Are you confident about the amount of life insurance coverage you have? Are you maximizing your tax savings with the principal residence exemption? In this episode, we delve into life insurance and optimizing capital gains to answer these essential questions. In our conversation, we unpack the nuanced topic of life insurance, what people get wrong about it, and how to effectively calculate your life insurance policy needs. Using his own experience as the lens for the conversation, Mark shares how he calculated his life insurance and incorporated costs such as funeral cover, emergency funds, short-term expenses, and income replacement. Learn about using the safe withdrawal rate shortcut, free resources for calculating life insurance costs, and the best financial tools for getting the most out of your policy. He also delves into capital gains and how to use a lesser-known exemption to reduce the amount owed significantly. Mark walks listeners through how the principal residence exemption works and how it impacted the sale of his rental properties. Then, jumping to a brand new segment on the Rational Reminder Podcast, Ben introduces his financial decision-making iteration of the game of ‘Would you rather’. Finally, we share listener reviews and feedback on previous episodes and debate whether to lease or buy a car in our after-show segment. Tune in now!

Key Points From This Episode:

(0:03:13) Mark explains how he and his wife calculated their life insurance needs.

(0:06:55) Learn how to plan for income replacement and why it is so complicated.

(0:12:10) Ben’s perspective on Mark’s approach to calculating his life insurance coverage.

(0:13:54) Find out why there are differences between Ben and Mark’s calculations.

(0:18:17) How Mark factored in retirement costs into his life insurance calculations.

(0:22:30) Free resources and tips to accurately calculate your life insurance needs.

(0:27:04) Why Mark considers whole life insurance as a separate asset class.

(0:31:25) The principal residence exemption and how Mark applied it to his situation.

(0:39:19) How we would choose to invest $1 billion in today’s market.

(0:42:26) Would You Rather segment: only life insurance versus only disability insurance.

(0:45:02) The exciting development of a tool for realizing capital gains in a corporation.

(0:51:06) Trends in the awareness of corporate notional accounts and tax planning intricacies.

(0:54:12) Listener reviews, episode feedback, and leasing a car instead of buying.

Read the Transcript

Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We are hosted by me, Benjamin Felix and Cameron Passmore, Portfolio Managers at PWL Capital.

Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making from three Canadians. We are hosted by me, Benjamin Felix and Cameron Passmore, Portfolio Managers, and Mark McGrath, Associate Portfolio Manager at PWL Capital.

Cameron Passmore: Nice touch on the intro. A little modification. Very well done. First take.

Ben Felix: Cleaned it up a bit.

Mark McGrath: What was different? What did you draw up?

Ben Felix: I took out one of the PWL capitals. Instead of saying Ben and Cameron, Portfolio Managers at PWL Capital, and Mark, Associate Portfolio Manager. I said, the portfolio manager pieces first and then the PWL peace second. I thought we could get a little bit more efficient, although we've now lost that efficiency by discussing the change.

Mark McGrath: This is the kind of stuff that you work on in your spare time, even?

Cameron Passmore: This is Ben’s deep thinking. Anyways, welcome to Episode 307. This week is a little bit different, a little bit different prep on our side. Mark, you came up with a couple of topics, and maybe you want to queue them up.

Mark McGrath: Recently, I was thinking about life insurance as one does, of course. It kind of occurred to me that I very frequently see clients who have, in my opinion, the wrong amount of insurance. They'll have some term insurance in place, but how they derived the number for the size of the policy they bought seemed kind of like stick your thumb in the air, or an agent kind of pick the number for them. When I do insurance needs analysis for clients, I usually find the number to be inadequate. So, I thought it might be helpful to write a piece on how to calculate your life insurance needs yourself, just using a couple online calculators and tools.

So, I wrote this piece, and I thought it'd be a good topic for today's conversation. Then, the second topic, same kind of thing. I wrote a piece about this. But I had sold my rentals last year and we've talked about that, I think on the podcast here. When it came time to do my taxes this year, I was prepared for a big tax bill for capital gains. Then when I started crunching the numbers on it, I was like, “Oh, I think I can eliminate a lot of this tax bill using the principal residence exemption” because I lived in one of the rentals for a period of time, not the full time that I owned it, obviously. When I got to it, I eliminated like 60% of the capital gain on the property, and then combined with RRSP contributions and income splitting with my spouse who's a co-owner who's not working, actually ended up getting a tax refund, which is really interesting. I thought I'd just kind of walk through how that principal residence exemption works, and how it affected me personally with respect to that rental.

Cameron Passmore: Then after that, we're going to try a new segment that Ben came up with. Ben, you want to tee that up?

Ben Felix: Yes. We’re going to play “Would You Rather” which is again, that lots of people will be familiar with. There's many different iterations of it. We're going to play it with financial decisions. So, we're going to cue up a question of would you rather do this thing or that thing as the game goes. I don't even know what we're going to do yet today. Cameron mentioned that the prep has been a little bit different today. What he meant by that is we've done very little prep, Cameron and I. Mark did more for this week. But this is by far the least prepared that I personally have ever been for a Rational Reminder episode in my entire Rational Reminder career. Hopefully, it goes well. I'm sure it will.

Cameron Passmore: It's going to be great.

Mark McGrath: I think you’ll be okay, Ben. This doesn't require like 62 academic papers being read the week before, right? It's just a couple of threads that I wrote on Twitter, I think, you’d be okay.

Ben Felix: It'll be good content. The second one is, I've said this before, many times, we've covered Canadian topics. The second topic on the principal residence exemption is Canadian-specific, but it's also a super interesting optimization problem. I've heard this from many listeners that even if it's not exactly the same in their country, there's some similar analogue where the decision-making framework is still useful. We'll definitely get some of that.

Mark McGrath: The US is quite different. I think we have a principal residence exemption on gains up to, I want to say, USD 250,000 per spouse. So, might not apply there. But to your point, maybe the decision-making framework will be interesting.

Cameron Passmore: And after that, we'll go to the after-show and see how it goes from there. Alright, let's get going.

***

Mark McGrath: So, my wife and I have $2 million of term life insurance each. We arrived at that summit strategically. We worked with an insurance agent to implement the policies, but I wanted to discuss how we came up with $2 million.

Cameron Passmore: Are they policies or one policy?

Mark McGrath: Good question. So, we have a joint first-to-die policy. The first of us to go, the survivor will get $2 million. We bought a term 20 policy. I should clarify, we bought two $1 million policies. One for 10 years, and then one for 20. The idea being after 10 years, the $1 million of coverage will drop off. Ideally, we've converted our human capital into financial capital and our need for insurance is lower now. So, we can let the one policy just expire, and then we'll have 10 years left on the 20-year term for $1 million. But they're both joint first to die. So, whoever goes first, survivor gets it.

Cameron Passmore: Sensible. Got you.

Mark McGrath: I believe so. The way we thought about this was we wanted the survivor to be fully covered for life. When we think about insurance, it really is a spectrum. You're transferring risk to an insurance company, and I think the question is how much risk do you want to transfer? For some people, they're okay just covering things like debts. They just want to make sure the survivor is able to pay off the mortgage or something like that, and they might expect the survivor to go back to work, or to remarry or something like that, and worry about their own financial independence afterwards, just cover the debts. We went the full other direction and said, “If one of us goes, we want the survivor to be able to raise our kids, fund retirement, never have to worry about going back to work, never have to worry about remarrying or finding somebody with money. So, the one of us dies, the other set for life if they choose to be.”

That's, I think, the extreme end. When I wrote this thread, a lot of people were like, “You're overinsured. You're overinsured.” I was like, “Well, no. That's our goal. We had conversations about what we wanted for the survivor and that's what we determined for ourselves. Not everybody's going to go to that length. But we were comfortable with that.”

Cameron Passmore: How much of that decision was predicated on knowing that term insurance isn't that expensive?

Mark McGrath: A big chunk of it. Our policy, policies, I should say, we pay about $2,000 a year, and we got them when we were in our mid-30s, I would say. Kind of standard health ratings. No concerns there. I think that's about 1,800 bucks annually for the whole kit. So, it's very cost-effective. The amount you need is going to depend on the goals that you have for your family and for the survivor, and if you've got kids, you may want to fund things like education plans for the kids, or homes for them, whatever it is that your goals are.

But I'd say at the very, very minimum, the first thing you should consider is your debts. That's pretty simple. Look at your balance sheet, you tabulate the total amount of all your debts, consumer debts, credit card debts, mortgages, loans, lines of credit, student debts, just tally those up first. That's your starting point, and I would say that's the absolute, absolute bare minimum that you want to consider if you're looking for life insurance. I should specify that. I guess there are probably situations where you don't need to cover even your debts. There's no blanket approach here. But as a minimum, I'd say look at your debts.

The second and generally much smaller amount that I added to that was funding things like an emergency account. Final expenses, like funeral costs. I want my wife to throw a massive party if I go. Six figures like hired bands, open bar, the whole nine, assuming I have friends at that point that will actually show up to it. But I wanted to be able to fund like a party, not a sombre funeral.

Ben Felix: You really thought this through.

Mark McGrath: I think so. We'll see if it all works out in the end, I guess. But this is based on conversations from, say five years ago and life changes, and that's something that I think is important that we'll discuss is that you should review this pretty frequently because life changes pretty fast. So emergency funds, final expenses, and also any short-term expenses. I'm going through a landscaping project right now. If you had that planned already, and you knew that was going to cost $150,000, and it was still important for the survivor to go through with that expense, you might want to add any short-term goals that have been planned for it, but not yet completed or implemented. That's kind of the second part.

Then, by far the most complex and potentially important part, in our case, was income replacement. So, the biggest asset for most people is their human capital. Their ability to convert their income into financial capital over time. Calculating how much you need for that income replacement can get a little bit tricky, and it depends on the depth that you want to go to. We don't know how much income we're going to earn over our lifetimes.

Depending on your stage of life, like your current salary, maybe, or your current income adjusted for inflation is a reasonable starting point. Of course, if you're fresh out of university with a starting position, you might want to start with a higher salary number accounting for the fact that you expect your income to grow maybe more rapidly than inflation over the first 5 or 10 years. But the idea is to get an idea of what you think your lifetime income is going to be between today and your expected retirement date. That's the amount that you want to cover with insurance.

But there's two big things that affect the amount of insurance you want to buy. The two big things are inflation, and the expected return on the portfolio, that the survivor would implement. So, if I go and my wife gets, say, a million or $2 million, what's the expected return that she's going to get when she invests that money? If she was really, really conservative, a very conservative investor, I would use a lower expected return for her. Whereas I'm a very aggressive investor, I'm effectively 100% global equities, my expected return is higher.

Cameron Passmore: Why did you go out there from the income side, as opposed to the expense side? Can you talk through that?

Mark McGrath: It kind of depends. At higher income levels, you probably want to use expenses. If you're a physician earning 500,000 a year, and you're only spending 100,000, it's really the expenses that you want to consider.

Ben Felix: But expenses and future savings. If someone's earning half a million dollars a year, then they want to be able to replace whatever they were spending. But if someone's super frugal, that doesn't mean they need less life insurance.

Mark McGrath: True. So, I broke this down into two parts. One is just covering the lifestyle expenses. But the other component to this, which you can combine, is calculating the need for retirement income. So, replacing the savings that you would have. At the time that we calculated this, we used income.

Cameron Passmore: So, it's not a net present value of lifetime spending, is what you're saying. You're doing like spending needs up to age 65 or whatever retirement age and then the ability to save and that to fund your own retirement?

Mark McGrath: Yes. You can combine those two into one calculation, but the way I broke it down, just in the way that I wrote it so that people understood the two components separately. I did basically income up to age 65, and then desired retirement income from 65 to say, 95. We usually go up to 95 for projections. But you could combine that. If you're 30 when you're buying insurance and you want income replacement all the way up to 95, you can essentially combine this into two calculations.

So, the example that I wrote out was for a 30-year-old making about $100,000 a year, and expecting a 6% annual return on the portfolio for the survivor, as well as two and a half percent inflation throughout the life of the plan. Now, obviously, varying either of those is going to drastically impact the amount of insurance that you should buy for yourself. There's no perfect way to know exactly how much insurance you should have. So, I would say, you might want to do this calculation with maybe higher or lower inflation and higher expected returns, maybe take an average. This will give you a good idea, at least have a starting point. So, with the 6% annual return and two-and-a-half percent inflation, you're looking at a three-and-a-half percent real return for the survivor. What I did, is I just use the present value of an annuity calculation to figure out how much over 35 years, this person's 30, we're taking them to retirement at age 65, over 35 years to replace $100,000 of income, adjusted for inflation at two and a half percent, what's that lump sum that they need today?

Using a present value of an annuity calculator, which just calculates if you were to buy an annuity for a set amount of income, what is the lump sum value that you would need today to purchase that annuity from an insurance company? There's many good calculators online to figure that out. But in this case, the math works out to around $2 million. So, $2 million of cash today, at a 3.5% real return after inflation would be enough for $100,000 of income for the next 35 years for the survivor.

Ben Felix: Can you clarify how are the present value of the annuity and the expected return being used differently?

Mark McGrath: Well, I used 3.5% for the annuity. So, I use the real return for the annuity calculation. If you go to like a present value of an annuity calculator online, the inputs they're going to ask you for, are what is the income you desire? What is the interest rate or the return? Then, what is the number of years over which you need that annuity to pay? I use the real return of 3.5% here to account for inflation.

Ben Felix: So, it's just a present value calculation, not like an annuity pricing calculation?

Cameron Passmore: Correct.

Ben Felix: If you did like an actual annuity, I thought you were talking about annuity pricing. If you priced out an annuity for the same thing, you’d need way more presumably, than if you were investing in asset of the 3.5% real.

Mark McGrath: An annuity, I guess, at age 30, you would need way more, because that would be into perpetuity.

Ben Felix: Yes. You can even buy it in the first place.

Mark McGrath: In this case, I specified the number of years that I needed the annuity to pay for. So, in that case, you need about two million bucks. So far, we've got debts, we've got short-term cash needs, and we've got $2 million for income replacement all the way up to age 65.

Ben Felix: Can I make a couple of comments?

Mark McGrath: No, Ben. Absolutely not. You haven't prepared.

Ben Felix: I know what I'm going to say. I prepared in my head while you were talking. When we do this for clients. We use financial planning software and we just model how much they would need to make their plan sustainable with an early death. I think the way you're describing it is something that anybody could do. But just to be clear, that's not how we do it. We use financial planning software that does the Monte Carlo simulation and figures out how much insurance you'd actually need.

Personally, I did not do that. I didn't do our financial planning approach. I just use the 2% withdrawal rate, and figured out how much. Same type of thinking that you did in terms of how much would my wife and kids need to fund their ongoing lifestyle, and I just use this 2% withdrawal rate, which is super rough and probably overly conservative. But pretty simple to, just pointing out the way that you've described how to do this makes sense. There are simpler ways to do it, that are probably okay, and there are also more complicated ways to do it that are probably better, but maybe marginally.

Cameron Passmore: Back to my original question on costs, over the years, when I bought insurance, I always just aimed high because it was such a nominal amount of money to get way more coverage. Yes, the math might say X, but I didn't get 50% more than X in the hundreds of dollars more per year. So, over the years, we always just aimed higher.

Ben Felix: I have way more life insurance than you do, Mark. I don't know the intricate details of your financial situation. But I have a nice one-page insurance document that I wrote for myself. I'm looking at it right now. I have $4.7 million of coverage on myself and my wife has a million. She does not earn an income. It would be a bigger deal financially for our household if I died. Yes, very different from your numbers.

Mark McGrath: So, a few things. One, we use fairly advanced financial planning software to calculate this. My goal for writing this was more towards if you're getting sold insurance by somebody, and they're just kind of sticking their thumb in the air and picking out a number. If you want to go and get into the weeds a little bit about how to think about calculating the amount of life insurance you need, that's why I wrote this thread. The way you've done it just basically like dividing by the safe withdrawal rate that you're comfortable with, is going to get you relatively close as well. There's no way to know actually how much insurance you need to perfectly line everything up.

In our case, at the time that we bought the insurance, my wife was actually earning more than I was. So, it made sense for both of us to have the same amount. Since then, we've had two kids, and she's stayed at home for the past five years. She will go back to work eventually. But now, my income is basically the income for the family. Things do change.

Ben Felix: You've had two kids since you updated your life insurance, Mark? That is the time to update your life insurance is after having a child.

Mark McGrath: So, we actually bought it while my wife was pregnant with our first. It was an anticipation of the first one. We were aware of that. Then obviously, the second one. But I've looked at it since and as I mentioned before, we have saved a good amount of money since then, since that happened. We don't need more life insurance just because we've had a second child, but some people might.

Cameron Passmore: Go the other way. Think of the number of people that you've met over the years and say, “I don't believe in life insurance.” Or, “My spouse will be fine.” You have to give this kind of math serious consideration. It's no joke, right? And you said it off the top, it's all about who do you want to assume the risk of something happening?

Mark McGrath: When I wrote the thread, somebody reached out to me and said, “How do I get this concept through to my son? Because they have that exact viewpoint that insurance is a scam, and they don't need insurance.” In this case, this individual is quite religious and said that their God would show the survivor the way.

To your point, Cameron, and how much risk do you want to transfer? In their case, they were, I guess, spiritually transferring their risk to the deity that they worship, instead of to an insurance company, which is just a really fascinating way to think about it. But I wasn't able to really answer that question for that person who reached out. I was like, “I don't know how to pierce that veil, or if it's even a conversation that you want to be having with that person.” Maybe I think as some people get older and kind of mature and start to see, or if a life event happens, that kind of spooks them, they go, “Okay.” They start to face their own mortality and think, “Yes. Maybe this is the time to start thinking about insurance because you never know when you're going to go.”

Cameron Passmore: Well, it's the other interesting thing. When something happens near to you, family member or people around you, neighbours, or someone dies, also, the risk seems higher. But that doesn't change the basic statistics. For me, there's a 1.16% chance of me dying in the next 12 months of a 58-year-old male dying as a population not taking any specifics about my health or history.

Ben Felix: Just to your earlier point, Cameron. But the cost, for my $4.7 million of life insurance coverage, I pay $240 a month. That's a lot of money. I don't want to minimize that. But it's also, I think, for what you get. The difference is I've got a $2 million policy, the premium is $121 a month, and then two other policies that are each $65 a month on different term 10 and 20 for the same reason that you described earlier, Mark.

Mark McGrath: When did you get them? Like at what age?

Cameron Passmore: I don't have that on my sheet. I have when they renew. I don't have when I bought them.

Mark McGrath: Just pointing out that the younger you are, the cheaper it is. Men are more expensive to insure than women because women tend to live longer, which is interesting, though, because the younger you buy it, the cheaper it is. Obviously, young, late 20s, people getting a million, $2 million dollars of term insurance for $900 to $1,200 a year. You're talking $200 a month and you mentioned the cost of 248 a month being “expensive”, I like to say about disability insurance. If you think the policy is expensive, imagine how expensive life's going to be if you get disabled.

Ben Felix: Cameron always says the same thing.

Mark McGrath: Well, that's just it.

Cameron Passmore: It’s true.

Mark McGrath: If you can't afford that cost, you can't afford to get disabled or die.

Cameron Passmore: If you can't afford it, you cannot afford it.

Mark McGrath: Exactly. Very, very true.

Cameron Passmore: Part of the old, no matter what, I can drive myself in front of the computers. It’s like, “Really?” Over the years, we've seen some pretty horrible things happen to some pretty great people that render them unable to work.

Ben Felix: Head injuries, brain injury type stuff. People can't even look at the computer anymore.

Mark McGrath: I have a client exactly in that scenario. She got in a car accident. She can't use her phone. So, when we have to send documents back and forth, we have to mail them now. She can't use a phone or computer. If she walks into like an office building, she has to wear sunglasses, because in her case, it's the light that the computer and the phone gives off. But head injuries are no joke.

Ben Felix: Same as the one I'm thinking of.

Cameron Passmore: We've seen it happen.

Mark McGrath: The second component that I calculated was just the retirement costs. So, right now, we've calculated your working lifetime income. Now, I'm calculating the post-work-life income for the survivor for retirement. It's a similar idea, but you just have to adjust for inflation between now and retirement. I actually used the shortcut that you described, Ben. To say if it’s already a shortcut, and you do get different numbers doing that, but they're relatively close.

So, for retirement, in this case, to keep it simple. I said, “Okay, they also need $100,000 of retirement income for the survivor.” At a three and a half percent withdrawal rate, which I know is more aggressive than what you've used and even more aggressive than what you've shown in some of the work you've done. But for the sake of the example, I hate the 4% rule, so I just basically brought it down from 4%. You just need to figure out what's the inflation-adjusted amount in retirement, I guess, that the three and a half percent safe withdrawal rate would allow you, or you would need to basically be able to withdraw three and a half percent into perpetuity at $100,000. Then, you have to adjust that by inflation for this 30-year-old hypothetical scenario, a three-and-a-half percent withdrawal rate, for $100,000 a year of income, they would need $3 million in today's value, which works out to about $7 million in nominal value at retirement.

These are big numbers. It just worked backwards, what $7 million 35 years from now, what would you need today at your expected return of say, 6%, to get you to $7 million dollars 35 years from now. Likely, go to a million bucks. So, if you have a million dollars today, you just park it at 6%, that will grow, and this is obviously before tax. But that will grow to $7 million at age 65, or 35 years from now. That $7 million at a three-and-a-half percent withdrawal rate would allow them to have an income for life of $100,000 adjusted for inflation.

There's probably some shortcuts to this. I'm sure I just walked a long way around, and I've probably done more math than I needed to. But in my head, sometimes I have to make things really, really simple and break them down into really simple steps for them to make sense to me. That's what I thought about that.

So, what you get is a million dollars for retirement coverage, and then we said $2 million for income coverage during their working career. You're looking at $3 million now just for income replacement. But then to your point, if you just assumed a three-and-a-half percent withdrawal rate on $100,000 starting today, if you divide $100,000 by 3.5%, you get 2.85 million, which is very close to $3 million. That's the shortcut.

We've got $3 million now for income coverage. If you add in the debts, if you add in the cash needs, you could be in the $4 million range, and for a 30-year-old, that just seems like an astronomical amount of money in a lot of cases. Telling a 30-year-old, yes, you need about $4 million of insurance. On the surface, it might seem like a lot. So, often what I've seen is insurance agents will say, “Yes, but let's go with two million because four seems excessive.” But if you do a proper needs analysis for a client and insurance needs analysis, you're likely to come up with a pretty big number.

I've seen some of my physician clients in their 30s and we look at their insurance needs and like, “Yes, you 12 million bucks.” And they're like, “What do you mean, I need $12 million?” It's like, “Well, you earn a half million dollars and your spouse earns 300,000, you need a lot of insurance to cover off the total amount of income and expenses that you're going to face over your lifetime.”

Cameron Passmore: But again, how many people have you seen that have smaller policies like a few $100,000? Enough to cover off my mortgage or whatever. They haven't thought through the income replacement, let alone the retirement replacement. It almost feels like it's just enough to get the sale close by the agent. I know it's a pessimistic view. But in many cases, that's what it feels like.

Mark McGrath: I saw yesterday with one of my newer clients, and we were looking at it and he has, I think, a million and a half dollars of insurance. I ran an analysis using the financial planning software that I use for him. I'm like, “You need both 5.8, 5 million. That's the number that I'm coming up with.” So, you're underinsured by 75%. Now, if we make these tweaks, if you were to pass away, and your spouse is willing to downsize the home, free up a ton of capital there, cut their expenses by 40%, cut their retirement expenses by 40%, then you're still short, but only a million-dollar short.

So, this goes back to that spectrum of risk and what sacrifices you're willing to make or not make when talking about your family's goals. We just want like the full meal deal. Cameron, like you said, it's cheap enough when I just get the coverage. You can always cancel this or amend it later. You can always get a new policy or just cancel it outright, when you've built up the savings and your net worth is sufficient.

There's some free online tools that are pretty good, I find as well. So, I've always used, it's a calculator called InsureRight by Manulife. It's just a free tool online that people can use. It's just a little bit more detailed, I find than some of the other free ones. The nice thing is it will show you also disability insurance, and it will give you kind of a ballpark quote or estimate for what the insurance might cost, given the inputs that you've used. So, I find that's a handy way to do it.

If you're working with an insurance agent, like ask for a full – we call it an insurance needs analysis to make sure you're getting an insurance needs analysis and not just back of the napkin type of calculation. Then yes, I think the last one is that, like I just mentioned, you can cancel your insurance when you don't need it anymore. When I wrote this, there were a lot of people saying like, “Oh, you'll always need insurance. What about this? What about that? I have no interest in a permanent insurance policy for my family.” If I've gotten to the point where I can cancel my term life insurance, it's because that risk has been taken care of. There's no longer a financial risk to my death and my spouse and kids will be fine and there will likely be something left for them at the end anyway. So, I just don't have a need for a permanent policy.

Ben Felix: Same as me. I bought one once though, sold it to myself when I was an insurance agent.

Mark McGrath: A permanent policy?

Ben Felix: Yes. I had to meet a weekly sales target or something.

Cameron Passmore: Do you still have it?

Ben Felix: No. I don't have it anymore.

Cameron Passmore: Oh, you don't. You dumped it? I have a very tiny permanent policy. I bought it for like $100,000.

Ben Felix: I ran the calculation of am I better off cancelling it and taking the hit or continuing to pay? I was way better off taking the hit.

Cameron Passmore: Interesting.

Mark McGrath: It's tricky because there's a sunk cost there and I think a lot of people have difficulty just dealing with that. I talk to people all the time and it’s just like, “Well, I've lost $14,000 to two years of permanent premiums. So, I'm just going to keep it.” But to your point, Ben, you need to calculate that cost and whether it's worth keeping.

Ben Felix: There's two sides. There's a sunk cost and there's the opportunity cost of future premiums going into the policy, and to the opportunity cost of any cash value that may exist in the policy. So, I got some small amount of cash value because I'd had the policy for a bit. And then I had whatever, I don't remember what I was paying in premiums, but I can redirect that now to other stuff.

Mark McGrath: But it's interesting because the commission on that policy, you could have thought about it as a discount to the premiums, I guess, which would have changed the math.

Ben Felix: It would change the initial math a bit. Yes.

Mark McGrath: But there's some ongoing commissions with permanent insurance on the anniversary date as well?

Ben Felix: Yes. But for a policy that size, it would have been nothing. Probably too small for the insurance company to even distribute.

Mark McGrath: Interesting.

Cameron Passmore: Just love all these true confessions about life insurance. This is good.

Mark McGrath: I've never bought a permanent insurance policy. I actually just got a quote for a permanent insurance policy for my kids, though. I think that's actually a fascinating strategy. But once you've, I think, ticked all the other boxes, like if your RRSPs, your TFSAs, your max education funds are maxed and funded, permanent insurance on a child's life as a parent actually becomes a really interesting topic, because when they become adults, you can transfer the policy to them on a tax-free basis. I think there's a number of reasons why that's not a bad thing.

So, in general, I have a bit of a disdain for permanent insurance. But when it comes to these policies, I'm not yet convinced that they're bad.

Ben Felix: Skeptical. You said this to me before and I've been skeptical, and I remain skeptical. You think that the policy growth, because the cash value of the policy is what you care about, in that case, you think the cash value growth in the policy will exceed your after-tax rate of return or your tax rate?

Mark McGrath: Potentially, and I think the other interesting component, there is just the insurability question. They at least will have some insurance in place. So, if there was something that happened to my kids from a health perspective, they would at least have some kind of form of insurance, and they could borrow against it and that type of thing. I just think if you've maxed out everything else, I'm not saying people should just rush out and do this for their kids. But once you've maxed out everything else, I think it becomes an interesting option. I didn't buy it. I got the quotes and I've looked at it. I'm still not convinced, but it's interesting.

Ben Felix: So, they have cash value in a policy. Alternatively, you would have had more money, presumably, say it's the same amount of money. But unless they need contractual help, in the case of their death, it's life insurance policy. If it's a $50,000 policy, you could just give them the $50,000 as the helpful parent later, or if they needed to borrow against the policy, you would have had more money that you could help them with later once or an adult.

Mark McGrath: Maybe.

Ben Felix: Yes, maybe. If you're worried about your ability to give them the cash value of the permanent insurance policy in the future, I don't know, man.

Mark McGrath: There's a couple other things. Life insurance is far more creditor-proof than other asset classes, even like RSPs and stuff. If I get sued for something later on, that money is still theirs, and so those of them that would be protected.

Ben Felix: I like that.

Mark McGrath: You're going to smack me for this, but I almost think of whole life as a separate asset class, and this is partially your fault, because of the permanent insurance paper you did. Because when I think of permanent insurance, and the dividends and the cash value, or function of not the performance of the underlying investments of the whole life policy, but a function of the performance of the block of underlying insured versus their expectations. I wonder if that's a distinct and uncorrelated asset class to say markets. It is, for me, I don't know is that diversification? I'm kind of convincing myself of it here.

Ben Felix: It's going to depend on the insurers claims experience versus their expected experience, partially, and also on the realized versus actual performance of the participating account, which will be affected by market outcomes. So, it's not going to be totally uncorrelated, but the claims experience piece is going to be uncorrelated, or often called an uncorrelated asset class. It's also smooth. The insurance company smooths the policy dividends over time. If they have a really good year in the market, they're not going to distribute a much larger dividend. They're going to smooth it out over time.

Mark McGrath: That's a feature, not a bug.

Ben Felix: Yes. I don't know. I think it's the same kind of smoothing you get in private asset classes. Private equity looks uncorrelated. But is it? I don't know. I think it's probably somewhat similar with insurance except for the claims experience piece. There are some sources of policy dividends that are not going to be correlated with financial markets, for sure. But is that enough to make it interesting? I don't know.

Mark McGrath: Is insurance also a tax diversification tool? We've been talking about capital gains taxes and increasing capital gains taxes. Yes, there's a big threshold for that right now. But if capital gains taxes went up on every dollar to 75% in the future, the marginal decision of whole life versus a non-registered account, I think becomes a lot more interesting. We talked about tax diversification on a webinar we did yesterday. So, I think when you look at the creditor protection, the ability to transfer it to a child tax-free, the potential for diversification through the claims experience of the company, the insurability of the child being intact, because at least they have some kind of policy. Again, after you've maxed out things like education funds, tax-free savings accounts, I think it does become an interesting tool to at least look at. I haven't bought it yet.

Ben Felix: If you're doing a participating policy, which is what we're talking about with the policy dividends, you’re paying a lot more for that. Unless you're going to keep the policy for a very long time and have very favourable assumptions about the future policy dividend rate, you could buy a guaranteed policy that has, I don't know, for the same amount of premium. I don't want to say the number. I haven't run the numbers in a while, but a much larger guaranteed policy.

Mark McGrath: Like a non-participating whole life policy.

Ben Felix: Correct. You could buy a much larger policy for that, to the extent that the participating policy, there's a decent chance that it will never reach the guaranteed cash values of a much larger policy.

Mark McGrath: Of course. Well, that depends on the dividend scale, I guess, right?

Ben Felix: Totally. So, when you see like an illustration of, look, you can buy this participating policy, but look at the future cash value. Look how high it's going to be. I always want to see the illustration at, at least, the current dividend scale minus 1%, and I usually want to look at it at the current dividend scale minus 2%. When you run those comparisons beside a guaranteed whole life policy, the cash value of the participating don't look so attractive. So, you end up paying much higher premiums for the same amount of coverage with potentially more to show for it if policy dividends are great, but they're not by any means guaranteed. So, you could end up being like, “Well, I should have just bought the guaranteed policy. Oh, well.”

Mark McGrath: But what if dividends go up then? What if it's plus two? There's risk there, obviously.

Ben Felix: I would rather not take that risk. If I wanted higher expected returns, I would buy the guaranteed whole-life policy for the child if I wanted to do this, and then invest the difference in stocks.

Mark McGrath: Interesting. I hadn't thought about the non-participating policy. I didn't get a quote for that.

Ben Felix: I like the arguments about there's a little bit of legal diversification in there, creditor protection, whatever want to call it. Tax diversification is a real thing, because life insurance does get different tax treatment than other assets. So, that's a legitimate argument.

Mark McGrath: I feel validated. Thank you. I am going to buy it now. Now, that you've rubber-stamped it for me. Thanks, Ben. That was the entire purpose of this episode. I just wanted to get Ben's opinion live so that when I buy it, he can't make fun of me later.

Ben Felix: I still wouldn't do it.

Mark McGrath: Like, “Remember episode 307, Ben? You told me to do it.”

Cameron Passmore: Topic number two?

Mark McGrath: So, the principle residence exemption. I bought two rentals. There was a point in my life where I thought I was going to be like a real estate emperor of some kind. You read these books about the returns on real estate and all this kind of stuff. Once again, I'm going to build this real estate empire.

Cameron Passmore: Because you can touch the walls and the bricks and stuff.

Mark McGrath: It's tangible.

Cameron Passmore: Tangible. It’s a real asset.

Mark McGrath: I would go every week and I would just pet the walls of my rental and I would say, “There you are.” This is before the Rational Reminder of course, and before I smartened up. But it was too late by then. I'd already bought two. They were presale. One was a condo and one was a townhouse. One was a presale condo in Vancouver, and one was a townhouse here in Squamish. The condo I never lived in. It was purely a rental the whole time. Interestingly enough, that one just never really went up in value. We bought it in 2016. I sold it in 2023. So, call it seven years and I made basically nothing on it.

Cameron Passmore: Really?

Mark McGrath: Yes. We had rents of course, but the value didn't really increase.

Cameron Passmore: In Squamish?

Mark McGrath: No, in Vancouver.

Ben Felix: Vancouver.

Mark McGrath: Yes. A one-bedroom condo in Vancouver. East Vancouver.

Ben Felix: How did you find the one condo in Vancouver that didn't go up in value?

Mark McGrath: Well, it's funny because when you look at all like the private real estate funds, they seem to only find the ones that go up in value and not go down in value. I seem to at least find the one that doesn't go up in value. So, somebody's got to be buying the ones that I bought, I guess.

Cameron Passmore: That’s wild.

Ben Felix: Classic.

Mark McGrath: It did go up a little bit. But it was basically a wash after the GST. You have to pay GST on new purchases. So, you had to pay GST. You factor in realtor commissions and stuff and it was basically a wash.

Ben Felix: It's kind of like the private credit funds. They also only find loans that increase in value over time. It's interesting how private funds tend to find those.

Mark McGrath: Fascinating, those deals.

Ben Felix: Very impressive.

Mark McGrath: I'm the opposite. I can only find the ones that – and now, having said that the one in Squamish did really, really well. Purley by dumb luck. COVID had a lot to do with that, I think because here in Squamish, a lot of people left Vancouver during COVID to work from home. I think a lot of people that wanted to live here, who couldn't because of the commute or chose not to because of the commute. Now, that they were working from home, they came to Squamish. So, we saw a really, really big increase in real estate prices.

Given that the condo in Vancouver was a wash, we'll just talk about the townhouse. So, we bought the presale in 2016, late 2016, and it completed in early 2019. Technically, when you buy a presale, you don't actually own the property until it's completed. It's kind of like a call option. There's features of a call option in there, I would say. You have the right to buy it when it's complete. It's a little bit harder to sell than a call option would be, but you basically are buying the right to move into it when it's done.

Cameron Passmore: Right. It's not yours until closing.

Mark McGrath: Basically. So, for the purpose of calculating the principal residence exemption and ownership, you don't really own it until 2019, even though you've technically bought it in 2016 in my case. It was completed in 2019 and when it was completed we moved into it. So, in February 2019, we moved into the townhouse. We did this just to kind of test if we liked Squamish because we were moving from Vancouver, and we decided we wanted to stay. In April of 2020, about 14 months later, we bought a home here for ourselves in Squamish, but we kept the townhouse as a rental. So, April 2020, we turned it into a rental until we sold it in the summer of last year, 2023.

Ben Felix: Did you do an appraisal when you turned it into a rental?

Mark McGrath: No. So, this was a really interesting topic that came out of some of the discussions when I wrote this on Twitter. In hindsight, I think I kind of lucked out, because what you can do is you can appraise it, and then you can submit it like a change of use, and you can kind of basically tell a CRA, “I'm turning this into a rental now.” So then, I think you lose the ability to claim the principal residence exemption the same way, and I can only claim it for those two calendar years that I lived in 2019 and 2020. It's only those two years that I can eliminate in terms of the growth of the property. But a lot of the growth of the property happened after it turned into a rental, like from 2020 to 2023 is where a lot of the growth was.

Thankfully, I didn't submit a change of use for that property. As a result, it worked out in my favour, even better. But to your point, you can do that. You can get an appraisal. I'm just going to make up numbers here. But let’s say I bought it for 600,000 in 2019, and it went up to 700,000 in 2020. You can submit a change of use. That $100,000 is exempt from tax because it's your principal residence for those two calendar years. Then, from 2021 onwards, it would all be taxable. When you do that, you're not able to kind of average out the total growth of the property over the years you owned it because you're basically saying it's these two years of gains that I'm claiming as the principal residence exemption.

The way we did it was a little bit different because I didn't do that and I'll get into the details. But because I didn't do that, when we sold in 2023, we owned it for five calendar years, 2019, 2020, 2021, 2022, and 2023. We lived in them for two calendar years, 2019 and 2022. But the way the principal residence exemption is calculated is it gives you a, what I call the plus one. So, if you actually look at the formula, there's a plus one in the formula. The actual formula is the number of years it was your principal residence, plus one, divided by the number of years you owned the home, times the capital gain. That's how much you are exempt for the capital gains.

In my case, I lived in it for two calendar years, out of the five that I owned it, but I get to add plus one to those two calendar years. I lived in it for two calendar years. I get to add plus one. So, three calendar years, divided by the five years that I owned it, is 60%. That's how much of the capital gains exempt. The reason for the plus one is to account for the fact that people own two principal residences in a single year when they move. In my case, we owned that home in 2020, plus the home we live in now in 2020. So, they give you the plus one as a way to account for those calendar years where you own two homes as a principal residence. It's just fascinating the way it worked out were exempted 60% of the capital gain.

What's even better though, is I didn't lose any of the capital gains or the principal residence exemption on my current house. Because even though I've already claimed 2020, I've already claimed that townhouse as my principal residence for 2020. When I go to sell this place, 2020 is off the docket. I can't use 2020 against this house. I can only use 2021 and onward. But because of the plus one, I can basically recapture the calendar year of 2020. So, if I sell it, say 10 years from now, I get nine years where I can claim it as my principal residence. I can't use 2020 anymore, but because of the plus one.

Cameron Passmore: You get it back.

Mark McGrath: I get to 10 years divided by the number of years I owned it, which is 10. So, it'd be 100% exempt from tax.

Cameron Passmore: That's cool.

Mark McGrath: Yes. It was just a really interesting outcome, I guess. Then, we used RRSPs and both my spouse and I owned that property. And because she has no income, half the capital gain was hers. So, the way it all worked out is net as a family, we ended up with about a $3,000 tax refund last year, even though that property went up by quite a bit.

Ben Felix: Super interesting.

Cameron Passmore: So, the key is that change of use notification. That would have locked in the gains at that point in time.

Mark McGrath: Yes, exactly. So, had I submitted a change in use instead, 2019 and 2020 would have been exempt from tax. 2021 to 2023 would not have. Because most of the growth happened in 2021 to 2023. I would have got pinched.

Cameron Passmore: Exactly. You would have locked in the starting point.

Mark McGrath: For the big growth years, yes. I think there's a really interesting four-year look-back rule, which always confuses me. I don't know if you guys have heard of this. But if you move out of your home and turn into a rental, and you later sell it, you can actually go back four years and claim it as your principal residence, even though it wasn't your principal residence and you turned it into a rental. Now, you would lose the principal residence exemption on the current home you live in. For me, I didn't want to do that. That didn't make sense. But even if you turn it into a rental, you get like this four-year window, where you can still claim it as a principal residence. I might have that wrong. So, somebody will probably correct me in the forums. It’s what they like to do lately, apparently.

Ben Felix: Just a little bit. You ruffled feathers with some of your physician-related content.

Mark McGrath: Yes. The headline, specifically.

Cameron Passmore: So, do we want to take a stab at this next question?

Ben Felix: Yes. I mean, my answer to this question is super simple. But let's do it.

Cameron Passmore: I think all of ours will be pretty simple and nobody will be surprised. So, Ben, how would you invest $1 billion today?

Ben Felix: I would put all of it in DFA607, which is Dimensional’s Canadian global equity portfolio. Basically, global market cap weights with a Canadian home bias with a small cap and value tilt across all stocks in the world. That's how I invest my money now and I do the exact same thing.

Mark McGrath: Lump sum to dollar cost average.

Ben Felix: Lump sum.

Mark McGrath: Check comes in today, order goes in tomorrow for the full billion.

Ben Felix: See you later. Placed the trade.

Cameron Passmore: I mean, a billion so much that you can live with volatility, especially the spending habits that the three of us have. I thought I'd do 70/30, but the number is so big. I do something either six or seven, or whatever the 70/30 code is something like that, and be done with it. I have no interest in doing private equity or finding other fancy investments for real estate. Simple man, it's just a thing of beauty to me, and markets work.

I remember your tweet, Mark, where you said something like $1,000 how to invest. By 10,000, you scaled it up, and it was the same answer all day long, fully diversified index-type portfolio. I completely agree with that, especially this philosophy is all about the fact that markets work, and the markets are so much bigger than if any one of us had a billion dollars. So, why not?

Mark McGrath: Well, that's the question. Is a billion enough to move prices? But if you're handing it over to an institutional manager, I guess they've got a lot easier ways to enter. But if you're buying as like a single stock with a billion dollars, that can move the price.

Cameron Passmore: So, what would you do?

Mark McGrath: The whole thing. Whole life policies for my kids. No, it would be half whole life, and half Bitcoin, actually. But no, I don't know. It's interesting, Cameron, what you just said is that you can just accept the volatility when you have that much money, depending on how you spend. But I think there's also the question of do you need to take that kind of risk as well? If you define risk as volatility, which I know most of us don't, but could you look at your statement and see negative 200 million on the statement over a few months period?

Ben Felix: Wouldn't look at it.

Mark McGrath: Yes, fair enough.

Ben Felix: Don't look at it now. I've looked at my accounts and I don't know when the last time I looked was, I don't know how much is in there.

Mark McGrath: Same.

Ben Felix: I know how much I put in there every year. I don't know how much is in there, though. Honestly, couldn't tell you. Probably couldn't tell you within tens of thousands of dollars released.

Cameron Passmore: So, you're doing your own homemade volatility laundering, basically?

Ben Felix: Yes.

Mark McGrath: Exactly.

Ben Felix: Basically.

Mark McGrath: The only reason I have an idea is because I had to take money out for this landscape project. But it was the first time I checked in a long time and it was much higher than I thought it would be, because I hadn't checked in a long time. The market has been pretty good. I was like, “Oh.” But the problem with that is when the landscapers started going, like, “Oh, do you want this? Do you want this? Do you want this?” And they'll start going up, I was like, “Yes, I can afford that. Because I saw my portfolio and things are going well.” So, it kind of reframed my decision to spend more on this project.

It's interesting, for very wealthy people, somebody who's just landed with a billion dollars in their lap, their capacity to take risk goes up exponentially, but their need to take risk goes down exponentially. So, I wonder if that decision comes down to tolerance for risk more than anything else.

Cameron Passmore: Willingness to take an honest, Larry Swedroe would say, “How willing are you?”

Mark McGrath: Exactly. My answer is the same as you guys and I don't want listeners actually think I would buy Whole Life and Bitcoin. It would be DFA607, as well. Just globally diversified index fund portfolio of some kind with dimensional funds, obviously, we have the factor tools.

Cameron Passmore: Okay, Ben. Mind to cue up the next question?

Ben Felix: The would you rather game?

Cameron Passmore: Yes.

Ben Felix: The first one is the question that I thought of when I thought of this segment for the podcast. I sent it to Mark in a message. What do you think of this? Would you rather game for the podcast? And then I suggested a couple questions. So, this was one of them. Mark, thought it was pretty good. But I'm going to ask the question, you guys have to answer would you rather. Would you rather have only life insurance or only disability insurance?

Cameron Passmore: All day long, disability insurance. Just based on stats. I couldn't find the stats for the chance of a 58-year-old becoming disabled, but 1/3 of people will have a disability lasting greater than 90 days before they reach age 65. Whereas I have a 1% chance of dying this year. Especially, the younger you are, disability all day long. Mark?

Mark McGrath: The younger you are, I think is the key here. It's so situational. The probability of getting disabled is obviously much higher, but the financial impact is going to be dependent on your age and your current financial situation and everything else. I think disability insurance. I wouldn't say that answer applies to everybody. But I will say it applies to me.

Ben Felix: I thought of the question, I should have looked at the statistics, but I would need the statistics, not just on disability. Disability lasting more than 90 days could mean a lot of different things. We all work professional services jobs where, and I know Cameron, you gave this example earlier that I can always go to my computer, whatever. But I would want to see statistics on the proportion of people that are disabled to the extent that they can no longer work like a desk job. Probably, I would rather have disability. I would want to dig into the statistics on that more.

Mark McGrath: The duration of the disability is important too. Disability can be long but temporary. It could be two or three years. To bend this out, I think you'd have to look at a lot of stuff but off the cuff.

Cameron Passmore: And the cost of disability can be a lot higher too.

Mark McGrath: It’s very high.

Cameron Passmore: If you're unable to work or the cost of care might even be higher or the need for total capital, it can be a lot larger than what it would be for life insurance, possibly. I’ve seen those situations before.

Mark McGrath: Disability insurance is expensive and it's also much harder to get these days too. You guys don't do insurance and I don't do it anymore either. But even last year, I was finding a lot of difficulty getting disability insurance approved for clients. When it was approved, it was really expensive, which makes sense from the insurance company's standpoint. But as the end user of the product, it's tough.

Ben Felix: It is expensive. My disability policy, which is a very, very good policy, but it costs almost the same as all of my life insurance.

Cameron Passmore: Okay. You guys good to go to the after-show?

Mark McGrath: Let’s do it.

Cameron Passmore: For the three of us to stick around.

Ben Felix: We're just doing one would you rather question?

Mark McGrath: I think one per episode is good. We don't want to burn them all out in the first like four episodes, and then have no inspiration or ideas for other ones.

Cameron Passmore: Okay. I got a topic for the after-show. You and I talked about this, this week or last week, Ben, but just the learning and the improved help in making financial decisions that happen by you going through this capital gains thinking with software working with Braden. I thought that was so interesting.

Ben Felix: I mean, it's still ongoing. That's why I didn't prepare for this episode, because that's all I've been thinking about. Mark Soth too, The Money Scope co-host, that's all he's been thinking about too. We've been exchanging notes and experiences as we go through the analysis and it's complicated, man. It's really complicated. It's a lot to try and model. Right now, we do have a functioning web application internally. I don't know if we're going to release this one to the public, honestly, because it's so complex. I'm a little bit worried about model risk. If someone puts a set of inputs that don't agree with how the model was set up or something, and they get a weird output. I don't want people to make bad decisions based on that.

So, whereas an advisor would be more likely to be able to spot like, “Oh, that doesn't seem right.” We still have to make that decision. We haven't even released it internally yet. We've shown it to the advisors. We've gotten feedback and stuff like that. But it's been an interesting process to think through it, for sure. We will do a money scope on this. Mark and I are recording on Monday.

Cameron Passmore: So, does it boil down to any rules of thumb might be to light a term? But any sort of general guidance? I'm not asking for the guidance, but just having ground through these details for what, a few weeks now? Does it come down to a few key points? Or is it just so complicated, you need some sort of model to operate?

Ben Felix: There's some stuff you can kind of start to build intuition around. So, just to be clear, for listeners, we're talking about realizing capital gains in a corporation. The individual one for just to your individual personal assets, we built that calculator within a week of the budget coming out.

Cameron Passmore: Four days, yes.

Ben Felix: That’s been available to the public for a while. The ones for corporations is a lot more complicated because it interacts with spending and income. If you have a corporation that you're running a business through, you have revenue coming in, you're paying yourself through salary and dividends, that makes the decision of whether or not to realize a capital gain in the corporation a lot more complicated to think through. There are a whole bunch of different trade-offs.

I don't want to turn this into a Money Scope episode. But basically, if you realize a capital gain in a corporation, it creates capital dividend account, which can come out tax-free to a shareholder. So, you can end up deferring a bunch of personal tax by paying yourself with capital dividends for a period of time, depending on how large the capital gain was. That's good because it defers personal tax. But there's also a trade-off there where if you're deferring personal tax, but living off capital dividends, it means you're not paying yourself salary, which ends up reducing your lifetime RRSP room. One of the things that both Mark and I are finding is that actually is detrimental.

Cameron Passmore: CPP as well?

Ben Felix: Yes. You're missing out on CPP. I don't have CPP in my model. Mark does, but he treats it as an asset with a 2% expected real return. So, it's not perfect. My model excludes it, which basically just assumes it's a wash. I'd like to build it in eventually, but just haven't had time to do that. But yes, if CPP is not a wash, which is kind of what my model assumes, then yes, you're missing out on that too, and I don't think it is a wash. It is a positive expected return asset, especially if you live to age 95 or whatever.

So, you miss out on RSP room, potential IPP room as well. You miss out on CPP contributions. You defer personal tax, which is cool. The other thing that happens is that, and again, I don't want to turn this into a Money Scope episode, but when you realize a large capital gain in your corporation, it adds to your adjusted aggregate investment income, and adjusted aggregate investment income reduces your small business deduction. Basically, for people who aren't familiar with Canadian corporate taxation, which is probably most people, it basically means that you can end up paying more corporate taxes.

If you have a lot of adjusted aggregate investment income in a previous year, that reduces the limit that you have to pay tax at a low rate in your corporation the following year. So, you can pay a bunch more personal tax. The knock-on effect of that is that it actually lets you pay dividends to yourself more tax efficiently. It lets you pay eligible dividends to yourself, which you pay less personal tax on.

In Ontario, specifically, there's a funny anomaly where the province of Ontario does not recognize the reduction in the small business deduction due to adjusted aggregate investment income. And so, you can actually end up in a situation where that's advantageous. New Brunswick is the same. One of the things we have noticed is that in Ontario and New Brunswick, realizing a capital gain in the corporation is more advantageous, all else equal, compared to say, BC, or Alberta.

Cameron Passmore: Do you see why I asked the question?

Mark McGrath: It's a big question.

Ben Felix: There's a lot in there. I don't know. It's complex. We're getting a lot of questions from clients about this. I think there are some cases where it's much more obvious. If someone has a large known expense in the next couple of years, then realizing a gain, to pull out the capital dividend account is much more likely to make sense.

The other big thing that I've noticed is that all of this is super sensitive to optimal compensation. We did a couple of Money Scope episodes on how to pay yourself from a corporation. This decision of whether to realize a capital gain or not, is largely dependent on your ability to implement the right sequence of future compensation after realizing the capital gain. So, if you realize a capital gain in your corporation, then continue paying yourself a salary, and you realize the gain for no reason other than to realize the gain before June 25th. That's almost certainly going to make you worse off. Whereas if you do the right sequence of eligible dividends, non-eligible dividends, and capital dividends, over the few years after realizing the game, then it can make things look a lot better.

A big portion of the tax when you realize the game is refundable. But to get that tax refund in the corporation, you have to pay yourself a non-eligible dividend. So, if you just keep paying yourself a salary, that’s no good. But if you get the sequence of future dividends stream right, then it can start to look more advantageous. But again, it's super situation dependent.

The other big thing is the size of the gain, relative to your personal spending needs. It's a huge gain, and you have low personal spending needs, realizing the whole gain is probably not going to make sense. If you have a huge gain and really, really high spending, it can start to look more attractive. Maybe there is no intuition. This is really complicated.

Cameron Passmore: Do you think in general, the awareness around all these notional accounts and the intricacies of tax planning corporations has increased due to this? Do you have any general observations?

Ben Felix: I don't know if it's increased due to this. But I think when Mark and I did those two episodes on optimal compensation from a corporation, I think that was a big lightbulb moment for a lot of people. I've heard from a ton of people who were just like, “Wow, I had no idea about any of this.” So, I think, at least people who are listening to Money Scope are becoming aware of this. I think it is really important. It makes a big difference in the long run.

Cameron Passmore: So, the proposed tax changes may have been an accelerator?

Ben Felix: To make people think about it? I don't know. People who haven't been listening to Money Scope, probably still wouldn't be thinking about this.

Mark McGrath: I had advisors reaching out to see if they were allowed to attend the webinar that we put on yesterday on optimal compensation. This is totally anecdotal. But there's obviously interest in this concept amongst at least some advisors. To your point, it's so complex, and there's very few people in the country besides you and Dr. Soth that understand it to that degree. Giving all this research to the public for free, I think is, for a lot of advisors, they're like, “Oh, there's this whole thing I hadn't really considered and I just thought was the domain of accountants.” Obviously, we need the accountants to help us with this. But you're projecting 30, 40, 50 years of optimal compensation versus non-optimal compensation. The difference in outcomes is just huge. It's encouraging to see at least that other people are interested.

Cameron Passmore: Yes. The webinar was a great success. You had almost 300 people, which is amazing.

Mark McGrath: Yes. It was crazy. I basically just did the opening remarks, and Brady Plunkett, our colleagues, a portfolio manager and financial planner, and Spencer Brooks, who's a tax partner at Hendry Warren, who has an accounting firm out of Ontario that we work very, very closely with. They did most of the heavy lifting for the content of the webinar, and they just crushed it. It was really, really good. I was trying to monitor the chat and answer as many questions as I could and I couldn't even keep up. There were so many people asking great questions in the chat and I was trying to get as many answers in there as I could. But yes, I think we peaked at 270 attendees. Again, lots of great questions. Lots of great engagement. Should be available on YouTube, I guess, once it's uploaded, and I don't know when that's going to be.

Cameron Passmore: You talked about IPP, so I know Brady has had a few people reach out to talk about that since the webinar.

Mark McGrath: Yes. It was great. They did a really, really good job. I told Brady, I nominate him for the position of Chief Webinar Architect going forward. Just crushed it.

Cameron Passmore: He brings the energy, that's for sure.

Mark McGrath: Sure does.

Ben Felix: Once we're done with this corporation realizing the gain or not modelling, I think we're going to be able to use the model that we build for that, to build an optimal compensation calculator application, whatever you want to call it, so people would be able to put in their notional accounts, their portfolio balance, and all that kind of stuff, and it would spit out – Mark Soth already has this on his website, to be clear, so we're not reinventing the wheel here. He's got something very similar. But the idea is that you put in all of your information, and then it spits out how you should pay yourself in this year, and that's a request we've had from advisors internally to help them give advice to clients.

Cameron Passmore: The capital gains calculator for non-corporations is available on our website.

Ben Felix: It includes AMT, which we talked about in the past episode, I think.

Mark McGrath: Alternative minimum tax.

Cameron Passmore: Mark, do you want to read out the first review we got?

Mark McGrath: Sure. This is from DH@Winnipeg, “Great for self-directed investors. Always interesting content. I've been fascinated by the parallels between medicine and finance. Some professionals in each sphere trying to make the optimal decisions for clients using a body of evidence that has limitations and caveats. Others making unsubstantiated claims of getting better than average results with more expensive products.”

Ben Felix: Love it. Such a good analogy.

Cameron Passmore: Ben, you want to take the next one?

Ben Felix: I'll do the next one. I had someone tell me a while ago that their physician, the episode that we did with Dr. Wendall Mascarenhas, where he talked with the evidence pyramid, and talked about the analogies between medicine and investing, someone told me that that was a huge lightbulb moment for them, which is really hammered home the idea that there are for sure limitations with what we can do with evidence and how certain we can be about anything in financial economics and portfolio management. But there are at least parallels that comment, touched on that, wherein both cases, there's uncertainty. And in both cases, there's competing evidence, and all you can do is use the evidence to try and make the best decisions possible.

I think probably the big difference still between financial services, and I mean, even just financial services, asset management, all that kind of stuff. The big difference between that and medicine is that in the case of financial services, a lot of people just aren't using the evidence at all.

Mark McGrath: It's funny. I had a client of mine, I called her a scientist. Basically, she's a physician. I was talking about the science of investing and I thought she'd appreciate that. She told me, she's like, “Well, you'd be surprised how little science there is in medicine.” She didn't elaborate. This was years and years ago and I still remember that comment. That's really, really fascinating. To your point, I think there's other parallels. I've made a diagram once on the parallels between the diagnostic process that physicians use in the financial planning process, even down to like referring out to specialists and monitoring the health outcomes of patients. There's a lot of analogues, I think, between the two practices.

Ben Felix: All right, next comment from Randall in the United States. “Exceptional evidence-based show, Rational Reminder is an exception.” I think they mean exceptional. “An exceptional evidence-based show in a field filled with self-interest and strong opinions, and the lack of necessary depth of understanding. I am American, so not sure everything directly applies to my situation with” – this might be the comment that I was thinking about when I said that thing earlier. “I'm American, so not sure everything directly applies my situation. But the logic and reasoning behind the decision-making is often useful regardless. For example, tax diversification is a concept that absolutely applies with 401(k) and Social Security or TFSA, and Canada Pension Plan.”

Cameron Passmore: Very nice. Then, a common friend of all of ours with a great first name, Cameron, reached out to me. It's a bit of a sympathy note that said to be on LinkedIn, but it was very kind to hear from him. Great guy, great advisor. “Since you didn't get any LinkedIn retails on the last episode, private credit, I thought I send you one for the next. Lots of chatter around the show being mandatory listening for new advisors. But I would argue it's even more important for existing ones. Timeless advice and both you and Ben's ability to distill seemingly complex topics down into easy-to-understand language can't be celebrated enough. Thank you for all that you guys do for our industry. Mark, it's been a great addition and I look forward to the show every week.” So, Cameron, thank you very much. Very kind of you.

Ben Felix: That reminded me that I did get a comment on LinkedIn on the private credit episode. So, this is from someone who they're currently an advisor, but they work in finance, but not as an advisor previously, so they said that they used to structure private credit investments on behalf of life insurance clients, so like institutional clients at a previous firm. So, they said that this private credit episode hit close to home, and then they gave me some anecdotal observations based on their experience, creating private credit investments for institutional investors. They said that oftentimes, the financial covenants negotiated in private credit transactions are weaker than they would be in a public bond deal, and that's to give the borrower financial flexibility in order to make payments.

There's also a huge amount of concentration risk, since the firm that's underwriting the private credit transaction usually wants to take a big chunk of the deal for themselves because they're doing most of the heavy lifting on the analysis. That means that if the deal does go south, they will have a bad time. They might not be able to unload it to someone else and they're obviously concentrated in the investment. The funds may have multiple transactions in each fund that gives the illusion of diversification. But his suggestion is that in a lot of cases, they probably own a big chunk of each transaction, which makes them pretty illiquid and risky.

He said that life insurance companies and others, we talked about this briefly in the private credit episode about internal valuations as well. Internal valuations from the fund itself. They're allowed to provide internal ratings and internal prices on most of the transactions, and so that lets them give a credit rating of whatever they want, an evaluation kind of whatever they want, that may be misleading. Smoothing to a point where it's misleading. We talked about that in the private credit episode too.

Anyway, so really interesting. Told me all that and I just said, “What did you think in general about the accuracy of the episode based on your experience?” He said, “It was great. It hit the nail on the head in terms of what's really going on under the hood in that asset class.”

Cameron Passmore: Awesome.

Ben Felix: That was good to hear. Not every day you get to hear from someone who's like been in the trenches doing something like that, give their thoughts on it.

Cameron Passmore: I have a story for you guys. My daughter and her boyfriend leased a new car this week. So, I went for the “meeting”. Incredible how you can have such a shady experience is such a big brand name, an incredible industry. I'm not that demanding. But I'd like to know some details. All she got, until I pushed for it, was written down with the monthly payment would be, I’m like, well it’s based on how much down? What’s the residual? What’s the interest rate? I get as kind of math-y we might be skewed that way. My daughter is not a math person. That's not her gift to the world. So, she gets the numbers, “Well, that’s affordable.” We have no idea what's in there, including a trade-in. She was trading in your old car, which is paid for. “That payment plus your car is what you're paying for this.” “Okay.” So, she just started thinking about what the total cost of ownership is for the time of the lease.

But to throw a chicken scratch number that your monthly payment is across the table. I said, “Well, I want the details.” “Well, I'll have to do up a bill of sale.” I’m like, “We don't want to buy. Just show me the numbers.” So, you have to wait 20 minutes. They go back to some manager's office to come back with his bill of sale that they forced me to take a picture with on my phone because it wouldn't give me the piece of paper because it's a contract.

Ben Felix: That's wild.

Cameron Passmore: I couldn't believe it.

Mark McGrath: Wow.

Ben Felix: I just did that too, actually. I also forgot I wanted to talk about this in an episode, maybe I can mention that. I also leased a vehicle recently. My experience was not like that at all. I got an extremely clear sheet that showed the sale value of the vehicle, the residual value, and the interest rate on the financing on a lease. I leased my vehicles. I'll talk about that. People are always interested to hear this. That experience is fine.

I was just thinking about leasing versus buying a vehicle when I went to do this. When you lease a new vehicle or buy a new vehicle, the biggest cost is depreciation. You're eating a whole bunch of depreciation early on and that's never fun. You can reduce the depreciation cost of vehicle ownership by buying used vehicles because a lot of that depreciation has already been paid for by somebody else.

Cameron Passmore: Depending on the brand.

Ben Felix: Sure. In general, any vehicle after the first two years is going to have a lot of its depreciation already gone down. But for sure, you can look for vehicles that hold their value better than. And the other ones are financing costs and you pay a financing cost no matter what. Whether you lease, finance, borrow, or pay cash, you're paying a financing rate. If you pay cash, it’s the opportunity cost of what would have otherwise done with the cash. If you borrow, it's the borrowing rate. And if you lease it's also the borrowing rate. So, the big difference is really the depreciation cost.

Mark McGrath: Why'd you lease instead of buy?

Ben Felix: I don't like owning vehicles. When I'm done with it, I don't like to have to deal with negotiating a sale price and all that stuff. You're taking some price risk too. I mean, during COVID, I think use vehicle prices were super strong.

Cameron Passmore: Still looking for that sweet spot of interest rates and high residuals in your world. After having talked to a number of dealerships, they kind of look to me like I've got three heads. I’m like, don't you get what I'm talking about? Where's that sweet spot? Because you get newer cars got a higher residual might lower your payment depending on the interest rate or other incentives. Am I weird for thinking this way? This seems so logical once you understand how a lease actually works.

Ben Felix: The other thing, the reason that we did this, so this is before a lease term as opposed to end. What happened was we moved out to the country early on in this lease. We are on pace to quite meaningfully go over our allotted kilometres. If we kept up the same pace of driving, the penalty would have been about $5,000 when we return the lease, which is obviously no joke. We negotiated that down to $2,500 and we're able to roll that into the lease and the lease is rate 3.99%. It was a cost to capital. I thought that was pretty reasonable, instead of giving them cash to cover that penalty cost.

Cameron Passmore: Buying a car is just not an experience I want to go through again, anytime soon.

Ben Felix: Do you buy or lease?

Cameron Passmore: I used to buy used vehicles. I know less about cars than probably anybody you know. Cars are just never been my thing. I don't understand them. I'm obviously ripe for being taken advantage of when it comes to these transactions, which is also why I try to avoid them as much as possible. I just don't like cars all that much.

So, I used to buy used cars and then when I finally got like my first big boy Job a while back, I think it was when my wife got a significant promotion or there was some sort of financial events in our life. We should buy our first new car. So, we bought, I think, it was a 2018 Mazda and it was just no upgrades, nothing like the absolute base model. They tried to upsell us on every single thing and maintenance packages and everything else and like what I thought was going to be relatively painless. Because we knew exactly what we wanted, the colour and everything. It took hours and hours and hours to just get out of there with the car that we wanted.

I just felt really, like, I needed to take to shower after and I decided, like, I'm never going to go into a dealership and buy a new car again, even if I now know what to expect from the sales pressure. I just don't want to experience it again. Even though I kind of want a new car, at some point in the next couple of years, we don't need one, we don't drive very much, we just have the one car between us. That experience alone is sticking in the back of my throat, and I just don't want to deal with it.

Ben Felix: I agree with all of that. I think that's one of the reasons I like leasing is that information asymmetry. You can't get taken advantage of beyond the potential that the residual value is taking advantage of you in some way. You know exactly what the car is going to be worth when you return it. You're pre-agreeing on the depreciation.

Cameron Passmore: Depending on your usage. My last lease, I was way, way under mileage. So, how much equity it gets. I ended up buying out my car because I was 40,000 kilometres under the usage. Well, if I rolled into another lease, that equity would have been largely vaporized.

Mark McGrath: Is that negotiable?

Cameron Passmore: You can try, but they told me that I might have a few thousand dollars of equity in there.

Mark McGrath: But I mean, it's like the number of kilometres, that limit in your driving, is that negotiable?

Ben Felix: It's not negotiable. But you can pay for a higher limit. It's negotiable to an extent. I mean, everything's negotiable. The interest rates are negotiable. The price is negotiable. Every single piece of the transaction is negotiable, which is the worst part about buying a vehicle. So, when you buy a vehicle, you have like the salesperson, the business manager who limits what the salesperson can negotiate, and then you have the finance manager that you have to talk to you about if you're going to lease or finance the vehicle.

The salesperson was talking to the business manager, and he goes back and goes, “I’m trying to get the best price.” He comes back and shows me the quote, or whatever, which is super detailed and clear and it made sense. So, I called my wife and explained to her what was going on. She was like, that seems like they can do better than that. I was like, “I mean, I don't know. I asked the guy to give me the best deal. I don't know what you want to do.” And I walked over to the business manager who's like in a separate area and I don't think he was expecting me to come to talk to him because he's supposed to talk to the sales guys. I was like, “Excuse me, would you talk to my wife?” He said, no. I was like, “Please, can you just talk to her?” And he's like, “Okay.” Super awkward. I gave him the phone. I don't know what they talked about. They were on the phone for like 15 minutes. Came away from that conversation with another, I think, $1,500 knocked off a couple of other things. That was also interesting. Also drives me nuts, though, that it's such a negotiation.

Mark McGrath: I know. Just give me the bottom price. Just be done with it. I don't want to deal with the back and forth. Let's just sit on the price. But you have to negotiate because to your point, or at least your wife's point that there's usually room to go lower. That’s $6,000 an hour she just saved you. Not bad. Send her in. That's the thing though. She's now accepted the position of leasing the next car for your family.

Ben Felix: That’s what the sales guy said. He was like, “Wow, does your wife want a job?”

Cameron Passmore: Nice. She's something. All right. Good to us bring in for a landing?

Ben Felix: Yes.

Mark McGrath: I think so.

Cameron Passmore: Everybody. Thanks for listening.

Mark McGrath: Thanks.

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Links From Today’s Episode:

Meet with PWL Capital: https://calendly.com/d/3vm-t2j-h3p

Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582.

Rational Reminder Website — https://rationalreminder.ca/ 

Rational Reminder on Instagram — https://www.instagram.com/rationalreminder/

Rational Reminder on X — https://x.com/RationalRemind

Rational Reminder on YouTube — https://www.youtube.com/channel/

Rational Reminder Email — info@rationalreminder.ca

Benjamin Felix — https://www.pwlcapital.com/author/benjamin-felix/ 

Benjamin on X — https://x.com/benjaminwfelix

Benjamin on LinkedIn — https://www.linkedin.com/in/benjaminwfelix/

Cameron Passmore — https://www.pwlcapital.com/profile/cameron-passmore/

Cameron on X — https://x.com/CameronPassmore

Cameron on LinkedIn — https://www.linkedin.com/in/cameronpassmore/

Mark McGrath on LinkedIn — https://www.linkedin.com/in/markmcgrathcfp/

Mark McGrath on X — https://x.com/MarkMcGrathCFP

‘How Much Life Insurance Do You Need?’ — https://www.linkedin.com/pulse/how-much-life-insurance-do-you-need-mark-mcgrath-cfp-cim-clu--tjwwe/

InsureRight — https://www.insureright.ca/

Dimensional Fund Advisors — https://www.dimensional.com/

Money Scope Podcast — https://moneyscope.ca/

Braden Financial Services — https://www.bradenfinancialservices.com/

Hendry Warren on LinkedIn — https://www.linkedin.com/company/hendry-warren-llp/

Brady Plunkett on LinkedIn — https://www.linkedin.com/in/brady-plunkett-712489105/

Capital Gains Calculator for Non-Corporations — https://research-tools.pwlcapital.com/research/realize-gain