Real estate is a good fit for this young couple
Nancy and George, as we’ll call them, 30 and 31 respectively, came to Canada from a small town in Scotland in 2006 seeking better financial prospects. They gave up a familiar way of life and close family ties for a new, cold country. “We took a risk,” George says. “It has paid off.” George, who sells construction equipment, has a six-figure annual income. It was $135,000 in 2013, or $6,750 a month, after 40% average tax and paycheque deductions. They have a rental unit that produces about $400 a month pre-tax income.
Nancy is a self-employed marketing consultant taking time out to raise their ninemonth-old son. In spite of their present income, as much as $200,000 a year when Nancy is working, there are no guarantees that George’s commissions will keep on coming. They need to build capital for potential downturns in income and maybe even an early exit from work if all goes well.
Family Finance asked Graeme Egan, a financial planner and portfolio manager with KCM Wealth Management Inc. in Vancouver, to work with Nancy and George.
“The future is bright for this couple,” Mr. Egan explains. “They are well educated. Their finances are solid. Nancy is getting parental benefits and the Universal Child Care benefit, in total, about $1,000 a month. They have about $535,600 net worth of which $140,000 is cash awaiting investment. They have become landlords with a $300,000 condo they rent out for a modest return while awaiting a capital gain.”
Investment strategy
Nancy and George like bricks and mortar — assets they can see. If they invest in properties and realize gains, only half will be subject to tax. That would mean a tax of likely no more than 20% to 25% of the gain, depending on their bracket at that time. In comparison, investments in financial assets (real estate is not allowed for RRSPs), they would get a current tax reduction, but money coming out would be taxed at full rates.
If they leave Canada and cease to be permanent residents, the tax would be 25% if the entire plan is collapsed. That is about the same tax they would pay on property gains but leaving Canada would not trigger a deemed sale of real estate. From their point of view, real estate is ideal.
George and Nancy have set up a Registered Education Savings Plan for their son. They have $2,500 in it now and expect a $500 bonus from the Canada Education Savings Grant. If they continue to contribute until they reach the $50,000 for each beneficiary and get the $500 grant to a lifetime maximum grant of $7,200, then at age 18, the plan, growing at 3% a year after inflation, would have $71,300 in 2014 dollars. If they have more children, and use a family plan, they can shift benefits among beneficiaries.
Tax Planning and Savings
George has $119,394 of unused RRSP contribution room. Assuming that he has reserved $30,000 for a down payment on a new rental property and $2,500 for the RESP, he should contribute $100,000 to Nancy’s spousal RRSP before Feb. 28, 2014. He will get a $37,000 tax deduction for it. That can be used to pay down the mortgage on their home. They are allowed $41,150 in annual mortgage pre-payments, so the additional payment will not trigger a penalty, Mr. Egan says. Then, for the next few years, George can contribute to his own RRSP until it is about equal to Nancy’s. Thereafter, he can split RRSP contributions between his plan and Nancy’s, Mr. Egan suggests.
It’s a long way off but if George were to contribute the maximum $22,500 each year for the next 24 years to his age 54, then at age 55, invested for a little more risk with a 4% return after 2% annual inflation, their RRSP portfolio would have a value of $1,176,000. This could provide $49,400 a year for forty years to his age 95.
If George and Nancy add $11,000 a year to their existing $18,000 of TFSAs for the next 24 years, the accounts would grow at 4% after 2% inflation to $493,250. At the same rate, the funds would provide $19,730 a year indefinitely.
That isn’t counting their real estate potential for profits. If the rental properties, the present one and another of the same $300,000 value they want to buy — total $600,000 — rise at just 2% a year over the rate of inflation for the next 24 years, they would be worth $965,060 in 2014 dollars. Take off the $600,000 cost and their capital gain, $365,060, would have a tax of about $80,000, leaving net value of $885,060. If the properties were then sold and invested in financial instruments to yield 4% over the rate of inflation, this sum could generate $35,400 a year indefinitely. This portfolio of RRSPs, TFSAs and rental properties would then provide $104,170 annual income before tax. After 25% average income tax, they would have about $6,500 a month to spend. That would sustain their present way of life with savings removed.
Assuming George makes maximum annual contributions to the Canada Pension Plan for the next 24 years, then at age 60, his CPP benefits, about $12,000 a year at current rates, would be reduced by a 36% penalty so that he would have $7,680 a year in benefits. Nancy’s CPP will be negligible if she remains a transitory member of the labour force.
This would boost annual family income after tax to $111,850. At ages 67, they will receive full Old Age Security, adding $13,236 a year, push- ing total pre-tax income to $125,100 a year. At 30% average income tax, they would have $7,300 a month to spend — more than their present living costs net of debt service and savings.
George and Nancy can build stability into their lives by investing in income-generating assets and use of tax deductions based on RRSPs.