Situation: Alberta couple considering building cottage, but can’t afford to borrow more
Solution: Downsize house, pay off their debts and focus on investing for retirement
In Alberta, a couple we’ll call Fred, 66, and Marcia, 62, are headed into retirement. They have two children in their 30s. Marcia does administrative work for Fred’s civil engineering practice. Together, they have been bringing home $7,964 per month composed of Fred’s $5,500 after-tax income and $1,464 package of CPP and OAS, and the $1,000 Marcia earns for helping to run the practice.
The couple’s annual gross income is sufficient to cover living expenses and debt service costs.
Fred wants to call it quits and retire provided that he and Marcia can attain a $5,000 monthly income in 2019 dollars after tax. He has $500,000 of retained earnings in his engineering company. But there are debts that must be paid before retirement: a $94,280 line of credit and $21,298 racked up on credit cards. But rather than pay those debts down, he and Marcia consider adding even more.
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“We are thinking of building a cottage. We could take out a mortgage to finance it or increase our line of credit. The cottage could be where we would live in retirement,” Fred explains. On the family balance sheet, the rural land parcel where the cottage would go is a $125,000 asset not for sale. The plan is for Fred and Marcia to move to the cottage and have the kids and their families as guests. How they finance the cottage is critical for their retirement.
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Fred and Marcia.
Too much debt
“This is a debt management issue,” Moran explains. “Adding debt is not wise. Reduction of debt has to come first.” $115,578 has to be paid off. Credit card debt, which carries interest at 20 per cent year, should be paid off in full before Fred retires. The way to do it is to use the line of credit with a four per cent interest rate. Then the line of credit should be paid off. With debt repayment now at $917 per month, full repayment will take a decade.
Alternatively, they could downsize, free up cash, have a retirement house and no debt.
Their principal residence has a $550,000 estimated market price. If they get $522,500 after five per cent transaction costs, they would free up cash for building a $275,000 cottage on their rural land and paying off their line of credit.
Investment management is a priority. They have abundant TFSA room at $63,500 each, but there is no cash at present to take advantage. Their RRSPs are also underfunded.
Setting aside the cost of the cottage would leave them $247,500. That can be used to pay off their debts, leaving $131,922 — just more than enough to top up their TFSAs. The balance from sale, $4,922, could help with moving costs.
If the $127,000 TFSA balance grows three per cent above inflation, it would become $143,940 in four years. If that sum is spent over 24 years to Marcia’s age 90, it would generate $8,250 per year or $688 per month tax-free.
The couple’s RRSPs are growing. Fred recently added $46,000 from his corporation to the former $71,000 balance, making it $117,000. His present $90,000 salary allows him to contribute $16,200 per year. He plans to work four more years. If the sums grow at three per cent after inflation, his RRSP will have a $199,450 balance in four years at his age 70. The money still growing at three per cent after inflation then paid out for 24 years to Marcia’s age 90 would generate taxable income of $11,778 per year or $981 per month in 2019 dollars.
The corporation has $500,000 cash. If paid out in one or two years, the tax bill would be very high. It would be more tax-efficient to pay the sum out over an extended period. Assuming there is still $450,000 in the corporation after this year’s RRSP contribution, then with $100,000 reserved for operating expenses, the $350,000 balance could be invested at three per cent after inflation. In four years, it would be $393,930. There would be another $100,000 earnings in four years from engineering work. That would lift company cash to $493,930. Still earning three per cent per year but paid out over 24 years, it would provide taxable income of $29,165 per year or $2,430 per month.
Retirement for the couple is going to be a moving target. While Fred and Marcia are both working, they will have taxable incomes of $90,000 and $12,000 per year, total $102,000 and Fred’s OAS of $7,289 per year plus his CPP of $10,284 per year. Total income enhanced with government benefits will be $119,573. After 20 per cent average tax, they would have $7,970 to spend each month. That’s way over their $60,000 or $5,000 monthly after-tax retirement income target.
When Fred and Marcia are both fully retired, their income will consist of two Old Age Security benefits of $607 each at present rates, Fred’s Canada Pension Plan benefit of $857 per month and an estimated $577 per month for Marcia. Add RRSP payments of $11,778 per year or $981 per month, TFSA payments of $8,440 or $703 per month and corporate investment payments of $29,165 or $2,430 per month. The total is $81,144 per year or $6,760 per month before tax. If eligible income is split and then taxed at 12 per cent after applicable age and pension credits and no tax on TFSA payouts, the couple would have $6,034 to spend each month. That is over their $6,000 after-tax monthly retirement income target.
With debt service costs of $917 per month terminated, they would have monthly expenses reduced to $5,703 and thus have a surplus. The surplus could be more if they buy or lease a more modest vehicle.
If Fred and Marcia add debt by keeping their house and building the cottage, Fred will have to work many more years. Retirement will be almost impossible. If they downsize and use cash to discharge debt, the plan should work, Moran concludes.
Retirement stars: 3 *** out of 5
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