inclusion rate ($10,000 x.50 x.40). If it goes to 75%, then you’re out of pocket $3,000 ($10,000 x .75 x.40). Hopefully, if the inclusion rate is increased, it’s not quite so drastic – I just used 75% as an example since it was a number our government had charged previously. Essentially, just like when setting any other tax rates, they can pick any number they want, limited only by the fact that they want to get re-elected and probably don’t particularly enjoy having their likeness burned in effigy.

A) Capital Gains

For those of you with unrealized capital gains from those bank stocks you bought in the days of disco, there are some planning opportunities available for you, particularly if you expect to be in a lower tax bracket than usual this year anyway.  Here are some of the reasons why you might want to trigger some of those gains now:

  • Your other sources of income are also affected this year and you’ll be in a lower tax bracket than usual. Although paying taxes ahead of schedule is not something I love doing, you might be better biting the bullet now vs. selling in a few years during the new tax reality. It also may also mean not having as much money in the market to capture any future market recovery and receive dividend payments if you have to divert some of your capital to pay the tax bill next year unless you have offsetting capital losses so consider this carefully. On the other hand, it’s not like you need to pay the tax bill today – this is a bill you won’t need to cover until April 2021.
  • You have other stocks that are underwater and would generate capital losses upon sale. You could apply those losses against those gains so you won’t have to pay the tax man this year and can keep all of your capital invested to hopefully participate in any recovery and generate income while you wait.
  • You have losses from previous years already on the books to use up so you won’t actually be triggering a tax bill. Triggering gains at the current inclusion rate, even if you aren’t actually paying any tax on them because of your offsetting losses, will still save you tax in the future if inclusion rates change going forward as I explain later in this article.
  • You are worried and were going to take some money off the table anyway.
  • Your portfolio wasn’t properly diversified, previously, it would have meant paying too much tax to rebalance previously. Now that values might have declined, that tax bill isn’t so high and the tax pain isn’t too great. Although you are selling when markets are down, you will also be purchasing your new investments at a discount. This works even better if you have some of those offsetting losses we also discussed.
  • Your risk tolerance has changed, or you no longer like your current mix of investments anyway.
  • Your capital gains are inside your company and you are really worried about the inclusion rate for gains increasing going forward. If this happens, corporate investors will suffer another hit. Our tax system allows companies to pay out the non-taxable portion of capital gains tax-free to its shareholders (i.e. currently the 50% that isn’t taxed). If the inclusion rate went to, say, 75%, then shareholders would only be able to take out 25% of the gain tax-free, which is half of what they can do now. When coupled with the higher tax rates we’ll likely be paying in general going forward, this might be enough incentive to lock in those tax-free payments now, particularly if the business owner isn’t making as much money from other sources that year anyway. If this might be you, then you might hold off on selling company-owned investments that have losses, as realized losses offset how much of the gains you can withdraw tax-free.
  • You are looking at other uses for your money, such as permanent life insurance, income-splitting it with a spouse or through a family trust, paying down debt or perhaps helping the children out a bit more now than you’d previously anticipated.

As a final point, it is also important to remember that if you do sell a stock that is in a capital gain position but you still love it, there is nothing that stops you from buying it back whenever your heart desires. Although you must wait 30 days after selling a loser before repurchasing it, there is no such rules when reconnecting with a former flame that you previously sold at a profit.

Capital Losses

When deciding whether or not to trigger capital losses, here are some of the things to keep in mind when making decisions:

  • If tax rates and the inclusion rate both increase in the future, triggering capital losses in later years to offset future gains might save you more money over time than triggering them now, particularly if you’re ultimately going to be in a higher tax bracket in the future anyway.

 We talked earlier about how the inclusion rate works for capital gains and how an increase of the inclusion rate from 50% to 75% would mean including $7,500 of every $10,000 capital gain as taxable income rather than just $5,000. The same is true for capital losses – if the inclusion rate was increased from 50% to 75%, this means that you get to deduct $7,500 per $10,000 of bad decisions rather than only $5,000.

It all comes down to when you trigger the losses. Typically, when inclusion rates are increased, those increases don’t apply to losses already on the books. For example, if you trigger a $10,000 gain in a dystopian future reality where inclusion rates are 75% but had an unused $10,000 capital loss on the books from this year, the two would no longer cancel each other out. Because you triggered the loss at a time when the inclusion rate was only 50%, you would only get to deduct $5,000 of that total loss of $10,000 but had to include $7,500 of the $10,000 gain as income, meaning you would still need to pay tax on $2,500. It’s always possible that the government could increase the inclusion rate for past losses if they decide to increase the inclusion rate for new gains. Personally, I think it’s more likely to find discount hand sanitizer  and toilet paper on sale next week than for that to happen.

  • If you want to trigger capital gains this year for some of the reasons discussed above, i.e. you’re going to be temporarily in a lower tax bracket and are okay paying some tax now at current rates, you won’t want to trigger any capital losses this year, as they have to applied against this year’s gains.
  • Triggering losses now will give you more flexible for rebalancing your non-registered portfolios going forward since you can apply these losses against future gains so that you can rebalance without tax consequences until those losses are used up.
  • You have some big capital gains from the last 3 years and want to carry back this year’s losses to get back some of last year’s taxes. You’ll have to wait until you file your 2020 tax return to do this, but it might be worth the wait if you were in a high tax bracket then and don’t expect to be in the same place going forward.
  • You adopt the bird-in-the hand approach and want to deal with today’s taxes and inclusion rates rather than guessing about how things might look in the future. Likewise, you might expect some of your losers to rebound and might want to just lock in the losses now for flexibility’s sake even if this means having more taxable capital gains in the future if your reinvested dollars make money.

As a final thought, it is important to remember that you,  your spouse, your company, etc. must wait 30 days to repurchase any investments you sell in order to be able to realize your capital loss. If you are still really bullish on the investment’s long-term future, then you could look at similar alternatives, at least until the 30 days have expired, unless you’re happy to sit on the sidelines for the short term.

Find Some Balance

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Somewhat ironically, some of my client’s biggest financial planning headaches a few weeks ago was not being able to rebalance their portfolios without triggering big tax bills. In many cases, this meant having a disproportionately large share of their investments in perhaps a few stocks that had been in their lives longer than their children.  Adding to the risk,  many clients owned several similar stocks in the same sector with the same problem, such as perhaps 3 or 4 Canadian bank stocks they’d first started acquiring when the first Trudeau was doing his thing.

All that has now changed. Although you may still love your BMO or Royal Bank shares, it may now be possible to trim those positions in favour of a new infatuation. It doesn’t mean abandoning all of those legacy stocks, but merely hedging your bets. Although playing the field is not a great recipe for romantic success, investing is an entirely different kettle of fish. Rather than just looking at the tax side of things, you might be better off focusing on building a properly diversified portfolio that fits like a glove even if it means cutting an extra cheque to Ottawa in order to make this happen.

If you are looking to rebalance, perhaps this is the time to add a few new types of investments to your portfolio, particularly:

  • some that don’t trade on the stock market and hopefully haven’t taken as strong a gut punch to their prices as public market stocks have suffered;
  • expanding your portfolio geographically beyond just Canadian dividend payers and some companies from down in Trumpland;
  • investments that offer some downside protect through options or the ability to short-sell or which are designed to allegedly make money in any market conditions, although this doesn’t always happen.

The current buzzword is that people should “invest like a pension” and strive for less risk and smoother returns by expanding their mix of investments. Although even pension funds or companies that invest like them have taken a kick to the teeth this last month, their extra levels of diversification have generally helped them some of those extra body blows that the average Joe has endured.

Look to Refinance Loans

For those of us with mortgages, one of the consolation prizes (albeit one on par with a getting a participation ribbon for finishing  58th place in a 5 km race) are much lower borrowing rates. If you have loans of any type, get professional advice regarding whether it makes sense to redo those loans at current rates despite any penalties that might apply.  For those of us with variable loans, the monthly savings can be really significant and will hopefully help ease the pain for years to come.

For those of us with family trusts and loans at 2%, start planning to refinance those loans at 1% this July, as it appears very likely that the minimum loan rate will drop back to 1% at that time.  This will also apply to spouse loans as well, so it’s worth looking at updating those too. Despite the hassle, it’s recommended that you actually physically repay past loans and then re-advance the funds.

This will allow more future investment income to be taxed in low-income family members’ hands and less in yours at your higher rates.

Consider Setting Up a Family Trust or a Spousal Loan

If the rates do drop to 1% in July (this will be clear by the end of April and is based on a government formula that suggests that this will happen with room to spare), then those of us with large unregistered investment portfolios have the opportunity to income-split a lot more successfully with spouses, children and other lower income family members. Noting the current yields on many investments and the hope of stocks eventually recapture some of their past glories, the tax savings from loans to family investment trusts or spouses are even more mouthwatering. Until now, the unrealized gains on the higher income spouse’s portfolios may have been a deal breaker, as it meant paying too much tax to free up the capital to loan to your spouse or trust. For better or for worse, this may no longer be the case, both because of reduced gains and perhaps if the higher income spouse is in a lower tax bracket this year.

Be Prudent If Investing New Money into the Market Today

Although current yields on many investments are (apologies to my vegetarian, vegan or pescatarian readers) as mouthwatering as prime rib on a cold winter’s day, there is still a lot of uncertainty in the market. Although it is a personal decision as to whether you wish to deploy any dry powder you may have to take advantage of these eye-popping yields, do keep in mind that we might not have seen the bottom and it’s hard to determine how the fallout will affect different stocks and industries. Consequently, you may wish to keep in mind some of the following if you’re contemplating dipping a toe back into today’s rather frothy investment waters:

  • Consider dollar cost averaging rather than trying to do market timing. We don’t know if we’ve hit the bottom so you may benefit from easing money bank into the market over a number of weeks or months rather than going “all in” on what your fortune teller says is your lucky day.
  • Yield is a wonderful thing. If you do want to put new cash into the market, take advantage of those high yields rather than counting on future gains. The income will reduce the risk and can be redeployed back into the market if you so desire or can be a way of providing more money for your family during a time when many family budgets will be stretched extremely thin. Because of the current calamity, even blue-chip stocks have yields formerly reserved for junk bonds. As a result, there is no need to travel too far down the risk spectrum just to get a few more percentage points when safer stocks are already paying you handsomely
  • Be sure that you have a sufficient contingency fund set aside to cover you and your family’s expenses so you’re not stuck having to sell some of those investments you just purchased at the worst possible time. If in doubt, bump  up the size of the contingency fund.
  • Be even more conservative if you are borrowing to invest. Although rates are astonishingly low right now, leveraged investing only works if you can pay back your loans when the time comes. Accordingly, think long and hard before proceeding and reread my last three bullets at least twice. I strongly suggest staying away from margin accounts at this point as a margin call might ultimately be the financial kiss of death. If you do borrow to invest, carefully investigate the spread between secured lines of credits and borrowing using a traditional mortgage. Despite the decrease in rates, there can still be a big difference in cost between borrowing using a HLOC or using a mortgage. Although the mortgage option is less flexible and requires you to also pay down some of the principal with each payment, it might still be the way to go.
  • Diversify, diversify, diversify. Because the fallout is still so uncertain, spread your money over many different sectors and investments. It’s better to take some of the risk off the table by hedging your bets. Rather than waiting for fair weather and your ship to come in, consider funding a fleet of smaller boats that will see you safely into the future even if some of them don’t ever reach the shore.

Look into Estate Freezes

An estate freeze is a strategy that involves owners of private companies swapping their common shares for fixed value preferred shares. New common shares are then issued to other family members or to a family trust and all future increases in company value will be taxed in their hands. Private business owners do this sort of thing this for a couple reasons:

  • To increase how much capital gains can be sheltered from tax if the business is sold. If the existing shareholders won’t be able to shelter all the gains from tax upon sale under their own lifetime capital gains exemptions, having new growth taxed in other’s hands allows these other family members to dip into their own exemptions to increase tax sheltering at that time.
  • To minimize the tax bill on their deaths by capping the value of their shares and transferring future growth to younger generations.

Despite not owning a private company, are you the proud owner of a non-registered investment or real estate portfolio that you want to pass along to your kids, grandkids or favourite financial planner? An estate freeze might still be the thing for you. Transferring those assets into your company on a tax-free rollover basis in exchange for fixed value preferred shares lets any future growth accrue inside a family trust or in your heirs’ hands rather than yours.  As a result, when your time comes, you can pass into the great beyond knowing that your final tax bill is a lot smaller and your heirs’ inheritance that much larger than might have been the case.

In most of this instances, estate freezes only work if the new common shares subsequently grow in value.  Accordingly, doing a freeze this year when share prices for most private and public companies are at Black Friday prices can mean tremendous tax savings in years to come if values do bounce back, particularly if tax rates and the inclusion rate are both higher in the future.

Learn About Your Options

Keep informed about government programs and tax changes that might help you and your family, such as EI, reduced RRIF withdrawal requirements, extensions to tax filing and installment payments, changes to your bank rates, mortgage or loan deferral options and so much more.

Conclusion

I am hoping that one day, hopefully soon, we can look back on today’s events in the same way many of us look back on 2008 and 2009 and perhaps how my parents viewed my teenage years – incredibly trying and stressful, but something we all survived and put behind us.  I’ve tried to give you a lot to think about but there are so many moving parts and uncertainty that this is probably a good time to get professional advice before taking any big steps. In the meantime, let’s just focus on being good to each other and realizing that we’re all in it together.