Dave and Sandra are in their 50s and have just inherited $150,000. They rent their home. Both are working and making ends meet, but they have very little saved for retirement and neither has a pension.
Should they use their inheritance to buy a house or continue to rent and deposit the money in their Registered Retirement Savings Plans (RRSPs)?
“Dave and Sandra have a pleasant problem to deal with,” says Rick Bassett, FCPA, FCA, a Taxation Partner with Durward Jones Barkwell & Company LLP in St. Catharines. “A windfall can be used to shore up their personal net worth statements.”
Bassett suggests that Dave and Sandra first consider paying off any high-interest debt, such as credit card debt. “Interest rates on such debt will often be at rates of 18 per cent or more, and sometimes as high as 29 per cent,” he explains. “Reducing such debt should be a priority.”
Dave and Sandra’s second consideration should be whether they should continue to rent, or buy a house.
“They may want to continue renting, since their rental costs are likely no greater than the costs of home ownership,” says Derek de Gannes, CPA, CA, a Tax Partner with CW Partners LLP in Toronto. “Mortgage principal and interest, repairs, utilities, etc. are all part of those costs.”
On the other hand, Dave and Sandra may want to think about buying an affordable house that will grow in value. “There is no better tax rate than zero per cent, and that is the rate that Canadians pay on any capital gains earned on the eventual sale of their principal residence,” says Bassett.
Should they use their inheritance to buy a house or continue to rent?
“They may also quality for the First-Time Home Buyers’ tax credit worth $750 if they buy a house, as long as neither one of them has been a homeowner during the past five years.”
A third consideration is whether to contribute to their RRSPs.
“They may want to avoid RRSP contributions, as the tax savings may not be significant at their current income levels,” advises de Gannes. “There is also the potential for higher tax expenses upon death or deregistration of the RRSP, when it all turns into taxable income.”
However, RRSP contributions could provide some advantages. “Because Dave and Sandra do not have pension plans through their employment, and because they have not found it possible to make significant contributions to their RRSPs to date, they will each most likely have ample contribution room,” says Bassett. “If they do contribute to their RRSPs, they will need to decide when it is most advantageous to claim the resulting tax deductions.”
For example, if Dave has a taxable income of $54,000 for 2013 and lives in Ontario, he will pay a little over 31 per cent on the last $10,000 of his taxable income.
However, for taxable income less than $44,000 his tax rate will be just over 20 per cent. “Under this scenario, if Dave contributed $25,000 to an RRSP this year, he would be best to use approximately $10,000 as a deduction on his 2013 return, $10,000 as a deduction on his 2014 return and to use the remaining $5,000 on his 2015 tax return,” explains Bassett. “By doing this, he’ll reduce his tax bills by 11 per cent more – extra tax savings of $1,650 – on the last $15,000 contributed.”
Dave and Sandra could also use funds in their RRSPs to help them finance a house purchase. “They could each contribute $25,000 to their RRSPs, find a house, and ensure the closing date is no sooner than 90 days after their RRSP contributions were made,” explains Bassett. “Then, under the Home Buyers’ Plan, they could use the $50,000 in their RRSPs as part of a down payment for the house. They can still take advantage of the tax savings from the RRSP contributions.
Then, over a 15-year period, they must either repay the $50,000 to their RRSPs or choose to include annual amounts of $1,667 each in their taxable incomes.”
Finally, Dave and Sandra should consider contributing the maximum amount to Tax-Free Savings Accounts (TFSAs). “If they have not put anything in TFSAs to date, they each can contribute $5,000 per year since 2009 ($5,500 for 2013 and 2014), or, cumulatively $31,000 to date to a TFSA,” says de Gannes.
TFSAs are more flexible than RRSPs because you can take money out without affecting your ability to use a TFSA again in future years.”Contributions to TFSAs don’t give you a tax deduction, but when you withdraw money from them the accumulated contributions and income you receive are not taxable,” adds de Gannes.
Dave and Sandra could use any money left over for other investments, says de Gannes. “They should invest in conservative equity investments yielding low tax dividends and capital gain potential,” he says.
So, how do Dave and Sandra decide what to do? “They need to consider their specific circumstances closely to determine which combination of these various tools will provide the optimal result for them,” says Bassett.
“They may also wish to seek professional help to determine their best options from a tax perspective.”
Source: The Institute of Chartered Accountants of Ontario. www.icao.on.ca
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