Using the profits from the sale of the condo toward savings will give this couple a more solid plan for retirement
Situation: Hefty childcare costs, modest savings and an unprofitable rental cloud couple’s retirement picture
Solution: Sell the rental, use cash to boost RRSPs and pay off the home mortgage then finalize retirement income
A couple we’ll call Steven and Amanda, 43 and 42 respectively, live in B.C. with three children ages 3 to 8. They bring home $10,936 after tax each month and add $286 from the Canada Child Benefit, total $11,222. A high-tech manager and a health-care consultant, respectively, they are typical west coast investors with a taste for real estate. Their $1,689,000 house and their $819,000 rental condo make up most of their $2.97 million total assets. Their liabilities are two mortgages that total about $1.13 million.
“Can we retire at 65 with our present standard of living intact?” Steven asks. And can Amanda work only part time in order to get there?
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to review Steven and Amanda’s finances and plans.
“If these folks are to retire comfortably, they will have to raise investment income,” Moran says.
Right now, their largest single investment is the $819,000 rental condo with a $373,357 mortgage. Their net worth, including RRSPs, RESPs, their own house and cash, less the two mortgages, is $1,838,376. It’s very good for a couple in their 40s with three kids, but 85 per cent of their total assets are in two properties. Ironically, their rental unit, while having appreciated in value significantly, is not a good producer of cash.
Educating the kids
The couple’s first priority in a chronological sense is educating their three children. They have $28,600 in their Registered Educational Savings Plan. At present, they add $300 per month. To make the most of the Canada Education Savings Grant, they should contribute a total of $625 per month or $7,500 per year. Then they will receive the maximum CESG, $500 per child, to make the fund grow at $9,000 per year. When the kids, now 8, 6 and 3 are ready for post-secondary education, the fund, growing at 3 per cent per year after inflation, will have about $31,500, $39,700, and $52,950 for the kids from youngest to oldest. It would average about $41,400 for each child with the parents ensuring equal sums for the kids. It would cover four years of tuition at most B.C. post-secondary institutions and be enough if the kids live at home. If Steven and Amanda trim other spending, cash on hand and, later, savings on daycare, will support higher RESP savings.
The rental condo brings in gross rent of $2,400 per month. After paying the mortgage, property tax, condo fees, insurance, cleaning and so on, they are left with a meager 2.66 per cent return on their equity. Purchased for $277,000, 15 years ago, it has appreciated to $819,000, but it is unlikely that that appreciation can continue forever, Moran cautions.
Were they to sell the rental condo, their use of it for personal housing for four of the 15 years they owned it would be tax-free. One more year is added, so 5/15ths of the gain will be tax-free. They paid $277,000 for the condo, so just two-thirds of the gain will be taxable. If the property is sold for $819,000 less $35,000 selling costs, they would have $784,000. The tax assessed would be about $68,000, Moran estimates. That would be almost fully offset by the income tax reduction produced should they contribute some of the proceeds into their RRSPs.
If they harvest $784,000 after costs, pay off the $373,357 outstanding mortgage balance and add $161,000 to their RRSPs to fill their combined space, they would have about $249,643 left over. That money can be used to pay down the $753,342 outstanding balance on their home mortgage, reducing it to $503,700. That balance, assuming a four per cent interest rate and the present payment rate of $3,127 per month, would be paid off in 19.5 years when Steven and Amanda are in their early 60s and just on the cusp of retirement.
The couple’s RRSPs have a present balance of $371,475. If they add $161,000 from the condo sale, total $532,475 plus $600 per month and the accounts grow by 3 per cent per year after inflation for 22 years to Lenny’s age 65, they will become $1,246,750 in 2018 dollars. Annuitized to pay out all income and capital in 30 years, the RRSPs would generate $63,610 per year.
At age 65, each would receive $7,160 from Old Age Security and $13,610 from the Canada Pension Plan at 2018 rates.
Adding up income components in retirement, Lenny and Dorothy would have $63,610 from RRSPs, two $7,160 annual OAS benefits, two $13,610 CPP benefits for total retirement income at age 65 of $105,150 per year. If eligible income flows are split and taxed at a 15 per cent rate, the couple would have $7,450 per month to spend.
The couple’s present expenses total $11,222 per month, including those related to rental income. If the rental-related costs are taken out, their expenses total $9,165. If other expenses not likely to exist in retirement such as savings and child care are eliminated, their expenses drop to about $5,900 per month. That would leave a surplus of about $1,550 per month for travel and other expenses as the need arises.
Their retirement budget would be enlarged if, once their mortgage is paid and the kids go off to university, they add sums previously committed to debt service to TFSAs, Moran notes. If the couple downsizes their home after the kids have finished post-secondary studies, retirement savings would grow.
The problem is too much real estate including one not very profitable rental, Moran says. With sale of that rental unit and increased savings as we have indicated, the couple can have a secure and adequately financed retirement.
If Amanda works part time, the family’s ability to fund RRSPs and RESPs would be reduced. With growing children and what are likely to be higher costs as the kids grow up, cutting income many years before retirement is not wise. When the kids are all in grade school and childcare costs, now $2,300 per month, drop, there would be cash for leisure, Moran says.