Reader Question #7

Alex from Montreal is in a bit of housing problem and sent me an email on it.

Q: I read one of your blog posts titled "Living in a hot housing market" and it brought up some questions. I'll give you a brief resume first:

I currently own a rental property in Montreal that is definitely in a hot sector. I was lucky to purchase it 2 years ago for under 110k even though it's evaluated at $250k. Add the mortgage cost, condo fees and taxes and it comes up to roughly $800/mo. It is currently being rented
for $1000/mo, which means I actually make profit from this (that's a good thing, right?).

My questions:
- Would it be a *waste* of money to rent an apartment (for myself) at $650/mo?

I ask this because everyone has to live somewhere. I understand that my *real* cost of owning would actually be $450/mo, but doesn't that defeat the purpose of having a rental property in the first place? If i'm renting for $650/mo, then i'm not making any profit, anymore.

I hope that makes sense because the $250k evaluation seems rather interesting.

A: Ah yes that wonderful question of should I cash out in a hot house market. It does get bloody tempting to do it. I should know it's crossed my mind as well recently.

The answer really depends on do you view the condo as an investment or a home. If you think of it as an investment selling it becomes an obvious choice. After all if you sell it at market price of $250,000 less fees (~8%) should easily have $230,000 left over. Assuming you have a 100% mortgage of $110,000, you could clear $230,000-$110,000 = $120,000. If you took that and invested it, you could skim off around 4% a year leaving the capital mostly in tact and you could have an extra $400/month which you could apply against your rent. Leaving you with a $250/month true cost for a place to live. Lets face it you don't get much cheaper than that and it would be providing more income than your condo currently does.

Yet if you view as the condo as a home, you might want to consider hanging onto it. Since you are going to need a place to live somewhere and if you sell and try to move in somewhere else in the same market you new place is likely to be just as overpriced. Leaving you with no real gain by moving. When looking at your primary residence there is a significant advantage of owning your own home in retirement. Any future house value increases become meaningless beyond your property tax bill, unlike renting where it tends to follow the market a bit closer for costs.

In the end it depends on your viewpoint and personal situation. For example, my wife is currently sick of moving, so regardless of my house value, I'm very unlikely to sell it. So that's my ideas on the topic, I wish you the best and let me know what you decide.

Have a good weekend,
CD

Reader's Question #6 - Part II

During last week I started to answer a long reader's question. Here is part II of that question.

Q:My father-in-law wanted to gift each grandchild $25,000 while he was alive. Due to a sudden decline in health he never got around to doing this. We are going to gift the money as per his wishes even though it is not in the Will. Our initial plan was to put it in an Informal Trust with the Financial Planner. Now I want to avoid him and do any future investing ourselves. I am very interested in Index Funds and not confident enough to jump into Exchange Traded Funds yet. But my understanding is that they are not great for taxable investment money because as the Index changes and the Fund is updated, Capital Gains are earned. Given that this money will belong to our children, we don't want it subject to tax in our hands.

In your opinion, how would an investor best take advantage of the Market to set up an investment on behalf of their children(ages six and four years and two months old). RESP's are already in place.

A: Really good question. How do you invest for your children if you already got the RESP in place and got enough in there to max out your Canada Education Savings Grant? An Informal Trust could be a good option yet they do present some issues you need to know about and fully understand (See this page from the Canadian Banker's Association - you will need to scroll down to near the bottom).

An informal trust is set up to provide taxable invests to a child which they will receive control of those assets once they hit the age of majority. To set one up you need three people: one person to donate the money, one to administer the money and the third person is the child which will benefit from the money. The trust income is taxable, but depending on what type will either be taxable in the donor's hand or the child's. Since the child can use the basic personal tax deduction they can typically get the invest income tax free or with low tax. The trick to all of this to ensure the income is coming in the correct form to avoid being taxed in the donor's hands. For example interest and dividend income is taxed in the donor's hands, while reinvested interest and dividend income and capital gains are typically not taxed in the donor's name if the trust is set up properly.

So overall the informal trust is a good format since you don't have any limits on money you can invest and if you keep the income from it low you can avoid tax in the donor's hands. Also the trust can be used for anything, it is not tied to the child's education. Yet there is also bit of downside that after the child is the age of majority you have no legal say on what they spend the trust money on.

As on how to setup the investments within the account I suggest you step back a minute and look a the big picture. You have two accounts for each child. One tax deferred (RESP) and one taxable (Informal Trust). So you want to take advantage of this fact to child's benefit. The best way to do this is make sure all the stable interest portion of the child's money is put in the RESP account to defer tax on that interest and then have all your capital gain and dividend income in your informal trust. Why both the capital gain and dividend income in the trust? They are often hard to separate. If you have one, you typically have the other in a fund. So the risk is the donor may get taxed on some dividend income, yet if you place this in the lowing income spouse's name there shouldn't be too much tax paid overall.

Generally this is complex issue that you will need to seek some professional consul on to ensure you minimize everyone's tax bill. As to the exact blend of investments to use, it is always a bit of challenge picking them out for kids. Since there is typically a shorter time horizon involved (less than 20 years) you want to ensure you stay fairly conservative overall. Index funds can be used, but keep in mind you will also have to be adjusting the balance on the account to become more conservative over time. I'm currently in a Dividend Mutual Fund for my son and we are going to start shifting over part of it to more conservative investments by age 5. At that point 25% of the account will be changed over. After that I'll move an additional 5% a year to more conservative investments, so by the time he turns 18 most of his RESP money will be in low risk investments. In your case you will need to do something similar, but over two different accounts.

I hope all that helps.

Reader Question #6

I recently go the single longest email question I have ever got from a reader. It's so long in fact I've had to break it off into two parts and do a bit of summary on it.

Colleen a reader from Ontario got a bit of windfall of some money. She ended up investing with Financial Planner in Spring 2006 and is now has a large amount of money in DSC (Deferred Sales Charge) type funds. So if she pulls them out early she gets hit with a large charge to get out of under performing funds. That's the bad news. The good news is she has taken this lesson is learning about investing herself and getting educated. As such she has two questions. Today we will have a look at the following question.

Q: Given recent creation of a Military Reserves Pension Plan, we have the opportunity to buy back all my husband's previous military service. For his twelve years or so of service, the buyback cost is in the ballpark of $70,000. The Financial Planner says to make sure we invest the money in our RRSP's first (through him of course) since we have the room and then transfer it to the military RPP. Reason being, we could take full advantage of deferring tax on that money through an RRSP. Now my understanding is that my own pension contributions through work defer taxes the same way. That is, whether in an RPP or RRSP, the contributions have the same tax advantages.

My concern is that this advisor has some financial incentive for himself in mind.

A: You are correct. When you put money into a pension plan your money has the same treatment as an RRSP for deferring taxes. So I would be questioning any advise this Planner is giving you as he seems to want to line his pocket with your money. If you feel the pension plan can offer a good rate of a return with low fees, then go for it.

Otherwise you might want to stick with a RRSP, but this time invest the money with someone else. You could start with a simple Couch Potatoe type portfolio made up with index funds from you local bank (shop around for who has the lowest fees (MER) on their funds) if you think you will be contributing on a monthly basis.

Either way I would stop giving your planner any more money and then have a hard look at the fee structure for the DSC and decide what would it cost you to get out of these funds sooner than later and take your money elsewhere. Often the emotional pain of living with those DSC funds can be an incentive to take your losses and move on to better things. After all if your funds are not doing well how much more money will you lose hanging onto them waiting for your DSC to drop.

I hope that helps. Any other ideas from other reader's would be welcome. I'll get to Colleen's second question about investing for her kids next week.

Reader's Question #5

Jordan left a question on the How Much Do I Need to Retire - Part V post that I thought needed it's own post to address.

Do you have any knowledge or forecasting the success of your retirement strategy with the mathimatical principal called "Monte Carlo".

It's the idea that there is no average return, so it tries to run your investment scenarios against historical variability thousands of times to tell you how likely your investment strategy will be to succeed for X years. (that's my understanding at least)

I don't think most people use it in their calculations or are even aware of what it is.

I've seen some retirement and planning software that offers this feature and thought it seemed very relevant for long term planning and "what if" situations.

I'm sure it could the topic could cover several posts, but I thought I'd ask what you know of it, if you can recommend any specific software and if there is a reason you would or wouldn't use it.

A free online tool is available along with some interesting articles from a retired software developer at:
http://www.flexibleretirementplanner.com/

Thanks very much for your input.

A: To start off with I'm familiar with the Monte Carlo simulation, we actually use them at work to help solve multiple variable problems into a single solution (for those of you who want to know the detailed mathematical uses check out this article).

In retirement calculations they are often used to help simulate the market by producing 'random' investment returns. The calculator will often run an enormous number of calculations over the years of your retirement savings and actual retirement to give you a probability of success that your withdrawals will work (for example 90% or 50%) for your entire planned retirement (yes you have to pick when you die). Since the returns will alter slightly on each run you can input the exact same data more than once to and get slightly different results each time. If your still a bit confused about how this works check out this article (it is a very basic description).

So overall the Monte Carlo can provide some insight on how a portfolio will do over a long period of time. The key word in that last sentence was 'insight' it will not produce a prediction of the future or address all your concerns. It will give you data, but it's up to you to decide if you can live with a 95% probability of success or 85%.

There are numerous calculators out there, some free and some that ask you to buy a copy, that all do the same general thing. The problem with these are they are almost always geared to the US market and often you can't just find the one you want with the correct features. For example I would like one that I could run different phases of retirement through with different pools of cash to generate an overall probability of success for my plan, but I just can't see to find what I'm looking for so far.

If you are from the US, I would suggest using FIREcalc which is likely the best free calculator out there (which is why I have a link to it on the left hand side under Tools called FIRE Calculator).

A few words of caution here. Monte Carlo simulations can be very useful if you know what your doing. If your new to retirement planning or you don't have a great understanding all the variables you can input into these calculators you will most likely just scare yourself to death with some weird numbers and then get depressed about this entire retirement planning thing. Don't worry your retirement plan can still work without a simulation.

My personal view of these calculators is they tend to be used by those who want assurance that they will be fine. The want to know they can survive the great depression again and the interest rates of the 1980's again, which is a bit useless in my opinion. Those events were highly unusual in terms of the history of the market. It's rather like building a house based on the 1 in a 100 year storm weather conditions. Yes your house will stand up to anything, but your going to be dumping in a lot of money to insure yourself for a rare event.

Reader's Question #4

Nancy left a great comment on Retire Happy - Part III, which I thought really should have a post to reply to the questions.

Q: I enjoyed your ideas. Kinda made me think: what if we all did way more of that? How would it affect our spending? -ie., if we regularly really absorbed, drank in the moment. Would we feel less compulsion to spend?

A: Speaking from experience, working on being happy has been wonderful to my quality of life overall. I've also noticed that my spending naturally dropped off a bit as I stopped buying things that really didn't generate much enjoyment for me and started spending more time with my family.

Perhaps the most useful thing that has come out of my work on being more happy is I don't obsess about savings and retirement planning as much. Retirement is no longer this thing in which my life will instantly be better, but rather now just the next phase in my life after my current one. You have to remember retirement is not a magic pill that will solve all your current problems in life. All retirement allows is the freedom to choose what you do with you time without needing to worry about the monetary compensation. Concentrate on being happy in your current life and you will make your retirement the next phase of your life rather than an escape from your current life.

Also I've come to realize that retirement itself is just a title and can mean many different things to different people. For some people retirement is just a scale back of their current work load, others a change in career and for some a complete absence of work. There is no one answer.

PS: The site over haul is basically done. I've moved some things around and added a new section to the left sidebar near the bottom called 'Tools.' Here I'll be placing some links to useful retirement information and calculators. If you have an idea of something I should add please let me know with a comment or email. Thanks everyone for your patience during this over haul to the site.

Reader's Question #3

Q: As someone in their mid-20s earning $32,000 in Ontario, who expects to earn more in the near future (~$40,000), is it worthwhile for me to invest in RRSPs, or is it better to save up the unused contributions for a couple of years until the tax break is bigger? I have heard that if you are making less than you expect to make when you're retired, then the tax benefit is lost. Of course the money would be invested, just not in a registered plan. Comments?

A: A quick look at the marginal tax rates for Ontario will show your first tax bracket changes over when you hit $35,488 in income for 2007. So for now there isn't much of a point going for an RRSP since you most likely will be in the same tax bracket in retirement. Yet once you do pass that mark you start to climb brackets again at $37,488 and then again at $62,485. So once you are earning over $40,000 I would try to contribute enough to drop you back under that $35, 488 bracket for the most tax savings. That $4512 RRSP investment could generate about another $1295 in a tax refund. If that's too much to save try to get back under that $37,488 bracket by investing $2512 and you would get about a $879 tax refund.

One very useful thing you should take advantage of with your current low income bracket is the negative taxation on dividends that qualify for the enhanced tax credit. Basically the government gives you a tax credit for your dividends you get, but once your in the lowest tax brackets you actually get a larger credit than your tax bill would normally be, so you actually reduce your regular income tax by an additional 5.97% of what you got in dividends (For example $100 in dividends would reduce your regular tax bill by $5.97). I know it is a very weird idea to wrap your head around at first but this is great thing for investors with low income like yourself since you can actually keep every penny plus some extra on every dollar of dividend income.

As per usual, I'm not a tax expert or financial adviser, so do your own homework. Any additional ideas/comments from anyone else would be appreciated.

Reader's Question #2

Q: Maybe someone could comment on a strategy I'm developing. My wife is older then myself (She is 55 and I’m 47), and she has stopped working. We plan to start withdrawing from her spousal RRSP account in three years to reinvest it in a Corporate Class Fund. Is this a sound investment plan? I figured it would be taxed lower at this point. When the RRIF point approaches we won't be forced into taking larger sums of money at a higher tax rate. Some details that might help are I’m in the $40,000 tax bracket and I will retire at 55 with a full pension. My wife worked part time and earn around $15,000. I will continue adding to my own RRSP although the tax break isn’t that large. The tax saving probably won’t be that large from this plan, but the concept interests me.


A: By the way in the interest of full disclosure I'm not a tax or investment professional, I just read a lot about personal finance and these are just my suggestions and should not be considered recommendations.

Pulling money out of a spousal RRSP would be a good idea if she isn't working since you can pull out up to the personal income tax deduction with no tax at all (provided she has no other income). So from now until you turn 55 you could pull out around $8000/year for a total of $8000 x 8 years = $64,000. (Check you province limits on www.taxtips.ca to confirm the exact number and any limits on spousal withdrawals) When you make the withdrawals do it in amounts of less than $5000 to reduce the withholding amount to 10% (or 5% in Quebec). You should get the amount back when you file taxes, but you will still have the withholding amount up front.

Once you turn 55 and start taking your pension you will want to reassess your situation. With the new pension splitting rules you might find it more useful to split your pension and take the tax hit on any RRSP withdrawals. You will have to do your own math on that one since I'm not sure exactly how that all works yet.

As for your choice of investment, Corporate Class Funds tend to have expensive fees with them so you might want to shop around for other options and make sure it makes sense for your situation. Some good dividend paying stocks might be a better option if they are invested in your wife's taxable account and they make sense in your overall allocation and comfort level. Check out the taxtips.ca web site to make sure you understand how each investment type will be taxed.

So follow reader's any additional comments or ideas on what to do please feel free to leave a comment.

Reader's Question #1

Well Canadian Money Blogs Reviewer asked me a question over at Million Dollar Journey and when I didn't get back fast enough I got the same question here.

Q: I'd really like to retire by 45 too :-) What would you say are the main strategies to use to get there? How much money will you need by then? Is your strategy also to live on dividend paying stocks?

A: First off if you want an idea of how much money I think I need to retire at 45 please go back and read my Retirement Calculation posts (Part I, Part II, Part III and Assumptions). I'll update those calculations after I get my tax return back, but for now you will get a good idea of what I'm planning. From those calculations you might be able to tell that I'm not planning on living off of just dividend paying stocks like Dereck Foster. I plan to have some blue chip dividend income, but also at least one REIT and some fixed income investments within an RRSP. I'm still working out the exact mix of investments as I go along.

My main strategies are fairly typically of most people looking for early retirement. I always live below my means (ie: live off of $30K even if you earn $60K), never pay any attention to trying to keep up with the Jonses and never pay attention to what anyone thinks about me for the most part.

I also avoid debt like it is a plague. I paid off my wife and mine student loans ($60,000) as fast as possible and then got saving for a house down payment and the car buyout on our lease. Now I'm 28 and the only debt I have is my mortgage which I'm going to accelerate paying down to hopefully get rid of it within the next ten years.

Perhaps the most useful strategy that I have is I hate wasting money on things I don't care about. Reading my saving money posts (Part I, Part II and Part III) you may notice that I don't like to pay more for my utilities. Also I don't pay full price retail on anything unless I have too. Most of my books I buy at sales (By the way I just found out my library sells old books they no longer need for $0.50 for a paper back!). I have no problem buying a nice shirt from Walmart if I like it and its on clearance for $5. I always check out the clearance section of any store I go into to see if there is anything I could use/like (For example, my wife got a piece of her china pattern that retails for $30 for $3.)

This isn't to say that I'm cheap. I also own a 32 inch wide screen LCD TV with surround sound. My wife owns some very nice china and crystal glasses. I also sleep in 400 thread count sheets during the summer. I just know what brings me the most happiness for my dollar. If you can master that, then everything else will fall into place fairly easily.