Case Study: Retirement Soon, RRSP or Mortgage?

Kayla from PEI emailed me for some advice about her financial situation.  She is 50 with a mortgage and small RRSP.  She’s wondering where she should focus her money as she hopes to retire when she is 55.  Here is more information about Kayla.

  • RRSP Portfolio Value: $6,000
  • RRSP Contribution: $110/month
  • Gross Income: $67,000 (after tax ~$3,220/month) increasing 2.25% per year
  • Mortgage Payment: $504 bi-weekly ($50 to property tax) @ 5.4%
  • Mortgage Balance: $84,000, 10 years remaining.
  • Car Loan: $14,000 @ 5.25% (~$265/month for 5 years)
  • Pension can start at age 55 with annual pension income of approximately: $42,000 per year (after tax ~$2600 /month)
  • Monthly Expenses (not including debt servicing): $1,400
  • Total Expenses: $2,757/month (without RRSP contribution)

With retirement on it’s way, Kayla will have to make a few changes.  I’m of the belief that all debt should be eliminated by the time that retirement starts.  For many, retirement income is fixed, who wants a portion of that income still servicing debt?

Another point I’d like to make is regards to RRSP contributions in addition to pension contributions.  In my opinion, if someone is fortunate enough to have a lucrative defined benefit pension plan, then debt servicing should come before any RRSP contributions.  Once debt is eliminated, I would personally move to maxing out the TFSA, then to the RRSP.  I would go that route because RRSP withdrawals are taxed as income which would be on top of any pension income received during retirement.

Having said that, looking at the financial specs above it seems apparent to me that she should focus on paying down her mortgage.  Even without looking at anything else, paying off the mortgage represents a 5.4% guaranteed after tax return which would be challenging to find anywhere else.  Once Kayla eliminates her mortgage, she will free up about $1,000 /month in cash flow (she’ll still have to pay property tax).  Should Kayla take her $110/month RRSP contribution and put it directly on her mortgage payment, her mortgage amortization would reduce to 8 years. If she really want to retire in 5 years mortgage free, she would need add $300 to her bi-weekly payment.

If Kayla turned 55 today, her car payment would be gone but a mortgage payment would remain.  Her total monthly expenses would be about $2,500 with a monthly income of approximately $2600.  Too close for comfort especially if inflation is added to the expenses over 5 years.  However, when the mortgage is paid off, the monthly expenses would reduce to $1,500/month leaving a healthy cash cushion.  To add to the picture, when Kayla turns 65 and assuming she qualifies, she’ll be eligible for Old Age Security which would give her another$516 /month (in today’s dollars).

In conclusion, it may be in Kayla’s best financial interest to pay off all debts before calling it quits.  It will give her a more comfortable retirement and perhaps peace of mind.  If Kayla were to simply redirect her RRSP contribution to her mortgage, then she could join the retired club in as little as 8 years.  Not exactly freedom 55, but freedom 58 has a nice ring to it too.

Back to you, how would you advise Kayla about her financial situation?

Disclaimer:  I’m not a financial advisor, anything written in this post should be used for informational purposes only.

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FT

FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.
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Gates VP
11 years ago

@Kayla: some additional questions:

Does the $1,400 in expenses currently include:
– Home maintenance costs? (e.g.: 1% of the value of your home each year) What have you fixed in the last 5 years?
– Car maintenance costs? (a typical car costs ~ $8k / year according to AAA, that’s a lot more than the $265 / month)
– All of the insurances you require?
– Budget for time with a fitness or health professional?
– Money for your hobbies?
– Money spent on travel?
– Money for time with friends?

I think that the consensus on paying off the mortgage is correct. You can likely “retire” sometime around 55-58.But I think that there are lots of other things to consider.

For example: you’re single. Most people are not intent on being single from 50 to 85. Does your current budget give you enough money to spend time with friends or prospective partners? I have a couple of family members who hooked-up with new partners in their 50s. One got married. As older couples, they really revel in trips and fine dining. But if you’re not doing those things right now, you’ll have to find that room in the budget.

You’re going to retire with 20+ years to live, maybe even 30 (say you live to 85). In big ticket terms that’s 3 cars, 3 sets of carpets, 2 interior paint jobs, 30 sets of x-mas gifts, kids (and / or grand-kids) going to University. It’s a long time.

I have a few retired government workers in the family all in their 50s. One hit the “magic number of 85 on his 55th birthday. He took his pension and started doing side gigs in manual labor. A few months here and there. Mostly to keep himself busy, but he derives an income from these as well. Another moved into “semi-retirement” to just work less and now she’s off to travel and teach English in South America. Another just moved from full-time teaching into part-time teaching. She loves teaching adults, so she just does night courses and gets to travel on the usual school breaks.

My point here, is that what’s far important than paying off the mortgage or really digging into the “can I retire?” question, is the “what is my retirement?” question.

Now we can answer the “can I” question. That’s easy. Pay down the mortgage and start collecting a pension. You’ll have enough to eat, clothe and house you until you die. There are millions of Canadians living on less than 2.5k / month.

The bigger question is really “do you want to live on 2.5k / month until you die?”

PIttyPat
11 years ago

Jeff – at the risk of getting too far off topic I thought I’d respond to your question about CPP at 60 versus 65. CPP bridging, as I understand it, is a type of “top up” of your pension until you are able to qualify for an unreduced CPP pension at 65. There is a penalty for taking CPP before age 65 and you’ll have to decide if it is worth it.

Calculation of reduction to federal public servant pension at age 65 due to bridging termination is: .007 x # years of contributory service X average max pensionable earnings for the year of retirement (max $42,500 but use average salary if less than this) = reduction. Example (all in 2009 dollars for illustration purposes) if you had 35 years service and qualify for maximum CPP: .007 x 35 years service X $42,500 = $10,412.50 reduction to federal service pension at age 65. The maximum CPP pension is $10,905 at age 65 in 2009 dollars. So if you wait until age 65 the decrease to your federal pension is about the same as the CPP pension you will start receiving – you just start getting this from two sources (fed pension and CPP) instead of one (fed pension).

Now lets see how that compares to the CPP benefits you would get if you elected to take CPP earlier:

Age 60
Penalty of 30% for taking it early (0.5% x 60 months early)
Annual CPP payments $7633.50
Total payments received prior to age 65 are $38,167.20
Age where reduction in CPP benefits equals $38,167 is 77 years old

Age 62
Penalty of 18% (0.5% x 36 months early)
Annual CPP payments $8942.10
Total payments received prior to age 65 are $26,826.12
Age where reduction in CPP benefits equals $26,826 is 79 years old

[Note – the gov’t is raising the penalty for early CPP with higher rates transitioning in starting in 2012. Not a huge hit in my opinion, especially when you factor in the reduced taxes because of the reduced pension received.]

You can use your own figures and dates and even get your own quote from HRDC to decide what makes sense to you. For me, I’d rather have the money sooner than later to enjoy, invest, whatever. Plus, who knows what the future brings in terms of life expectancy. I’ve already had one major illness.

Cheers!

Mark in Nepean
11 years ago

Seems pretty clear to me….Kayla needs to reduce debt.

(She) you should try to have no mortgage in your retirement years.

Pay-off the house and pay-off the car.
Any money after that should be put into a TFSA so income/interest earned is tax-free. Contributions to the RRSP would be my last choice; pay/contribute only enough to off-set an income tax payments to the Feds :)

Given her salary and some frugality, she will be more than fine.

Trajan
11 years ago

I think it could work out retiring at 56.
Dump the RRSP payments into the mortgage right away.
Between the lack of car payment, and the extra income she should be able to pay off an extra 885 a month when she is 55. That translates into a total mortgage term of 6 years 4 months.

After you retire, immediately start withdrawing the RRSP and start putting it into a TFSA. You want to have completly converted it over before you turn 65. Otherwise you miss out on tons of nice government programs. Spreading it out from 56-65 should mean it won’t increase your tax bracket any.

DG
11 years ago

Vancity1: If Kayla focused on her mortgage first she would have extra equity when downsizing which could be put into RRSP/TFSA or other… So both approaches yield the same result in many regards.

But… paying the mortgage first yields a guaranteed 5.4% tax-free return without risk. I don’t think you could get that kind of deal from other investments.

Dan.

Vancity1
11 years ago

I have a different take then most on mortgage payments. I think that one should be just the minium towards their mortgage and invest the remaining in RRSP’s, Tax free savings account and other investments.

I feel that over time my house would apperiate in value, and by the time I’m ready to retire I would not need a big house to live in, so I would downsize to a condo. After selling my house I would pay off the remaining balance and move into a smaller townhouse or condo without a mortgage.

I’m 27 and own two properties (One primary and one rental) in Vancouver, and if you look at the real estate market it’s nearly impossible to purchase a house in the lower mainland. Currently I’m only making minium payments on both properties but at the same time I’m building equitly and If/when I sell I will walk away mortage free.

I would like to hear your thoughts on my approch?

cannon_fodder
11 years ago

Another option would be to look at whether downsizing the residence would be an option in a few years time. I didn’t see any details as to what type of housing Kayla is in now, but in a few years time when retired, perhaps a move into a significantly less expensive residence could be an option.

I would imagine in PEI there isn’t as large a disparity between homes near the ‘big’ cities and in the far off suburbs as we see in other provinces. When my dad retired, they moved to an area that provided everything they needed within walking distance. Being positioned close to work was no longer a requirement.

But, the change in housing would have to be signficant because you would have to pay legal fees, commission to sell the house, moving costs, perhaps new window coverings, lights, etc.

I bring this up because a recent article in the Globe suggested to a single retiree that this was her best option in order to make it through retirement successfully. She was not in as good a position as Kayla, however.

Stuart
11 years ago

I am of the state of mind that some debt is good debt, especially if it carries a low interest rate. The current mortgage rate Kayla has is very low. Is this a fixed or variable rate and how long is she locked in?

Even with a defined benefit plan pension, if you have room to top up on your RRSP you should consider maxing this amount out. The income tax implications can be a huge benefit now, especially if you have reached a higher tax bracket. This is because you will have tax free gains within the account while you wait to reach retirement and a further tax savings as you likely move into a lower tax bracket once you actually do retire.

A home mortgage is good debt as it is cheap money. As long as you can create a return greater than the mortgage rate you are better off through simple leverage. Although most people are concerned about debt, you need to understand the basic implications of opportunity costs and time values of money. Also, don’t forget about your ability to write off interest from you mortgage against your tax return; this is a benefit in retirement as well.

Kayla may want to take a look at our RRSP vs. TFSA guide which is a series of 3 simple questions that will tell you which account is more beneficial for you.

Kayla
11 years ago

Thanks again for all your comments, feedback and suggestions.
It seems certain that all belief is pay down on mortgage. Makes sense and was interested to see what others would say.
This verified it for me.
Now,, to work on my plan!
Thanks again Frugal Trader and readers.