Small business presents big challenge for couple planning early retirement
In Toronto, a couple we’ ll call Louis, 46, and Laurie, 47, have two children 10 and 13 and a family management consulting business from which they take $ 10,594 a month after tax in salaries and dividends. Their spending is modest save for one huge expense — $ 3,500 a month for sports for their children. It’s affordable now, but they face a major hurdle.
“Can we retire in eleven years from full-time work?” Louis asks. “I would like to teach a business course at a community college on a part-time basis. We’d like to have $96,000 a year before tax for the first decade and a half and then $ 72,000 a year before tax after that.” They expect an inheritance of $500,000, but it could be long in the future.
Along the way, they’d like to buy a US$300,000 home in Florida, pay off their $ 195,000 home equity line of credit and help their aging parents with the costs of care should that be needed. It’s a big order for a couple betting everything on their small business, a business management company with $670,000 in annual sales.
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Louis and Laurie. “They are in the expensive years of life with costly kids’ sports and a lot of debt. But the interest costs, which are related to their business, are deductible from taxable income. Moreover, their home is fully paid, their $473,400 of Registered Retirement Saving Plans is respectable for their ages and their income draw from their company is reasonable and conservative.”
“The core problem the couple faces is that they have made one large bet on their business,” Moran explains. “Their family is dependent on its health and success, yet they are tempted to add more obligations on their income.
FINANCIAL MANAGEMENT
The easiest projection to make is the value of the family’s Registered Education Savings Plan, growing at $3,000 a year courtesy of gifts from grandparents. If the RESP balance, $84,600, continues to attract $1,500 per year per child and gets the Canada Education Savings Grant of the lesser of 20 per cent of contributions or $500 per beneficiary per year, $600 total per year in this case, with growth in a blend of fixed income and equity at 3 per cent per year after inflation they would have $ 55,400 for the older and $62,500 for the younger, all in 2017 dollars.
For retirement, fresh management is required, Moran adds. They should pay themselves more salary and cut dividends. Their salaries are $60,000 a year evenly split. They pay themselves $52,000 each in dividends. The result is tax efficient, for dividends are taxed at a lower rate than wage or salary income, but it leaves them very dependent on the success of their business when they retire. Building up CPP credits is vital, for without defined benefit pensions, CPP will be their largest guaranteed indexed income stream in retirement, Moran explains. Spare cash after the line of credit is paid should go to their badly underfunded TFSAs.
They could increase their salaries to $55,300 each before tax. That would boost them to the top of the maximum year’s maximum pensionable earnings for calculation of CPP.
Spending a lot of time in Florida would be accompanied by sale of their business. If they can sell it for $750,000 as a Canadian Controlled Private Corporation in a dozen years, there would be no tax after application of the lifetime exemption, about $ 825,000, assuming that it can meet the complex qualification tests on ratios of business assets used for carrying on the business.
RETIREMENT INCOME
The couple’s retirement income based on $473,000 of present RRSP balances with zero contributions — as they are now doing, would rise to $728,000 in 11 years assuming a 4 per cent rate of growth after inflation. They are skilled investors and run their portfolios with low fee exchange traded funds, Moran notes. That justifies boosting a typical after-inflation return from a customary 3 per cent to 4 per cent, he explains. If that sum continues to grow at 4 per cent over inflation and is spent evenly over the next 37 years to Laurie’s age 95, it would support annual pre-tax payments of $38,000. That works out to $19,000 each per year.
Proceeds of the company sale at $750,000 in the year of their retirement invested to generate 4 per cent a year for the next 37 years would pay them a combined sum of $ 39,200. The $ 500,000 inheritance, invested on the same basis, would add $26,000 a year.
When Louis and Laurie retire, they will have less than maximum CPP benefits, even if they begin to boost them in the near future. Early retirement at 58 and 59, respectively, and a decade of low contributions mean that they are likely to get no more than 55 per cent of the CPP maximum, currently $13,370 per year. If they raise their contributions, they could get 70 per cent or $9,359 each. Louis and Laurie would each get $7,004 a year from Old Age Security at 65.
Adding up the income sources with retirement in 11 years, the couple would have combined incomes of $103,200 from retirement to age 65, and $135,926 thereafter. With even splits of income, they would pay tax at 16 per cent to age 65 and 20 per cent thereafter, leaving them with disposable incomes of $7,225 per month and $9,060 thereafter. They would beat their targets.
VACATION HOME
The wild card is the Florida home. They could finance it at today’s low mortgage rates and cover that cost with rental income. Managing the rental from Canada would be problematic, though a manager could be hired — at a fee, of course. Just renting an apartment for a few months would be easier.