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Alan's long term goal is to increase his investment portfolio so that it generates $65,000 a year in dividends.Duane Cole/The Globe and Mail

Alan is 53 and runs his own small business corporation. He recently bought out his ex-wife’s share of the family home so their three children, all in their early 20s, “would have a place to live until they are ready to launch,” he writes in an e-mail.

Although he has no pension plan, Alan has substantial investments in dividend-paying North American stocks. He adds about $40,000 a year of retained earnings from his corporation to his portfolio. His house in small-town Ontario is valued at $739,000 with a mortgage of $288,000. “As an owner of an incorporated company, I can write off most of my expenses, and I live very frugally,” Alan writes.

Short term, his goal is to winter outside of Canada for three months each year. Long term, he wants to increase his investment portfolio to the point where it generates $65,000 a year in dividends, which are generally taxed more favourably than salary or interest income thanks to the dividend tax credit.

“I want to know if my idea of building up dividend-paying stocks to the point that they are my pension payments and never selling them is a good idea,” Alan writes. He hopes to achieve financial independence by age 60. He might choose to work less but never fully retire “because I like what I do,” he adds.

“The actual stocks are a safety net in case I need more money,” he writes. “I am hoping to find out where the tipping point is that I do not have to add new money to my investments and can just spend all the money I make from working.”

Alan says he would be happy to leave money to his children, “but that is not my goal. I raised them to look after themselves.”

At what point will his portfolio produce $65,000?

We asked Andrea Thompson, a certified financial planner and founder of Modern Cents, an advice-only financial-planning firm based in Mississauga, to look at Alan’s situation.

What the expert says

Alan lives frugally and has many of his personal expenses paid by the business, Ms. Thompson says. The company reimburses him for about $3,500 a month in expenses to cover such things as a home office and vehicle. He also does small jobs on the side occasionally.

Alan’s personal investment assets are spread out over registered and non-registered accounts. He is a do-it-yourself investor who buys mainly Canadian and U.S. dividend-paying stocks to hold. His portfolio yields dividend income of 5.98 per cent. That generates about $55,000 a year, which he reinvests. He transfers money from his non-registered savings to his tax-free savings account each year to take advantage of the contribution room.

Alan’s corporate investment portfolio is worth $157,000 and he has a federal Canada Emergency Business Account loan of $40,000, which he will repay by year end.

With 85-per-cent of his portfolio in Canadian stocks, 14-per-cent in U.S. stocks and only 1.4-per-cent in ex-North American stocks, Alan’s portfolio lacks diversification, Ms. Thompson says. “He may want to consider diversifying his exposure outside of Canada to more global companies, and to do so within his RRSP and/or locked-in retirement account [LIRA],” Ms. Thompson says. “Keeping Canadian dividend-paying companies in his non-registered account will allow him to continue taking advantage of the Canadian dividend tax credit.”

She recommends he keep one or two years’ worth of expenses in cash or cash equivalents to ride out any upheavals in the stock market after he stops working.

Because he is not drawing a salary, Alan is no longer paying into the Canada Pension Plan. He estimates he’ll be eligible for CPP benefits of $620 a month at age 70. He plans to defer his Old Age Security benefits to age 70 as well, which will increase his benefit by 36 per cent to $935 a month.

“Based on Alan’s current dividends, savings and dividend reinvestments, he should have no problem attaining his goal of generating $65,000 of passive income by age 60,” Ms. Thompson says. His portfolio is estimated to have risen to about $1.6-million by then, of which about $540,000 will be in his corporate account. That assumes a rate of return – dividends and capital gains – of 6.27 per cent preretirement, based on the Financial Planning Standards Council guidelines. At that point, Alan can stop adding the earnings from his corporation to his stock portfolio and start spending what he earns instead.

He may want to retain a balance in his TFSA as a health care emergency fund.

From a drawdown perspective, if and when Alan decides he no longer wants to work, the planner recommends that he draw a dividend of $49,000 a year from his corporate investment account, known as a non-eligible dividend. The amount of the dividend will decline as his other income sources kick in. (Typically, small private corporations pay non-eligible dividends to their shareholders from after tax profits, meaning that the corporation would have already paid corporate income tax on that income. To avoid double taxation, they are taxed at a different rate than eligible dividends.)

He will stop reinvesting the dividends he gets from his personal non-registered portfolio and begin taking them in cash instead. The dividends from that account will generate about $21,700 a year. “His average tax rate will be 1 per cent that year, making his income very tax-advantaged,” Ms. Thompson says.

At age 65, the planner recommends that Alan convert his RRSP to a registered retirement income fund (RRIF) to take advantage of the federal pension income-tax credit of $2,000 a year. He could also begin taking minimum RRIF withdrawals. Taking RRIF withdrawals earlier than age 72 would allow Alan to maintain a very low average tax rate throughout retirement and reduce the potential for Old Age Security clawback at age 70, she says.

The mandatory RRIF minimum will generate about $10,000 a year at age 65, allowing Alan to reduce the non-eligible dividend he is taking from the corporation, she says.

At age 71, for example, Alan’s income could include CPP and OAS benefits of about $31,350 a year, corporate dividends of $7,500 (down from $49,000), RRIF withdrawals of $13,700 and personal dividend income of $28,000, for total pretax income of about $80,000 a year. Factoring in an estimated 2.1-per-cent inflation rate, his expenses will have risen to $80,000 by that time, including his debt payments. His taxes would still be negligible.

Alan will also need to convert his LIRA to a life income fund (LIF) and begin making minimum withdrawals at age 72. This will increase his income by about $8,000 a year, at which point he could further reduce the level of non-eligible dividends he is taking from the corporation, the planner says. Since dividend payments are flexible, there is no requirement for him to take a certain amount each year. He can continue to use this to his advantage throughout retirement to ensure his taxes are kept low and that he maximizes any additional tax benefits available through his corporation.

While much could happen over the 40-odd years of this forecast, if Alan manages to live on his dividends and leave his principal intact, he could leave an estate of $6.8-million in future dollars at age 95, or about $3-million in today’s dollars, Ms. Thompson says. This would be after estate taxes and fees of about $575,000 in future dollars.

Client situation

The Person: Alan, age 53, and his three children.

The Problem: Can he generate enough dividend income to retire comfortably on it at age 60?

The Plan: Continue saving and reinvesting the dividends until he retires. Then he can take dividends in cash. If by some chance his dividend income doesn’t grow as expected, he can tap into his capital.

The Payoff: Investments enough for a lifetime.

Monthly net income: Taken as needed.

Assets: Bank account $9,000; locked-in retirement account from previous employer $51,765; RRSP $118,345; TFSA $186,595; non-registered investments $466,740; corporate account $157,940; residence $739,000. Total: $1.73-million.

Monthly outlays: Mortgage $1,370; property tax $335; water, sewer, garbage $105; property insurance $135; electricity $140; heating $125; maintenance, garden $605; transportation $1,160; groceries $400; clothing $25; vacation, travel $415; dining, drinks, entertainment $305; sports, hobbies, subscriptions $20; health, dental insurance $150; life, disability insurance $140; communications $120; TFSA $500. Total: $6,050.

Liabilities: Mortgage $288,000; line of credit $100,000. Total: $388,000.

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Some details may be changed to protect the privacy of the persons profiled.

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