Freedom 95

Opinion

Hey there, time traveller!
This article was published 12/03/2016 (3489 days ago), so information in it may no longer be current.

Ophelia sometimes wishes her work in the non-profit sector was a little more profitable. Maybe then the administrative worker in her late 60s could retire.

“Right now, I’m working on the Freedom 95 plan,” says Ophelia, who earns almost $70,000 a year between her job, CPP and OAS.

With about $250,000 in RRSP, TFSA and open investment accounts, she is hoping her work pension — about $1,300 a month before taxes— would be enough for her to retire tomorrow.

But she owes about $160,000 on a Manulife One account, a hybrid of her condo mortgage, a line of credit and savings account.

“The debt has been going down over time,” she says. “I started out at $177,000 two years ago.”

She had been making even better progress until the last year. “But then I bought my car and had to pay income tax, which cost me almost $20,000.”

She has 30 per cent taken off her OAS and CPP at source now to avoid a nasty tax surprise, but Ophelia still worries about the unexpected costs adding to her debt.

That’s why she is considering cashing out her TFSA and balanced portfolio of mutual funds in the open account — altogether worth about $152,000 — to pay off much of the debt.

In doing so, Ophelia hopes retirement is in reach.

“I just want to know what my options are and do I have any hope of ever retiring?”

Certified financial planner Uri Kraut with Assiniboine Financial Group in Winnipeg says the first step for Ophelia is determining how her guaranteed sources of income — workplace pension, OAS and CPP — stack up against her expenses.

“Ophelia’s income taxes have been a bit of a headache for her and have resulted in substantial tax bills,” the investment adviser with Credential Securities says. “But once she retires, this situation will improve considerably.”

Her guaranteed gross annual income will be almost $30,000 — or about $25,000 after taxes at roughly a 17 per cent average tax rate. This means once retired, she can reduce withholding tax on CPP and OAS to about 25 per cent, approximately the marginal (highest) tax rate on her income.

In terms of monthly income, Ophelia would receive about $2,077 a month after taxes if she retired tomorrow.

This falls short of her monthly expenses of $2,872, so she would need to look to her savings to fill the gap.

“(Her) monthly net income need from her investments is equal to $794.47 if you assume 40 per cent of this will be funded from her RSP,” Kraut says.

To do this, the before-tax withdrawal from her investments would be about $908 a month.

“This payment strategy would leave her with a depleted portfolio in 30 years time,” he says.

But there is some breathing room here. “It also assumes she will likely need to buy another car of similar cost sometime in the next seven to nine years and again sometime in the next 15 to 17 years.”

Given her age, she may choose not to buy new cars.

Crucial to this plan working are the following assumptions: two per cent inflation and an average annual return net of fees of 4.5 per cent. The plan also assumes continued low interest rates on her debt.

So yes, Kraut says, Ophelia can retire tomorrow and carry the mortgage. But it’s a risk-and-reward proposition.

“The benefit is that by not paying down the debt, she provides her portfolio the time and opportunity to outperform her current mortgage rate,” he says.

The downside is it’s dependent on investment performance and low debt-servicing costs.

“If things were to reverse — the markets dramatically go down and interest rates dramatically go up, which may be hard to believe — she could have a very difficult time paying off her mortgage and covering the rest of her income needs, which are about another $294 a month.”

Kraut says this scenario, however, may be more palatable than selling her investments and eliminating the debt for a couple of reasons.

For one, even if she liquidates her open and TFSA assets, Ophelia would still owe about $7,900 on the mortgage. And this isn’t taking into consideration any capital gains taxes owing after the sale of her investments in the open account.

To smooth over both issues, Kraut suggests Ophelia works another year-and-a-half.

But the biggest issue with the strategy is she would run out of RRSP/RRIF money — her only source of savings — by age 90.

Still, there are advantages to this strategy, which are “she does not have to worry about interest rates going up,” and while she still has to worry about portfolio performance, “a little less is riding on it.”

And if she does need more income, she can always borrow against the line of credit.

One other option is Ophelia could pay off most of her mortgage, and re-borrow money to invest.

“This would make some of the mortgage tax-deductible and may reduce her overall interest rate expenses by about $900 a year,” Kraut says.

But she would need to be mindful co-mingling her debts, which could result in the CRA denying the deduction against her income (which, by the way, can be from any source, not just investment income).

“This strategy is called the ‘Smith manoeuvre’ and although I am reluctant to recommend it most of the time, it would work in this situation,” Kraut says.

At 3.25 per cent interest on an investment loan of $113,000, she would likely receive about a $938 tax refund — effectively reducing the interest cost on her mortgage by 18 per cent.

Then again, this strategy “takes the level of complexity up a couple notches and may be more complicated than it’s worth,” Kraut says.

It’s food for thought — though Ophelia probably has enough on her plate to consider. Still, she can retire tomorrow if she wants.

Ophelia just “needs to reflect on the type of life” she wants: a retirement with a mortgage or one with fewer savings?

joelschles@gmail.com