Case Study: Mark the IT Contractor: Million Dollar Journey

Mark is an IT contractor residing in Alberta and needs some advice about what to do with excess capital and general tax optimization.

Here is the story:

We’ve got a rental property which we decided to try and sell. We located an investor who is interested. We’ve agreed on a price of $25,000 ‘cash to mortgage’. Once we pay legal fees, cancel the management company contract, and pay for title insurance, we’ll walk away with about $23,500. Here is our tentative plan for the cash (all numbers rounded for simplicity), but this is where I’d love some feedback.

• Credit card debt repayment $4500
• Line of Credit repayment $9500
• Leftover $9500

Paying off these two debts will leave us with no debt except for our principal mortgage. So, the question is, what to do with the $9500 extra?  Here are some other relevant details:

• I work as an IT contractor, earning approximately $80,000 per year in income through my corporation. I do not earn any “employment” income.
• Wife does not work.
• Most of the income is dividended from our corporation to my wife and I would like to have a nest egg in place to protect against job loss, as I am not protected by EI as a contractor.
• I have lots of RRSP contribution room from previous years as an employee, but I’m thinking this might not be the best, as I would like to keep the money accessible as an emergency fund.
• I’m in Alberta.
• My mortgage is approx $260,000 with a 35 yr amortization at 3.89%, 5 year term started in August. Regular payment is $267 weekly, currently we’re paying $325 weekly, with plans to increase that amount to the $400 a week range once the other debt is repayed.
• $11,000 in RRSP account.
• We have 2 kids under 3 and are planning to have at least 1 more, maybe 2 more, in the next 5 years.

As far as goals, we want to have enough money to enjoy life, take the odd vacation, and be able to retire comfortably (not expecting to be wealthy, although of course that would be nice.

Right now of the approx $1,600 per week I earn, we save $300 for taxes, $75 for healthcare (since I have no benefits).  The rest of the expenses are; $150-$300 goes to debt repayment,  groceries, utilities, property taxes, and all the rest ($4,500/mo total).

So the question is, what to do with the $9,500 windfall?  Before we get to that, lets take a step back.

Lets start with the rental property.  Typically speaking, selling a rental property for a profit would result in capital gains tax.  That is, 50% of the profit would be added to income and taxed accordingly.  But Mark’s situation is a bit unique where they have no T4 income to report as Mark is a contractor with his own corp, and his wife is a stay at home mom with no other income.  If we were to assume that the profit was split evenly between spouses, it would result in about $6,000 in income for the year (each).  Depending on how much is “dividended” out from the corp to the wife, it will most likely result in very little tax to be paid.

If they were to pay out all of the corporate income in the form of dividends, they would report $6,000 income each, along with $33,800 each ($80k after tax and assumed split in two) in dividends from the Canadian Controlled Private Corporation (CCPC), which would result in $4,700 family income tax.  The $4,700 family income tax is about $2,300 more than if they never sold the rental property.  Having said that, the $9,500 windfall is now $7,200 after tax.  Alternatively, they could reduce the payout from the CCPC equal to the amount that they will receive from the sale of the rental, which will result in about $200 tax payable on the rental.

Another tax issue that Mark might want to consider is paying himself a salary instead of dividends only.  Why?  Paying himself a salary will enable him to make CPP contributions along with build his RRSP contribution room.  Even though he would pay more tax personally, the corporation would get a tax deduction which generally evens things out in the big picture.

I’d also like to say that it’s generally a very good move to pay off consumer debt first.  Not only does it release the burden of those monthly payments, it offers a psychological and financial confidence boost.

Options

So lets go through some options on the windfall amount assuming all consumer debt has been paid off with the old payments going towards the mortgage:

1. RRSP – An RRSP contribution is an option, but in this situation, it’s perhaps not the most efficient choice.  I would avoid RRSP contributions as both Mark and his wife are in low tax brackets due to their corporate structure.  In addition, it’s not as liquid as other options should they need the cash.
2. Emergeny Fund TFSA – With 2010 here, people 18 and older now are permitted to contribute $10,000 to their TFSA.  With very little savings, a single income and 2 young children, I would highly recommend an emergency fund that can cover expenses should the need arise.  $7,200 is definitely a good start.  With the TFSA providing a tax shelter, it’s the first place that comes to mind.  Even though rates are low right now, he would want to have the cash easily accessible, like in a cashable GIC or a high interest rate account.
3. Corporate Account – As I mentioned above, instead of withdrawing everything out of the corporation, they could withdraw less and use the capital gains from the rental sale to cover regular expenses, thus get taxed less in the current tax year.  This would result in keeping the cash amount within the corporation until it is needed or withdrawn in a more tax efficient manner.  Note though that interest earned within a CCPC is taxed at the highest possible corporate rate which is close to 50% in most provinces.
4. Mortgage Paydown – To continue paying off debt, Mark could put the $7200 towards his $260,000 mortgage balance.  Although this option provides a guaranteed return higher than a savings account, it doesn’t provide his family with any liquidity.  The liquidity problem could be solved by obtaining a HELOC (providing he has enough equity) and using that if an emergency arises.

Conclusion

Personally, because of the financial scenario, I would use the rental sale windfall as an emergency fund.   There are a couple options for the emergency fund.  He could simply open a TFSA and deposit the money in there while withdrawing from his corporation as they normally do to cover expenses.  However, this causes additional personal income tax to be paid.

The alternative would be to withdraw a little less from the corporation for the year equivalant to the amount of the windfall to reduce overall taxation.  This would keep the emergency fund within the corporation temporarily until withdrawn during more tax efficient years.  At which point, a TFSA should be used.

What do you think?  What would you do with the extra money?

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