All-star plan ensures cushy retirement
Andrew Allentuck Dec 9, 2011 – 11:58 AM ET | Last Updated: Dec 9, 2011 1:17 PM ET
In Alberta, a couple we’ll call Edward and Wendy, both 60, have lived modestly and raised two children now in their thirties, while struggling to build retirement savings and to manage their taxes. Their frugal ways have paid off.
They will leave the working world with just one debt, deductible at that and readily dischargable if they like. They are in the position of having as much as 60% more spendable income in retirement than they had while working, and they have the enviable satisfaction of having prepared well for years when they can travel and watch grandchildren grow.
They raised their children in a 1,000-square-foot home in a working-class neighbourhood. Being careful with money is in Edward’s blood. He came from a family with nine children in which money was tight. “I learned to spend for value and my wife and I have continued that tradition. The result is that we have substantial financial assets. Getting our heads around applying our resources to our retirement plans is the problem.”
They have to be sure that their present net worth of $1.07-million will be sufficient to carry them for what could be three decades.
Edward is heading to the end of his second career. He quit his first job, in transportation, after nearly a quarter-century, taking a defined benefit pension of $3,250 a month before tax. Now working part-time for a high-tech company, he gets $2,675 from his first job’s pension and $1,450 from his present job, in both cases after tax. Wendy, a public servant, brings home $2,200 a month for her part-time work. They have other income that pushes their total take-home pay to $6,405 a month.
They wonder whether they should sell an income property and take a handsome capital gain and whether they can retire as planned at age 63. “We lack the confidence to proceed along a path that will provide appropriate income for us in retirement,” Edward explains.
Family Finance asked Lenore Davis, a financial planner and senior partner at Dixon, Davis & Co. in Victoria, B.C., to work with Edward and Wendy.
Tax Strategy
“There is a foundation for their issues,” Ms. Davis explains. “It’s their tax rate. The lowest tax bracket in Alberta is 25% on income up to $41,500. The next $42,000 is taxed at 32%, so that’s where attention has to be focused.”
Edward’s basic pension, $39,000 a year before tax, brings him close to the top of the first bracket and his employment income pushes him over the top. However, he can split pension income with Wendy and keep more of of their wealth for themselves. He can distribute $19,500 a year to her and save 7%. In retirement, they can split pensions, including CPP, to keep each partner’s taxable income in the lowest Alberta tax bracket.
Taking CPP is a strategic issue, Ms. Davis notes. If Edward were to take CPP before age 65, under new rules that take effect in 2012, he would lose benefits at a rate of about 7.2% a year. If he takes benefits and continues to work (allowed under new rules), he would still have to pay into CPP at a rate of 4.95% on his eligible salary. Reduced benefits would persist every year and he would be taxed on those benefits while employed.
If he waits to 2014 to start CPP benefits when both are 63 and retired, Edward’s CPP benefits would be cut by about 14%. But by waiting to draw benefits in retirement, his tax rate in 2014 on benefits and other income would be only 25%, Ms. Davis says.
Were Edward and Wendy to take money out of their RRSPs, where it is now sheltered, distributions would be taxed at 32%. So it is best to leave the RRSPs to grow at least until full retirement.
The condo
Edward asks what he and Wendy should do with their investment condo.
Purchased for $164,000 and with a present estimated market value of $305,000, it has a potential capital gain of $141,000. It is rented for $975 a month to one of their children, who plans to leave in a few months. Outlays, including mortgage costs, fees and taxes, are $1,220 a month. The mortgage and line of credit for the property, which total $128,000, could be paid out of $247,000 of cash in their bank accounts that earns a crummy 1% a year.
That would save $810 a month in finance costs and leave them with positive cash flow from the property. It seems so easy to do that the only reason not to would be waiting for a time to reap a larger profit than the $70,500 estimated taxable gain —only half of capital gains are taxable — that they have yet to realize. They could wait for the market to rise, though it could also fall. But in the meantime, they have a negative rental return on the condo and a pittance on the cash. The obvious course is to fix both with the low-yield cash paying off the mortgage.
The couple will eventually sell the rental property. If they do it when they are over 65, the capital gain, $70,500 a person before selling costs, could push them over the OAS clawback trigger point, now $67,668. It might be better to sell before they reach 65, perhaps in the year following Edward’s retirement, Ms. Davis says. That way their OAS will no be impaired.
At retirement at age 63, the couple will have Edward’s indexed $39,000 pension, Wendy’s indexed civil-service pension of $6,000 a year, CPP benefits of $11,520 for Edward and $6,500 for Wendy, less penalties of 7.2% a year for each year of early retirement, for a net CPP benefit of $15,425 and a 3% after-inflation return on 2014 financial assets of $653,808, or $19,614 a year, for total retirement income of $80,040 a year before tax. At 65, Old Age Security benefits will begin and add $6,456 a person to income, raising it to $92,950 in 2011 dollars.
If pension income, including RRIF distributions, is carefully split, the couple will not be affected by the OAS clawback. If their total income is taxed at a 30% average rate, they will have $56,025 a year to spend to age 65 and $65,065 a year thereafter. That’s far more than their current spending net of savings of $40,992 a year.
“With indexed pensions and potential for adding to savings even in retirement, the couple can make generous bequests to their children and good causes,” Ms. Davis says. “This is a case in which being frugal will produce many decades of financial rewards.”
Need help getting out of a financial fix? E-mail andrewallentuck@mts.net for a free Family Finance analysis.
