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By Julie Cazzin with Allan Norman
Q: I am 66 years old, retired and have about $30,000 of net rental income total from two rental properties I inherited when my dad passed away two years ago. I have gross income — including Canada Pension Plan (CPP), Old Age Security (OAS), a small pension as well as the net rental income — of about $95,000 annually. I also have $100,000 in my registered retirement savings plan (RRSP). I understand that net rental income creates RRSP contribution room. What’s the best way to make use of this extra room over the next few years? I plan on leaving an estate to my two children who are now in their 40s. — Ronnie T.
FP Answers: Ronnie, I don’t know how you can make the best use of your extra RRSP contribution room. I can do the math, but what am I solving for? The biggest estate? The least amount of tax? Or the most you can spend? How do you want to use your money in the time you have left? Your answer will guide you to your best solution. The best way I have found to solve these questions is to model them out with you and ask “what if?” questions.
You are correct that net rental income creates RRSP contribution room, which in your case is $5,400, based on 18 per cent of $30,000. If you have the same net rental income to age 71, you can continue making RRSP contributions up to and including the year you turn 71.
My quick advice to you is to forget about it — don’t make the RRSP contributions. Here’s why. I just had a call from a client who’s 61 years old. He wanted to tell me he has lung cancer even though he’s never smoked. Earlier this year, a client couple retired and then she passed away shortly after that. I can go on and on with such examples. On the other hand, I have a client who lost her husband, has recently found a wonderful man and they are having the time of their lives.
Simply put, we don’t know what the future holds, so you need to be thinking about the big picture first rather than focusing on what to do with $5,400 of RRSP contribution room.
To help you see the big picture, I’ve modelled your situation and made a few assumptions. I have you living in an apartment in Ontario and your two rental properties are worth a combined $1.45 million. I’m using a general inflation rate of 2.1 per cent, investment growth is five per cent and the rentals are appreciating at four per cent.
Looking at your future cash flow, a gross indexed income of $95,000 per year will provide you with income of $65,000 per year after tax and rental property expenses. At age 72, your required minimum registered retirement income fund (RRIF) withdrawals will provide an extra $4,000 per year after tax to spend. I’ll assume you won’t increase your spending, but will instead add that money to a tax-free savings account (TFSA).
Using these assumptions, you will leave each of your two boys about $1.76 million if you pass away at age 90 and you will have a tax liability of about $958,000, which is a result of the capital gain built up in your rental properties.
Now, let’s see what happens if you make the $5,400 RRSP contributions to age 71. You will have to reduce your annual income by about $4,000 a year to $61,000 per year, and at age 90 you will leave each of your boys about $1.87 million.
This is where it would be nice to have you in the room to provide feedback and model changes as we go. Is your goal to minimize your lifestyle in order to maximize the amount you leave to your boys? You’ve seen the big picture if you stay on your current path. It is time to experiment with some of the possibilities. I am going to assume you would rather have more spending money for you, or you and the boys, rather than try to maximize your estate value.
Let’s start with something simple. What will happen if you don’t make the RRSP contributions and start your RRIF withdrawals now, with the expectation of depleting it by age 90? In that case, you would have an indexed income of about $70,000 per year and you would be leaving each of the boys about $1.53 million, and final taxes of $815,000.
Building on that solution, what if you claim the capital cost allowance (CCA) on the rental properties? After the tax deduction, you will have an after-tax income of $79,000 per year and you will leave each of your boys about $1.36 million through your estate. Final taxes will be about $1.1 million. You will notice the tax has increased because when you claim the CCA, there is something called recapture when the rental property is sold.
One observation that has come to light through the modelling is that there is no liquidity in your estate to pay the taxes. The total value of your estate is in the rental properties, which will be a problem if you want to leave them to your boys like your dad did for you. They may be forced to sell the properties to pay the tax.
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In the end, it is up to you to add to your RRSP or not. But it is not that significant a choice when you look at the big picture. The things that will have real significance are how you want to enjoy using your money on yourself, or on you and your boys. I’d spend more time thinking about that and modelling that first, then test out the financial strategies such as RRSP contributions.
Allan Norman provides fee-only certified financial planning services through Atlantis Financial Inc. and provides investment advisory services through Aligned Capital Partners Inc., which is regulated by the Investment Industry Regulatory Organization of Canada. Allan can be reached at firstname.lastname@example.org.