Situation: Three kids, three rental properties, and a lot of pot stocks in portfolios
Solution: Sell rentals, build RRSPs, TFSAs, diversify, cut taxable income
In Alberta, a couple we’ll call Emily, 40, and Robbie, 37, are raising three children on a combined monthly after-tax income of $11,447. Their futures are tied to three rental properties in their town and to their portfolios of Canadian and U.S. stocks, many of which are not for the faint of heart. They would like to retire when Robbie is 50 and Emily is 53, then live half the year in a warm place far from Canada’s winters. Their target is $4,000 per month after tax in 2019 dollars.
Family Finance asked Owen Winkelmolen, a fee-for-service financial planner who heads PlanEasy.ca in London, Ontario, to work with Emily, a part time health care professional, and Robbie, who manages computer networks.
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Lack of diversification
Robbie and Emily have made a big bet on Alberta real estate, all of it in their own town. Their house plus local real estate investments in their RRSPs and TFSA portfolios amount to 70 per cent of their assets. That’s a concentrated allocation to one sector in one city in one province.
Not only are the three income properties exposed to rising interest rates, but they also are cash-flow negative. After mortgage payments, property taxes and insurance costs are taken off rental income, they are losing $74 per month. Higher mortgage rates will increase the cash loss, the planner estimates. Even if the forced savings part of the mortgage, that is, repayment of capital apart from interest, is figured in, the properties have a return of just 2 per cent to 4 per cent.
If their three investment properties are sold, then after selling costs of 5 per cent and a $9,000 reserve for estimated capital gains taxes, they would have about $310,000 in cash left for investment. Some could go into their TFSAs to fill space and the remainder could be shifted to RRSPs and other savings, including RESPs for their three children which have a present balance of $38,000. When proceeds of sales are combined with current financial assets, the family would have $921,000 of investment assets with 60 to 70 per cent in tax-sheltered accounts, the exact amount dependent on their RRSP and TFSA space.
There is a fringe benefit to be had from selling the rental properties. If they sell the properties and then invest as much of the proceeds as they can in RRSPs and TFSAs, they will see a drop in nominal taxable income. The remaining income and the proceeds of sale can be directed to sheltered accounts. With less taxable income, they may be able to obtain a larger sum from the Canada Child Benefit, Winkelmolen says.
Emily and Robbie have $38,000 in their family RESP. Though they have suspended contributions, they want to be able to provide post-secondary support for their three children currently ages 12, 6 and 3. That’s a total of $120,000 for four years of post-secondary education. If they add $2,000 per child per year to education fund to each child’s age 17, perhaps by cuts in travel and restaurants and eventually reduced child care, each would also receive a $400 annual Canada Education Savings Grant, the lesser of 20 per cent of contributions or $500. Each child could then have about $57,400 for tuition, books and so forth.
Currently the RESP is almost entirely invested in marijuana stocks. This is bold, but the portfolio is not only poorly diversified, it is very risky given that the industry is not even well defined. Robbie and Emily should broaden their holdings, Winkelmolen suggests. Mature industrials, financials, utilities and a small weight in government bonds would cut risk.
Emily and Robbie have $422,000 in their RRSPs. If they contribute $19,850 per year to their RRSPs for the next 13 years to Robbie’s age 50, then assuming 3 per cent growth after inflation, the accounts will hold $929,750 in 2019 dollars and support payouts of $39,050 per year for the next 40 years to his age 90.
Assuming they sell the investment properties, they will be able to boost TFSA contributions by $11,000 per year for the next 13 years. If the accounts grow at 3 per cent after inflation, they will have about $177,000 in the accounts. That sum, still generating 3 per cent a year after inflation, would support payouts of $7,435 per year for 40 years to Robbie’s age 90.
There is $126,000 in Robbie’s company’s defined contribution pension. He will receive $6,189 per year from his employer each year based on 5 per cent of gross salary before tax. If that sum grows at 3 per cent after inflation for 13 years, it will become $284,600 and, still growing at 3 per cent after inflation support payouts of $11,953 per year for the next 40 years in 2019 dollars.
After selling investment properties and investing in tax sheltered accounts, they would still have $188,550 left over in non-registered accounts. Assuming they shift $11,000 per year to their TFSAs and if their non-registered accounts grow at 3 per cent per year after inflation and pay 1 per cent tax, net 2 per cent growth, then in 13 years they would hold $405,500 in 2019 dollars, Winkelmolen calculates. That sum, growing at 2 per cent per year after inflation and tax, would support payouts of $14,532 per year for 40 years to Robbie’s age 90.
Adding up the pieces, in the 15 years from Robbie’s age 50 to his age 65, he and Emily would have cash flow of $72,970 of inflation-adjusted income. Allowing for a 15 per cent average tax rate, they would have $5,200 per month to spend, well above their $4,000 monthly after-tax income goal. At age 60, Robbie could take CPP at $6,873 per year and Emily at $3,400 per year. As each turns 65, there would be Old Age Security payments, currently $7,217 per year for each person.
At age 65, Robbie and Emily would have gross income of $97,677 before tax. Assuming that they split eligible pension income and pay 18 per cent average income tax, they would have $6,700 to spend each month, about 70 per cent more than their retirement target.