Harness the resources around you ? Ways to diversify, protect and build your wealth

When Ivy and Brent decided to start their own business 10 years ago, they discussed their plans with both sets of parents and asked them for guidance and assistance. The moral support their parents offered was invaluable, but it was their financial support that really made the difference and allowed Ivy and Brent to get their business off the ground. Each set of parents provided a loan of $10,000, and that money was immediately put to work to purchase supplies and make the necessary arrangements to get the new business up and running.

Ivy and Brent paid off those loans years ago, and their business is thriving. The stressful days of the start-up period now seem a distant memory. But the couple is still keenly aware that they could not have achieved their dream without the financial help of their parents.

From this experience they learned a lesson that they've tried to apply to other aspects of their lives: Some dreams can only be realized by harnessing the resources of others. They took this lesson to heart and successfully expanded their business through a bank loan and a partnership with a key supplier two years ago. And they were chatting about the importance of exploiting the opportunities around them as they drove to their meeting with Jay, their financial advisor, for their annual portfolio review.

Memories of a first meeting
Jay had come highly recommended to Ivy and Brent by a close friend. Five years ago, after their company had reached a stage of relative stability, the couple wondered if they should diversify their assets. Their business had grown nicely; however, after hearing about some financial difficulties a fellow entrepreneur encountered, they became concerned that their financial security was too dependent on the whims of their industry. Furthermore, they worried that, although their company was incorporated, their personal assets may be at risk if their business ever failed.

In short, they wanted to reduce the financial risk of having all their assets tied up in the business and ensure that their long-term financial goals could be achieved. They set up a meeting with Jay and he agreed that their assets were too concentrated in their company, which could put their future financial security at risk.

Jay had come highly recommended to Ivy and Brent by a close friend. Five years ago, after their company had reached a stage of relative stability, the couple wondered if they should diversify their assets. Their business had grown nicely; however, after hearing about some financial difficulties a fellow entrepreneur encountered, they became concerned that their financial security was too dependent Jay made two recommendations when they first met. First, he suggested that Ivy and Brent diversify their assets by taking some earnings out of their business to start a Registered Retirement Savings Plan (RRSP) and a non-registered investment account. Second, he advised that they choose segregated funds as their investment vehicle since segregated fund contracts, as insurance products, offer the potential for creditor protection if a business fails. For additional protection and security benefits, he recommended insurance-based Guaranteed Interest Contracts (GICs) for their RRSPs only.

Ivy and Brent took his advice. They withdrew some of the retained earnings from the business and used the money to catch up on their RRSP contributions. This provided them with a solid base of registered savings. Then they set up ongoing monthly contributions to their RRSPs so both of them could maximize their contributions each year going forward.

Because Ivy and Brent wanted to plan for a more comfortable retirement and diversify their assets further, they also set up a non-registered investment account, as Jay had recommended. Here, they invested exclusively in segregated fund contracts through an ongoing monthly contribution program.

The couple left their first meeting with Jay feeling confident because their financial security was now less dependent on the success or failure of a single investment – their business.

Fast forward to today
In the past five years, Ivy and Brent's trust in Jay's ability to help them manage their finances has grown. Jay has taken the time to understand their business and has made a number of additional recommendations to help them expand their company, while at the same time achieving more financial security. Their RRSP accounts have grown significantly and their non-registered segregated fund contract is now worth $75,000.

A significant reason for the rapid accumulation of assets in their nonregistered investment contract is that the couple's business has continued to grow quickly. Since their company was spinning off more cash than they needed to run it or to live on, and they were both already maximizing their annual RRSP contributions, they have begun to make bigger deposits to their non-registered investment contract. However, they are both aware that drawing more income out of their business's retained earnings is causing them to pay additional taxes. Ivy and Brent are delighted by the success of their business, but they wonder if there is a way to continue withdrawing excess cash from their company without incurring such a large tax bill.

As he's done in the past, Jay presents them with a solution to their problem. He shows them how they can use investment leverage,1 otherwise known as "borrowing to invest," to generate a tax deduction and potentially accelerate the growth of their non-registered savings. His recommendation is as follows:

1. Use their $75,000 non-registered segregated fund contract to secure a 3:1 investment loan of $225,000. This loan can be deposited into that same non-registered contract, increasing its balance to $300,000.
2. Withdraw enough cash from the business each month to cover the interest payment on the loan. For example, if the loan interest rate is seven per cent, the monthly interest payment would be $1,312.50.
3. Declare the withdrawal as taxable income, but take advantage of an offsetting tax-deductible interest payment of an equal amount. The net effect would be that these particular retained earnings could be removed from the business tax free.2
4. Benefit from the potential for greater long-term growth due to the tax deduction and the larger principal investment positioned to enjoy the
   effects of compounding.

To illustrate his point, Jay shows Ivy and Brent how, over a 10-year period, they could end up with $77,436 more after-tax dollars by using withdrawals from their business to fund a leverage loan than if they used those same withdrawals to fund a non-leveraged investing strategy.3

Jay explains that leverage is a long-term strategy involving greater risk than the non-leverage strategy. However, since Ivy and Brent have already established a solid base for retirement through their RRSP, they are comfortable taking on the additional risk. In addition, because they have already experienced the benefit of "harnessing the resources of others" within their business, they immediately see how harnessing the resources of a bank, through an investment loan, can help them realize their goals of saving taxes and building their non-registered investment portfolio.

Jay helps them secure a $225,000 investment loan leveraged against their 75,000 in existing segregated fund contracts. The loan features no margin calls and interest-only payments, which helps Ivy and Brent manage their cash flow from year to year.

With an investment leverage strategy, Ivy and Brent are successfully harnessing the resources of a bank to diversify their assets, protect their savings from potential creditors and build their overall wealth. The approach recommended by their financial advisor is also allowing them to refocus on growing their business, secure in the knowledge that they are converting some of the business's excess income into personal investments in a tax-efficient manner.

1 Borrowing to invest is suitable only for investors with higher risk tolerance. You should be fully aware of the risks and benefits associated with investment loans since losses as well as gains may be magnified. The value of your investment will vary and is not necessarily guaranteed; however, you must meet your loan and income tax obligations and repay your loan in full. Please read the terms of your loan agreement and the investment details for important information, and discuss with your financial advisor before deciding to borrow to invest.
2 This illustration assumes that a specific percentage of loan interest is tax deductible. However, actual tax deductibility of loan interest depends on a number of factors, with the Income Tax Act (Canada) providing the framework for determining tax deductibility. Tax laws are subject to change and, therefore, tax treatment of illustrated figures cannot be guaranteed. Results for Quebec residents may differ due to different deductibility rules. Readers should consult their own tax and legal advisors with respect to their particular circumstance.
3 Assumptions: 10-year investment period, 8% annual investment return, 7% interest rate on loan, 25% taxable portion of return, 30% tax rate on investment income, 46% marginal tax rate, 100% loan interest tax deductibility. Assumptions are for illustrative purposes only.