Large mortgage payments or big tax bill — that’s the dilemma

In Quebec, a woman we’ll call Marianne, 70, works at a non-profit organization focused on community health services. She brings home $6,280 each month from her job, Quebec Pension Plan benefits and partially clawed-back Old Age Security. She has no work pension. There are no dependents, no spouse.

Marianne has had a stellar career: PhD, many professional accomplishments and a perspective gained through working in several countries. On the financial side of her life ledger she has significant assets and government pensions that allow her to live as she does with a travel budget of $4,800 a year. But she also has a $400,000 mortgage with a 30-year amortization. She wants to remain involved with her profession, but if she takes payments from her Registered Retirement Income Fund on top of her salary plus what she draws from the QPP and OAS, her tax bill will be very high.

“I hope to continue working for as long as I can,” Marianne says. But will she be working for herself, or for the taxman? Family Finance asked Caroline Nalbantoglu, a financial planner who heads CNal Financial Planning Inc. in Montreal, to work with Marianne.

“She has $952,000 in savings, but she also has that big mortgage,” Nalbantoglu says. “That makes a huge dent in her budget.” That is the basis of her financial problem — a cost of living that’s OK now but that could become tight if she gives up her salary.

Marianne’s mortgage cost is $20,400 per year. That’s 28 per cent of her take home annual income, $71,760. That cost will rise when interest rates eventually go up, making it even harder to carry.

While earning income, she can cover that cost, and contribute to her RRSP and other accounts. By Dec. 31, of the year she turns 71, she will need to convert her RRSP to a Registered Retirement Income Fund. Given that she is likely to be receiving employment income, she should wait until the last minute to convert to the RRIF, Nalbantoglu suggests. Her $540 monthly car payments end in two years.

INCOME FUNDING

Marianne can defer her first RRIF withdrawal to age 72 while still working. At that time, based on her present RRSP balance of $875,000 and another $30,000 of combined contributions and growth this year, she would have $944,350. Using the mandatory 5.4 per cent minimum withdrawal, she would have to take out about $51,000. Combined with her employment income of $95,000, her QPP of an estimated $10,512 and Old Age Security that will be fully clawed back when RRIF income starts, her total income would be $156,500 After 36 per cent average tax, she would have about $100,160 to spend.

Marianne’s $77,000 TFSA will also have grown with present $6,000 annual contributions and a three per cent return after inflation to $93,900 by age 72. Paid out for 23 years with three per cent annual growth after inflation to exhaust all income and capital, it would generate an additional $5,500 yearly. Her income thus would be far greater than her current annual estimated expenses of $71,760; with RRSP contributions and car payments eliminated, the gap widens even further.

While she’s working, meeting expenses is not an issue. But once she retires, things become more complicated.

If Marianne retires in two years at the age of 72, her mortgage would still have 28 years to run. Her income would consist of RRIF payments of $51,000 plus QPP and OAS of $7,217 per year, which would not be clawed back. She could add $5,500 from her TFSA, for a total income of $74,229. After 20 per cent average tax, she would have $59,400 to spend. It would cover $57,000 expenses with no further RRSP contributions nor car loan payments, but just barely.

If Marianne decides to keep working beyond age 72, when she must start her RRIF, the marginal tax rate on withdrawals from the RRIF would be about 50 per cent on top of the total OAS clawback. That is a significant cost, but one Marianne might choose to pay if work means enough to her.

PAYING OFF THE MORTGAGE

Marianne has various other options she could consider, to free up income she is currently putting toward the mortgage.

“Marianne has a big house she can’t afford in retirement,” Nalbantoglu explains. “Downsizing is best.”

Marianne could sell her $1 million house for $950,000 after costs, pay off the $400,000 mortgage, and downsize to a $500,000 house bought outright. There would be no mortgage payments and, if property taxes fall by $450 from their present $900 per month, her monthly expenses would only be about $3,800. RRSP savings would have stopped. That would make her immediate retirement more affordable and she would be able to preserve much of her savings. This solution is uncomplicated.

She could also sell her house, pay the mortgage off, and rent an apartment with the income from her equity. That would leave her the difference of the $950,000 sale price of the house and her mortgage, about $550,000. That sum, invested at 3 per cent per year in a blend of bank and utility stocks after inflation, would generate $16,500 per year before tax or perhaps $1,030 per month after 25 per cent average tax. That would pay half her rent at an estimated $2,000 per month. She would have to add $970 each month to make her rent. Call this a tax-inefficient solution. If the rent she pays rises, then the gap she has to cover would increase.

Finally, Marianne could keep her house, lease it for perhaps $4,000 per month, then live in an apartment at $2,000 per month. She would capture $2,000 a month before costs and tax. Mortgage cost, property tax, and maintenance, total $2,000 per month, would be deductible from rent. After accounting and with costs as specified, she would have her house and live elsewhere. The house might appreciate. Or not. The rent she pays and the rent she receives might not move in equal steps. Keeping a house will be harder as Marianne gets older. She could spend money on a manager, but that just reduces her income. Travel would be harder if maintenance or vacancy problems arise. This is an inconvenient and potentially unstable solution.