Woman nearing retirement with income already below expenses must raise cash
In Toronto, Marla, as we’ll call her, is a 60-year-old self-employed art therapist working out of her home-based studio. She makes $24,000 a year from her work and rents out two rooms in her house for another $15,600 a year. She has a cottage a few hours from Toronto which she uses in summer and does not rent out. Her total income is $39,600 a year before tax, or $3,000 a month after 10% average income tax.
It’s not a lot for life in an expensive city. Worse, the largest part of Marla’s income from her practice is destined to shrivel as she downsizes her workload. Within a few years, five at the most, she would like to close her practice and retire completely. She runs a $1,020 monthly deficit, taking money out of her savings as needed. For now, that works, but without her professional income, she would eventually exhaust her savings and be forced to sell her house or cottage.
“I am wearing out,” she says. “Yet I don’t want to continue to be squeaking through financially, as I am now, running down my money.”
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Marla. “There really is an imbalance here,” he explains. “Her current income is modest. Yet her assets, a total of $1.18-million, include her $730,000 house and the $220,000 cottage, $190,000 cash in a savings account and $29,000 in an RRSP. Moreover, she has no children or other family. All the money is for her. What we have to do is to liberate this wealth and make it generate more income. That done, her future will be secure.”
BUDGET MANAGEMENT
Marla built her million-dollar-plus net worth by hard work and methodical savings. Yet that wealth is concentrated in her house, which makes up 65% of her net worth yet produces just $15,600 of annual rent, and her cottage, a further 19% of net worth, but an asset that produces no income.
The easiest move is going to be paying off the $62,300 mortgage on the house. The money can come from the $190,000 cash she has hoarded in the bank, reducing it to $127,700. Then $31,000 can go to a tax-free savings account. She has that much space because she has not opened a TFSA yet. She can use socalled dividend aristocrat stocks that pay dependable and rising dividends. Several companies sell exchange traded funds with these shares. The ETFs vary by such things as annual management fees and qualities of stocks held. Marla should go to the websites of various vendors, study the products and learn the differences among them.
Marla plans to boost her rental income from her present two boarders to three. That would push rents from the present $1,300 a month up by $800 a month to a total of $2,100 a month, or $25,200 a year. She would keep the last of four bedrooms for herself. She can rent her cottage for $1,333 a month for six months of the year for a total of $8,000. Her total rent flow would then be $33,200 a year from properties worth a total of $950,000. That is just a 3% gross return. However, if Marla gives herself notional rent of $1,000 a month for living in her house, which will in effect be a rooming house, then her return would be 4%, still very little considering the amount of capital involved, Mr. Moran notes.
If Marla invests the $127,700 in the bank after paying off the mortgage, using $31,000 for a TFSA, adds the $29,000 she has in RRSPs now, she will have a total of $156,700 invested. If she gets 3% after inflation, her pre-tax annual return will be $4,700. If she grows the accounts for five years, they would have $182,800. If that money were spent over the 25 years to her age 90, it could provide $10,200 a year.
Assuming Marla maintains her prac- tice for another five years, her present income of $39,600 before tax would continue with the addition of $8,000 of cottage rent and $9,600 of additional room rent for total pre-tax annual income of $57,200 a year. After deductions for business use of her home for her practice and rental expenses, Marla could have $4,200 of income to spend each month. That would cover present expenses and allow some free spending or savings after elimination of the $500 she now pays on her mortgage.
RETIREMENT PLANNING
At 65, Marla could retire. Her $24,000 annual income from her practice would end. She would have rental income of $33,200 a year, investment income of $10,200 a year, Canada Pension Plan benefits of $6,000 a year and Old Age Security benefits of $6,704 a year for total pre-tax income of $56,100 in 2014 dollars. Rental expenses, utilities, etc. could lower taxable income to $50,000 a year and age and pension income credits would lower her tax to an average 16%, leaving her with disposable income of $3,500 a month. After elimination of mortgage interest she pays now and various professional and business costs related to her practice, her present expenses of $4,000 a month would decline to $3,400 a month and be covered by her income. She would be living in her own home, have the cottage she could use in the off season, and have brought her expenses into line with income. She would keep her hand in the presently thriving Toronto real estate market at the cost and complexity of managing tenants, vacancy and damage risk in two communities hundreds of miles apart.
There are alternatives, such as selling both properties for $900,000 after costs, then investing the money at 3% after inflation to provide $50,200 a year with payout of all capital by age 90. Her total annual income, including $10,200 investment income, $6,000 a year from the Canada Pension Plan and $6,704 a year from Old Age Security, would add up to $73,100 a year before tax or $58,500 after 20% average tax. She could afford to spend $12,000 to $15,000 a year on a modest rental unit in an inexpensive community and have sufficient income to cover expenses net of terminated mortgage interest and professional costs. The trade-off would be the privacy of an apartment for one person in unfamiliar surroundings vs. the arrangement she envisages for her house in which she would be one of several housemates with no privacy.
There is a compromise: Keep the cottage, don’t rent it, and sell the $730,000 house. It would provide total annual income of $39,000 from house capital after selling costs earning 3% a year with all capital paid out by age 90. Add investment income, CPP and OAS and total income would be $61,900. After 20% average income tax, she would have $4,100 a month for $3,400 projected expenses. Late in life the cottage could be sold for long-term care if needed. This is the Goldilocks solution, the middle choice from the story of the three bears, the one that feels just right. Marla would have privacy in the cottage and ample cash. Each solution works, Mr. Moran says. The choice is, of course, Marla’s. email andrew.allentuck@gmail.com for a free Family Finance analysis