A retirement plan if you missed the bulletin to save

Share

You were told to save for retirement, but you didn't listen.

Presenting a rescue plan, not a lecture.

When you retire, sell your house and invest the proceeds in dividend stocks. Add Canada Pension Plan and Old Age Security and you might just squeeze by. At worst, you'll have an extremely tax-efficient stream of retirement income while you keep a hand in the work force.

The default solution to not having enough saved for retirement is to work longer, but that's not going to work for everyone. This is where this retirement rescue plan comes in. Think of it as an idea to consider if you didn't listen when you were told to save enough for retirement.

The rescue plan is based on the fact that you can earn $31,321 per year virtually tax free if you structure things right. That is, you draw maximum OAS and CPP and supplement it with $13,000 in eligible dividends (the kind typically paid by publicly traded corporations) per year. We know this thanks to some analysis conducted for this column by Silvia Jacinto, senior tax manager at Soberman LLP, Chartered Accountants.

The precise tally of income tax owing on your $31,321 depends on the province where you live. Ms. Jacinto found that combined federal and provincial income tax owing on $13,000 in dividend income plus OAS and CPP would range from all of $5 in British Columbia, Alberta, Saskatchewan, Quebec, New Brunswick and Yukon to as much as $990 in Nova Scotia. Note: This assumes no tax breaks from charitable deductions, medical expenses etc.

Now for a dose of reality: You need a big whack of money to generate $13,000 in dividends per year. If you assume a not-unreasonable dividend yield of 3.5 per cent, then you'd need a portfolio valued at $371,429. You didn't save for retirement, so we have to get creative in finding this money.

What about your house? If you've lived in a big city for a couple of decades, you could well be in a position to sell and generate a very large tax-free capital gain (applies to your principal residence). You could then either downsize to a cheaper house or condo, or rent. Either way, you should be able to come up with the money to build a dividend stock portfolio.

Ms. Jacinto confirmed that the retirement rescue plan can be used by one person, or by a couple. So two people with OAS and CPP can each generate $13,000 in dividend income with minimal taxes to pay on combined income of $62,642.

Dividends make the RRSP rescue plan work because of the light tax treatment they get, but they also introduce some serious risks to your retirement investing. Ted Rechtshaffen, president and CEO of TriDelta Financial, zeroed in on the fact that your retirement investments would entirely be in the stock market. "There could be considerable volatility and some urge to sell if things get rough," he commented in an e-mail.

Mr. Rechtshaffen said you might not care too much about fluctuations in the price of shares that are paying out stable or growing dividends, "but there remains some real risk."

Such is life if you use the retirement rescue plan. Diversifying your dividend stocks with bonds and guaranteed investments will drag down your returns before taxes and after. It's also worth noting that once the global economic funk is over and interest rates start rising, we could see bonds in a stock-like position of falling in price while still paying interest as normal every six months (of course, bonds will be redeemed at face value when they mature).

Now for some dividend quirks you need to know about. One relates to the dividend tax credit, which in non-registered accounts treats dividends much more favourably than regular income. Tax rules say that in applying the dividend tax credit, you must "gross up" your eligible dividend income by 38 per cent for 2012. So the actual $13,000 in dividends you received becomes $17,940 in taxable dividend income. This has little or no impact on the amount of income tax payable based on Ms. Jacinto's numbers, but it's still worth noting from a practical point of view.

Next, there's the issue of dividend growth. The companies you'll want to use to generate your dividend income will typically increase their quarterly cash payouts to shareholders annually or somewhat less frequently. This additional income will drive up the dividends you receive beyond $13,000 annually, thereby triggering more tax.

Offsetting this additional tax is the fact that federal tax brackets are indexed for inflation. So as your dividend income rises, so to some extent does the amount of money you can earn tax-free.

Another tax issue concerns the dividend stocks – you could choose exchange-traded funds or mutual funds as well – being used to generate dividend income. Eventually you or your estate will have to sell them, triggering capital gains taxes. Well-chosen dividend stocks will undoubtedly rise in price over the years, but only half of the capital gain must be included in your taxable income.

The actual dividend stocks or dividend funds you use may allow you to achieve $13,000 in income with portfolios valued at less than $371,429. A 3.5-per-cent dividend yield was chosen for this exercise because it's achievable with dividend exchange-traded funds and individual blue chip stocks.

I wrote a column last month (read it online at tgam.ca/DWt1) on even higher-yielding companies that in many cases are converted income trusts. They're smaller and riskier than blue chips, but they in some cases offer dividend yields in the high single-digit range. If you blend a small amount of these stocks with blue chips to get an aggregate yield of 4 per cent, then you need to invest $325,000 to get to that $13,000 threshold of near tax-free dividend income. At 4.5 per cent, you need $288,888.

The preferred way to cover your living expense in retirement is to save steadily and aggressively for decades in a diversified portfolio. If you missed that bulletin, you have recourse.

_________

A Life-Saver for Laggards

You've neglected your retirement savings, but you own a home. Here's a plan for selling your house and using the proceeds to generate a flow of dividends to supplement your Canada Pension Plan and Old Age Security benefits. As you'll see, you can generate roughly $13,000 in dividends per year and pay little income tax.

Notes

-Dividends must be "grossed up" for tax purposes; the gross-up rate for this year is 38%.

-The Northwest Territories provides a cost of living supplement as a refundable tax credit, triggering the refund.

-A provincial refund is triggered by the cost of living tax credit provided to Nunavut residents.

Source: Silvia Jacinto, Soberman LLP, Chartered Accountants