A man we’ll call Walter, 57, lives in southern Ontario. A manager of a non-profit organization, he takes home $5,175 per month before tax and adds $1,723 from taxable investments in stocks and mutual funds. His invested assets total about $428,900, a $100,000 drop from pre-virus levels. He has no dependents. The pandemic has made him think deeply about what comes next. He is being pushed by risk of layoff into a retirement he thought would begin at 60. He must service his $84,000 mortgage with 21 years to run and a $439 monthly cost. His goal in retirement: $50,000 per year, after tax.
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“I would like to retire in a way that is tax efficient,” Walter explains. “I am concerned about the OAS clawback.”
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Walter. “The good side of this story is that some of Walter’s income will continue even if he is not working. Income maintenance is supported by his employer and government financial programs. The downside is that he will go into retirement with two decades to run on his mortgage.”
Base for retirement
The first move to improve Walter’s retirement readiness is to make his investing and borrowing as tax efficient as possible. Right now, he must pay tax on the income he receives from $341,964 of investments and savings, but pays non-deductible interest on his mortgage, Moran says.
He could sell some of the taxable investments to pay off the mortgage and then borrow the sum back for investments, making the interest portion of debt tax-deductible. The downside is that some of the investments may have accrued capital gains that would be taxable if sold to pay the mortgage.
He can borrow to replace what is sold at 2.5 per cent and earn five per cent in dividends. An alternative would be the so-called Smith manoeuvre, which leverages home equity for investments, with the caveat that investments can be vulnerable to loss. Chartered banks and utilities have continued to pay their dividends during the ongoing COVID-19 crisis, but there are no guarantees. That said, his income from investments would not be terribly fragile. It is a risk worth taking, Moran concludes.
The interest he would pay would be deductible at a rate of 29.65 per cent. The tax on dividends is 7.56 per cent in his income range. It would be tax-efficient.
There is a paradox, however. Dividends are inflated by 38 per cent in the tax calculation before being given a credit of 15 per cent of the so-called grossed up amount — equivalent to 20.7 per cent of the actual dividends. These inflated dividends could theoretically trigger the Old Age Security recovery tax, a.k.a. the clawback, at $79,510 in 2020, but Moran says Walter is unlikely to reach that threshold.
Walter can work on filling his $100,000 in available RRSP space. He could get a 33 per cent refund until the tax reduction brings his income down one bracket to $48,535. The arithmetic is not difficult — assuming that he continues his salary at $62,100 per year and he contributes $62,100 less his bracket bottom $48,535 — that’s $13,565. Assuming he contributes $13,500 for three years and that it grows at three per cent after inflation, his current RRSP balance of $48,998 would become $95,270. If that money continues to grow at three per cent after inflation for 30 years to his age 90, Walter would have taxable RRSP/RRIF income of $4,860 per year to exhaustion of capital.
If he adds $6,000 per year to his $57,394 Tax-Free Savings Account for three years and that sum grows at three per cent after inflation, then the present balance of $57,934 would become $82,260. If the sum continues to grow at three per cent after inflation, it would support payouts of $4,080 per year for 30 years to his age 90 until all capital is expended.
Walter’s taxable investments and cash, currently $341,964, will support payouts of $16,000 per year for the 33 years starting this year to his age 90 on the same basis.
At age 60 Walter can have annual investment income of $4,860 from RRSPs and $16,000 from taxable investments for total income of $20,860. From that, he will face an average additional interest cost of $2,000 related to the funds he borrowed to pay off his mortgage. After average tax of five per cent based on a blend of fully taxable dividend income, and adding back $4,080 in TFSA income, he would have $22,000 per year or $1,835 per month for living expenses.
$1,200 in RRSP and TFSA savings would have ended. He could save $200 per month by not driving to work. His expenses with the loan to pay off the mortgage still outstanding would have declined to $2,417 per month. He could subsidize the difference by drawing down cash savings or doing part time work.
At 65 he can start Canada Pension Plan payouts at an estimated $10,860 per year and Old Age Security, $7,362 per year at present rates. His annual taxable income would rise to $40,222. After tax at an estimated rate of 13 per cent and adding back TFSA cash flow, he would have $3,250 per month to spend. Based on spending of $2,417 per month, he would be able to save $830 per month or $10,000 per year for travel or a new or newer car as needed. But his $50,000 after-tax income goal won’t be reached with his assets and income and these projections.
To get there, he would have to continue working until at least age 65.
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Retirement stars: three retirement stars *** out of five