National Post Article: Couple wonders – Start investing or stick with rental income to build nest egg?

The National Post asked me to review the retirement plan of a blended-family couple in their 40s from British Columbia.

Jennifer is 40 and Roland is 49. They live on a rural property with a hobby farm and have four children between the ages of 18 and 22.

With three rental properties, $180,000 sitting in cash, and a modest lifestyle, they’re wondering if they’re on track to retire when Jennifer turns 50 and Roland is 60.

They’re also considering whether to buy another property or finally start investing in the stock market.

With no RRSPs or TFSAs yet and a solid household income of $216,000, they want to make the smartest move now to build their wealth and future freedom.

In this article, I’ll answer their key retirement questions:

• Can they retire in 10 years—or even sooner?
• Are they missing some major expenses in the lifestyle they think they want?
• Should they buy a fourth rental or invest in the stock market?
• Will real estate or a globally diversified investment portfolio give them better long-term returns?
• Will real estate or a stock market portfolio give them better tax savings?
• Which of their 3 rental properties should they keep and which should they sell?
• How can they use RRSPs and TFSAs to reduce tax and grow wealth faster?
• Should Roland contribute to a spousal RRSP to income split in retirement?
• What’s the most tax-efficient way to structure their investments?
• How should they draw from their rental equity, pensions, and investment income once they stop working?

Here’s how they can simplify their decision-making, optimize their wealth, and build a retirement that supports both peace of mind and purpose.

CLICK THE LINK BELOW TO READ THE ARTICLE BY MARY TERESA BITTI:

Couple wonders – Start investing or stick with rental income to build nest egg?

Financial Plan

Roland earns about $176,000/year and Jennifer $36,000/year, plus $4,000/year rent income gives them total income before tax of $216,000. They say their monthly expenses, including their mortgage payment, is only $4,800/month, or $57,600/year. If that is true, they should be saving just over $8,000/month.

To maintain a retirement income of $4,800/month after tax, they need before tax income of $66,000/year. To have this retirement lifestyle, they would need $510,000 of balanced investments earning an average of 5%/year, or $460,000 of equity investments earning an average of 8%/year.

Most likely, their monthly expenses does not include some annual lifestyle costs, such as vacations, renovations and car purchases. Including modest additional lifestyle costs of $10,000/year for travel and $5,000/year for buying cars ($50,000 every 10 years), they would need a retirement income of $85,000/year before tax.

To have this retirement lifestyle, they would need $1,260,000 of balanced investments earning an average of 5%/year, or $950,000 of equity investments earning an average of 8%/year.

If they can actually save & invest $8,000/month, retiring when Roland is 60 and Jennifer is 60 is easily possible. If they invest their $180,000 in RRSPs or TFSAs earning only a modest 5%/year, they would only need to invest $3,200/month.

Investing their savings plus $8,000/month would allow them to retire as soon as ages 57 and 47 in balanced investments, or ages 54 and 44 with equity investments.

Questions:

Ideally, Jennifer would like to retire with Roland when she is 50 and he is 60. Is this possible?

Yes. If they will be comfortably retired with a lifestyle equal to their current monthly expenses of $4,800/month plus $10,000/year for vacations and $50,000 every 10 years for cars, then they only need to invest their savings of $180,000 and $3,200/month in moderate balanced investments. This should be easy for them to achieve.

They are wondering if now is the time to start investing in the markets to help fund their retirement or should they purchase a fourth rental property?

Their question is about real estate investing vs. stock market investing, but is really 3 issues:

• Which investment is expected to have the highest net return over time?
• Which investment has more tax advantages?
• Which of their 3 rental properties should they keep and which should they sell?
• How do they create their retirement cash flow?

Which investment is expected to have the highest net return over time?

In general, equity markets have had far higher growth than real estate. For example, in the last 50 years, Toronto real estate has averaged 6%/year growth, but the Toronto Stock Market has had 7 times higher growth, the global stock market 13 times higher, and the US stock market 17 times higher.

The advantage of real estate investing is that it usually involves a large mortgage, so you have much less of your own money invested. Jennifer & Roland have 3 rental properties with a total value of $985,000, but they only have $350,000 equity in the properties, so the real estate value is 2.8 times the amount they have invested in the 3 properties. However, if their properties grow at 2.8 times the normal real estate growth because of the leverage, that is still significantly less than the stock market has grown.

Rental properties also can produce cash flow, but their 3 properties and their farm together produce only $4,000/year cash flow for them. Having little or no cash flow from rental properties, or even negative cash flow, is very common today.

Jennifer & Roland have no investments in the markets, so they may be holding back because they are not familiar with them. However, starting to invest now can easily allow them to retire with their desired lifestyle.

Which investment has more tax advantages?

Roland and Jennifer are missing huge tax savings by not investing in RRSPs. Roland is in a 44% marginal tax bracket, so he would get a refund of 44% of any contributions. With his pension, he may not have a huge amount of RRSP room, but since he has none now, he likely has quite a significant amount he can contribute.

He can further split income by contributing to a spousal RRSP for Jennifer instead of his own RRSP. He has a modest pension and Jennifer does not, so they can split income most effectively if most of their RRSPs are in Jennifer’s name. Jennifer’s income is too low to contribute to her own RRSP.

Their small rental income would be fully taxed every year, while their RRSP investments would be fully tax-deferred until they start withdrawing from them after they retire.

After maximizing Roland’s RRSP room with a spousal RRSP for Jennifer, they can also avoid tax by maximizing both of their TFSA rooms. TFSAs provide tax-free growth.

Which of their 3 rental properties should they keep and which should they sell?

Jennifer & Roland have $255,000 equity in their first rental property, $100,000 in their second, and nothing in their third. Their net rental income is essentially zero, so this is a low rate of return for the first 2 properties, but not necessarily for the 3^rd.

I have a general rule of thumb that when the mortgage on a rental property is down to half the value of the property, it is usually best to sell it to invest in equities for a higher return, less tax, and no work. With this rule of thumb, they may be best selling their first rental property now and their second one in a few years, but they could hold on to their third rental property for quite a while.

How do they create their retirement cash flow?

How do you create a retirement cash flow from multiple rental properties? Most rental properties are like Jennifer & Roland’s properties that don’t provide anywhere close to enough cash flow to retire comfortably. In addition, once the mortgages are paid off, the cash flow would jump a lot, but it is fully taxed with no sheltering or deferral.

In most cases, the most effective way to create a retirement cash flow with rental properties is to first determine which properties are worth keeping (if any) so you can invest the rest into the markets, and then to work out a schedule to sell a rental property every few years.

In general, it is best to sell only one property per year if there is a significant capital gain, so avoid getting into too high of a marginal tax bracket.

This method usually allows significant market investments, in addition to real estate, plus you get a lump sum every few years from selling a property.

Recommendation:

For Jennifer & Roland, considering they want to retire in only a few years, their properties produce almost no cash flow, and they have huge opportunities with RRSP and TFSAs, they should invest their $180,000 cash and their available cash flow into the markets, focusing on Jennifer’s spousal RRSP and both their TFSAs to maximize their rooms if they can.

It is probably best for them to sell their first rental property now to invest in the markets, their second one in a few years, and hold onto their third one for quite a while.

This should allow them to retire comfortably with their desired lifestyle (plus a bit for travel and cars) sooner than ages 60 and 50. Investing their savings plus $8,000/month would allow them to retire as soon as ages 57 and 47 in balanced investments, or ages 54 and 44 with equity investments.

Ed