annuities_Annuities As Tax Shelters

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J. A. Taylor

Annuities As Tax Shelters                                                                                                                             .s
                                                                                                                                                            ,. .}.


Mr. Taylor, who formerly                       Imagine tax-sheltering earnings for     Tax Sheltering
counselled Individuals and                  10-20 years. Like most GICs, the rate      Investment Income
corporations on Investment and              of interest for GIAs is guaranteed for
pension management, is president            a maximum of five years. The capital          Anyone who receives more interest
of Taylor Investment Counselling            and accumulated interest (if not with-     income than $1,500 per year, and
Service lUmited. His firm is                drawn) earns interest for the next five    does not really need that extra income
retained by Annuity Research and            years guaranteed at the rate the issuer    to live on, should consider utilizing a
Marketing Service Limited of                is then offering for new money. This       GIA. The rationale goes like this: the
Toronto, which counsels clients on          is repeated every five years. While        first $1,000 of all interest income is
all types of annuities.                     this shelter has a few disadvantages, it   tax exempt. Each year the govern-
                                            has several distinct advantages. First,    ment is indexing our personal exemp-
 IN THE sophisticated realm of tax          the negatives: In all of them, there is    tions; conceivably they might one day
   shelters, obscured by the wide-          some kind of load charged-froilt,          increase the exemption for interest
spread promotion of oil drilling funds      middle, or if withdrawn prematurely,       earned to $1,500 or $2,000. There-
and MURBS, there exists a shelter so        at termination. Should you subse-          fore, having just $500 interest a year
simple and commendable it is surpris-       quently decide to convert all or part of   subject to tax is no big hardship.
ing that it is not better known. This       the value to a paying annuity, for         What hurts some people, however, is
shelter is perhaps overlooked because       practical purposes you are tied to the     having to pay tax on several thou-
it's uncomplicated, safe and makes no       issuer you bought it from, otherwise
splash at all. Yet it is the one shelter    you must pay tax on the earnings on
that provides absolute guarantees of        withdrawal. If you choose this settle-     Table 1
capital and income through written          ment, it would defeat the advantages
contracts backed by excellent cove-         built up in the shelter. Thirdly, you         Deposit .......             .            $10,000.0
nants.                                      should expect to stay with the plan at        Contract charge
   In the trade, they're unfortunately      least five years, preferably longer.            (initial deposit
called 'single premium deferred an-            Now the advantages: no source re-              only)............                         50.00-.
nuities' but they're not annuities at       porting of the income until with-                                                      $ 9,950.00
all. Annuities, as you've learned,          drawn. No management fees at any
                                            time. Compounding to your credit                              .
                                                                                          Loading (5%) .497.50
make regular payments-these don't.
They're also called guaranteed inter-       that portion of the earned interest           Net Investment . $ 9452.50
est annuities (GIAs). In essence, they      which you would otherwise have paid           Five year interest rate calculated
are accumulation accounts under the         annually to Ottawa. Excellent collat-         at 11.75%
same stringent government regula-           eral at most banks for about 97% of           Value end of year
tions as annuities and therefore able to    the accumulated value. Should you             1   ...............             ...      $10,563.17
enjoy a tax-sheltering of the interest      subsequently elect to convert part or                               2   .........      $11,804.34
earned. Unlike guaranteed investment        all to a paying annuity of five years or      3 ......                             .   $13,191.35:
certificates (GICs) and all other inter-    more, the issuer will credit you with a       4 ..                                     $14,741.33:
est-bearing investments where you are       bonus ranging from two to 12% of the          5 ..............                         $16,473.44
liable for tax on the interest received,    amount converted. This usually more           Assuming interest rate is ten
the interest in a GIA is added to the       than makes up for any loading charge.         percent for the second and
account and tax-sheltered until with-       The capital is liquid at all times; how-      subsequent five year periods,
drawn, which normally may not be            ever, just like the few GICs that may         the cash values would be as
later than age 75. Because these are        be redeemed before the maturity date,         follows:
                                            an interest adjustment is charged if
                                                                                          Value end of year $
not tax write-off vehicles, they're                                                       10 ..       .    .     $269530.64.

great for the modest investor or pru-       withdrawal takes place prior to the           15 ..                  $42,727.-87
dent parent. In several ways they're        end of each five-year period, and if          20 ..... $68,813.65
similar to GICs issued by trust com-        interest rates are then higher than was       All the above figures would be
panies. GIAs, however, may be is-            accorded the deposit.                        improved by three percent if the
sued only by insurance companies                Let's see in Table 1 how one con-         proceeds were converted into a
who have been doing so for more than         tract actually works and then we'll          paying annuity.
35 years.                                    look at some practical applications.
CAN. FAM. PHYSICIAN Vol. 26: JANUARY 1980                                                                                                        43
sands of dollars of interest income.                       he casts around for the best method to      the money must be invested in a GIA
The GIA is the answer. Consider the                        accomplish this goal. If he's abso-         when received. Since no interest is re-
example in Table 2. $2,500 is saved                        lutely sure each child will graduate        ceived, the trust pays no tax and there
every year and earns interest com-                         from university after a minimum of          is no attribution of earnings to the fa-
pounded at 11.75%. At the end of                           four years then the Canadian Scholar-       ther. When the first child is ready to
five years the amount saved equals                         ship Foundation will perhaps pay him        attend college, the mother pays out of
$17,660. Even if you are taxed at                          the best return. Those children who         the trust the required funds on behalf
62.5% (the maximum) upon with-                             don't finish the third year subsidize       of that child. As the child is part
drawal, you're left with $6,622-                           those who graduate.                         owner of the trust, the money is
a gain that you wouldn't have if you                          But if he has some doubt what his        brought into his income at his per-
were paying taxes on the interest each                     children will want and he wants to re-      sonal tax rate which most likely will
year.                                                      tain control of his money, there's a        be minimal. However, should one or
                                                           better way. He creates through a legal      more of the children end up not going
Education Trust                                            document an irrevocable trust with his      to university, the money can be used
   A father has two sons and a daugh-                      children as owners. He appoints his         at the mother's discretion to fund spe-
ter aged nine, seven, and five. He re-                     wife as sole administrator with full        cialty training, to start a business, or
alizes that the funds needed to educate                    powers of distribution. He then de-         to provide maintenance. Quite apart
his children will be quite substantial.                    posits say $5,000 per year to the trust     from the tax savings, this plan pro-
Not expecting to win a sweepstake,                         for eight years. The trust stipulates       vides more flexibility, more control,
                                                                                                       and more options when payments are
Table 2                                                                                                made. Caution: because provincial
                                                                                                       regulations differ, professional guid-
           Dr. X's Income from Interest Dr. as Income from Interest                                    ance is advised when drafting the
           sources:                     sources:                                                       trust.
             Bonds .      ...........$ 600Bonds .$ 600
                    Igage   ......  GIA (tax shelter) $5,000
                                       .           5,000
                                     ,.............5                                                   'Term Certain' Annuities
           Total on top of income Total on top of income                                                  Now the fourth category of annui-
             from practice .5,600   from practice .$ 600                                               ties, the 'term certain' groups. As the
           Amount of tax paid-                          Amount of tax paid to                          name implies, these annuities repay
             to Ottawa at                                 Ottawa ................. 300                 for specified periods of time. In the
                 50% tax rate                    2,800 ..Retained difference
                                                .......                            2,500
                                                                                      ...........      normal sense they have no life contin-
                                                                                                       gency but many insurance companies
                                                                                                       use the name with a life annuity to
Table 3                                                                                                state the guaranteed period. They're
                                                                                                       very much like mortgages with sev-
                                                                  Approx.             Spendable        eral important differences. First, since
                                                                  Annual          .
                                                                                     Income            they are issued by insurance compa-
                                                                  Income          After 30% Tax.       nies and backed by their assets, the
                                                                                                       convenant is usually better than mort-
    Plan 1                                                                                             gages. Secondly, you are not subject
    Bond investment @ 10.5% ................. $10,500....                                     $7,350   to management fees or collection
                                                                                                       problems. Thirdly, unlike mortgages,
   .R..PanZ2 life annuity ..........................                                                   the ratio of the amount of capital and
    Straight                                                        9,640 7,664
                                                                                                       the interest element in each repayment
                                                                                                       is always constant. In registered Term
        tPan 3                                                                                         Certains, this is still true, but the
     .Split annuity .........                   9,082 ..      .   7,818*                               whole amount is taxable if not offset
                                                                                                        by personal exemptions. They're
     I*The reason for this isto theaannuitant, andeach payment is original
     money being retumed
                              that good part of
                                                   only the interest portion                            usually issued for periods of five
                                                                                                        years or more. In 1978 a new concept
   w:taxable. Therefore while the amount of mnoney received per year                                    emerged with the federal govern-
   inPlan3.: is less than from bonds/mortgages, the taxable exposure                                    ment's spring budget-a fixed term
    is.also .much less, leaving more dollars for spending.                                              annuity to age 90, as a new option for
                                                                                                        maturing RRSPs. The trust industry
   i..Plan 1.                                                                                           for the first time was able to bid for
  r-.retains control of capital, .but because interest rates fluctuate up and                           retention of the assets they had accu-
   .-down, so does future income.                                                                       mulated in clients' RRSPs. The Reg-
                                                                                                        istered Retirement Income Fund
          Plan 2                                                                                        (RRIF) was introduced simultan-
        all. capital is exchanged for a guarantee of a fixed income for lfe.                            eously, and since it is not a term cer-
                                                                                                        tain, deserves separate discussion.
    'Plan 3
    o bines the advantages in 1 and 2, yet preserves the opportunity                                    Term Certains Plus GIAs
      tocange. the plan in future                                                                         A very interesting and useful repay-
 1% 'O.     -,

 44                                                                                                     CAN. FAM. PHYSICIAN Vol. 26: JANUARY 1980
ment concept for special cases occurs
when you parallel the use of a term
                                            When she can't
certain annuity with a GIA. This ar-
rangement is called a split annuity.         take a bottle
Consider the case of an accident vic-
tim who is awarded a substantial set-
tlement by the courts, or a wife who
wins a large divorce settlement.
   Having a great desire to preserve
the capital and obtain the highest pos-
sible income, recipients think first of
investing the money in bonds and/or
mortgages. Rarely, if ever, do they
think of an annuity, and in fact the
life annuity by itself is not the an-
   There's a better one in many in-
stances for all parties concerned. To
illustrate, assume the amount is
$100,000. Instead of a bond/mortgage
portfolio which will require ongoing
specialized management, see what
happens if $73,000 is placed in a sim-
ple term certain annuity with a 15-
year pay-out, and the balance
($27,000) is placed in a well-selected
GIA. The $73,000 provides the in-
come to live on, and the $27,000 is
kept in reserve in a tax-shelter. Lo
and behold: the recipient has more
spendable dollars. Table 3 shows an
                                            alo he take
actual case chosen from September
1979, mostly because interest rates
then were closer to normal than at
time of writing (November). Using
the current high rates would distort
the results in favor of the split annu-
                                            antci whn h
   When the term certain makes its
last payment in 15 years time, the
$27,000 in the GIA will have grown
to over $100,000. If appropriate, the
same process can be repeated. Note
also that in the case of the split annu-
                                             ~~~~Gelusil tabletsaipten
ity, you have access to the $27,000
without reducing the income level. In
a divorce case, the wife would wel-                           compliance in more ways than
                                                              one. Convenience of Portability
come the excellent third party source
of her monthly cheque-, and the hus-                          -Fresh Minty Taste. GelusI
band may be able to provide the same
                                                              liquid r the home and Gelusil
                                                                 tablets for patients on-the-go.
 amount of spendable dollars for less                           Gelusil or Gelusil 400 for
capital outlay.                                               individual patient needs.
    In a subsequent article, we'll de-
 vote space to the question asked more
than any other about annuities-
 "What do I do with my RRSP sav-
ings?"                                                                             Parke, Davis
                                                                                   & Company, Ltd.
                                                                                   Scarborough, Ontario.
Mr. Taylor will be pleased to an-
swer readers' questions, which
should be mailed to the editor at                   ~~~~ ~~~IPAABI |fPMAC 1
4000 Leslie St. Willowdale ON.
M2K 2R9. Confidential replies can
be given on request.                         Full prescribing information is available on request.

CAN. FAM. PHYSICIAN Vol. 26: JANUARY 1980                                                                  45