Taking lump sum pension payment now a bet on the future for this 29-year-old
Lenny, age 29, lives in Ontario. He brings home $5,230 a month after-tax from his job as a government employee and $3,980 a month from two rental properties for a total of $9,210 per month. He figures that his chosen line of work has its limitations. He wants to cash out his government pension with a commuted value of $235,000, put some of the money in a Locked-In Retirement Account and the remainder in an RRSP or a TFSA. He can keep or sell one of the rental properties — a condo and a house — or keep one as a future primary residence.
The issues come down to whether to take the commuted value of his pension, which is the sum required to provide promised benefits, or to sell. The condo, if sold, would generate a capital loss, the rental house, if sold, would generate a small taxable gain. He would get a tax break on the house, formerly his primary residence, for it has been a rental property for only a few months. It would also lighten real estate that is two thirds of his total assets.
From his vantage point as he nears 30, Lenny has a fundamental decision to make: either stick with his job and take promotions and his eventual pension with guaranteed indexation and almost no chance of default — or strike out on his own. He wants to go to graduate school. The tab would be $80,000 covered by a family gift. During the year to earn an MBA, he would generate no job income, though rental income could continue depending on whether he keeps or sells the rentals.
COMPARING PROPERTY VALUES
The choices and the profit or loss and tax consequences are complex, explains Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C. “It is vital to rebalance the portfolio, which is almost all in two properties,” Moran says. “That is a huge, undiversified risk.”
The rental condo has a present estimated value of $195,000 and a $175,000 mortgage. It earns $15,360 rent per year less $13,404 costs for net income of $1,956. That is a 9.8 per cent return on equity, which is very good, but it is the leverage that makes it attractive, Moran explains.
The rental house was Lenny’s home. It rents for $32,400 per year less $21,960 expenses. On Lenny’s $100,000 of equity, the net income is $10,440 and the return on equity is 10.4 per cent. The leverage is just 3.5 times equity and the yield
is also better. It is the better of the two investments.
In a few years, interest rates may rise, putting a damper on house prices. People only buy as much house as they can afford and as the cost of ownership rises, people can afford less house.
On a pure asset safety basis, the rental house, which Lenny could occupy one day, has a higher return on equity with lower leverage and thus less risk when interest rates rise. Keeping it and selling the condo is the better choice, Moran concludes. Moreover, it enables Lenny to reduce his huge commitment to real estate.
If Lenny does sell the rental condo, he can free up $20,000 less preparation costs and fees, say $15,000 net. He can add that to the commuted value of his pension. He is young, he can manage the money well, and can take advantage of the low interest rates that boost the sum required to pay the pension’s commuted value. However, the pension, if left in place, is bulletproof. He could live longer than actuarial tables predict and could always count on it.
If he takes it in cash, however, the first $100,000 would be taxable. The tax result would be eight months of employment income, plus the payout, which would push his total taxable income to $160,000. Income Tax Act provisions that allow some types of pension payouts to be rolled into RRSPs without tax only apply for calendar years of service to 1996. They would not help Lenny, who was born two years after the cutoff.
TAX MANAGEMENT
His best shot at tax reduction would be to use his RRSP. He has $38,000 of room, allowing some shelter for the large income that would result from taking the commuted pension.
Lenny has $15,000 in his RRSP. If he does the pension transfer, he would have another $135,300 in a Locked In Retirement Account (LIRA) plus the $38,000 contribution to the RRSP. The total would be about $188,300. Were that sum to grow for 31 years to his age 60 at three per cent per year after inflation, it would become $470,800 in 2018 dollars. That money, if spent over the 30 years to his age 90, it would provide Lenny with an income of $24,020 per year with the same assumptions.
Lenny has no TFSA. He can accumulate $50,000 with after-tax payouts from his job or sale of the condo and/or the rental house. If he starts with the $52,000 limit for 2017, he can add $5,500 for 2018. If that sum were to grow at 3 per cent after inflation for 31 years to his age 60, it would become $143,755 and be able to support an income of $7,200 for 30 years.
PENSION PROJECTIONS
Adding up income sources at age 65, Lenny could have $24,020 from his RRSP, $7,040 from OAS with 2018 values, $13,610 from the Canada Pension Plan at 65 also at 2018 values, and $7,200 from a TFSA. The total, $52,870, would be pre-tax income. It could be supplemented by rental income, depending on Lenny’s selection of properties to sell or keep.
Lenny will also have another 30 to 35 years to work and save, and could end up with substantially more if things go well.
If he stays with his job for 31 years to age 60, the pension would be $57,040 on top of which there would be CPP and OAS though subject to the clawback starting at about $75,000.
“If Lenny dots the I’s and crosses the t’s in his bureaucratic work, he will have security and a solid pension,” Moran concludes.
“If he takes the private business path, he may emerge a prince or a pauper.”