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Richard and Rachel on July 5, 2021.

Tijana Martin/The Globe and Mail

Like small-business owners everywhere, Richard and Rachel work hard, blend their corporate finances with their personal ones and spend every spare penny they have on paying down debt. This can make it difficult to know exactly how they’re doing financially.

Richard is 53, Rachel is 46. They have two adult children who are financially independent. Richard operates a successful small industrial business that they hope to sell for a tidy sum one day. Rachel works part-time in the civil service and does some work for the family business.

A few years ago, with the mortgage on their Southern Ontario home nearly paid off, they borrowed heavily against it to go into a second business – real estate investment. Their first income property is now valued at $1.4-million. They bought a second building in 2019 and leased it to Richard’s business. It’s worth $500,000. The first property is generating positive cash flow while the second one is roughly breaking even.

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Richard’s dividend income is $75,900 and his net rental income is $26,000, for total pre-tax income of $101,900. His net is about $77,100. Rachel’s pre-tax income is about $63,000 and her net is $54,920.

“We’re leaning toward holding the rental properties and having the rent as an income stream,” Rachel writes in an e-mail. Meanwhile, they’re living frugally, using any surplus cash flow to pay down their $1.1-million in debt in hopes of retiring, she at age 57, he at age 60. They’re focusing first on a credit line on their family home. “This month we paid $4,500 and the balance as of this moment is $72,295,” Rachel writes. “I am quite averse to debt and anticipate we’ll clear this line of credit within two years.”

Neither contributes regularly to their registered retirement savings plans or tax-free savings accounts.

“Will we be able to retire by our target dates?” Rachel asks. “Could we retire two years earlier?” Their retirement spending target is $100,000 a year after tax.

We asked Ralph Muth, vice-president and associate portfolio manager at Leon Frazer & Associates Inc. in Toronto, to look at Rachel and Richard’s situation.

What the expert says

Richard and Rachel would like to enjoy retirement while they are still relatively young, Mr. Muth says. For the first few years, they want to winter in the Bahamas for three months a year at a cost of $15,000 over and above their $100,000 spending goal.

“With the majority of their assets tied up in their house and rental properties, and fairly significant mortgages still to pay off, the prospect of retiring earlier without making changes to their financial situation isn’t possible,” Mr. Muth says.

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The first step is to pay off the debt on their home. They have surplus cash flow currently, so if they directed $13,500 a year to the debt, on top of their regular payments, they would have the mortgage ($90,000) paid off in 2026 and the line of credit ($72,295) in 2027, “just prior to retirement.” Mr. Muth also recommends they contribute the maximum each year to their tax-free savings accounts. That still wouldn’t take them to their spending goal.

Rachel has said she would return to full-time work and even work longer if it would help, Mr. Muth says.

“Unfortunately, working longer or even increasing her annual income wouldn’t be enough to cover the shortfall,” he says. In 2031, when Rachel plans to retire, the value of the couple’s RRSPs and TFSAs would only be about $480,000. That assumes they make maximum contributions to their tax-free savings accounts and is based on a conservative 5-per-cent annual pre-tax rate of return. But they do have other assets: The net value of all of their real estate holdings is estimated to be $3.2-million.

“For Richard and Rachel, it’s not an issue of having enough assets,” Mr. Muth says, “it’s having the cash available to support their retirement lifestyle.”

Reducing their retirement expectations is always an option, he says. They could retire on target if they cut their annual retirement budget to $70,000 after tax and reduced the time spent in the Bahamas from three months to two months a year.

Selling some assets would make a difference. “Selling the business – there does not appear to be a family successor – along with the building it occupies when Richard retires would generate sufficient cash flow to achieve their goals,” Mr. Muth says. They should keep the more valuable rental because it will provide them with nearly $26,000 a year in positive cash flow throughout their retirement, he adds. “If they don’t change anything, the mortgage will be paid off in 19.5 years.”

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Richard values his business at $1-million based on a multiple of four times cash flow, a valuation he says is conservative. The building that houses the business could net $500,000 by that time, Mr. Muth says.

“If Richard were to sell the shares of the company – the preferred option because of favourable tax implications – he would have a capital gain, which is 50 per cent taxable,” Mr. Muth says. “If these shares count as qualified small business corporation shares, Richard should be able to claim a lifetime capital gains exemption of $892,218. A very conservative estimate of Richard’s company is $1-million, but it could be much higher in a few years.” In his forecast, Mr. Muth assumes Richard sells the shares for $1-million.

They could invest the net proceeds of the sale in a portfolio of equities and fixed-income securities earning a 5-per-cent average annual pre-tax return. That would give them $50,000 a year to start, which would increase over time if they reinvested the dividends and interest rather than withdrawing funds. The inflation rate is assumed to be 2 per cent.

In addition, Richard has a defined benefit pension from a previous employer that will pay $4,000 a year at age 60, while Rachel will get $13,000 a year from her government pension, indexed to inflation. They will begin collecting Canada Pension Plan benefits at age 60 and Old Age Security at age 65. Assuming they sell the business and the less valuable rental property, Mr. Muth says they should be able to retire a few years early and meet their $100,000 spending goal, plus travel expenses – as long as they’re comfortable dipping into their savings.

Client situation

The people: Richard, 53, and Rachel, 46

The problem: Can they afford to retire a couple of years earlier than initially planned and still spend $100,000 a year?

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The plan: Sell the business and the property it occupies upon retirement and invest the proceeds. Pay off all debt on their principal residence before they retire.

The payoff: A mortgage-free home, a comfortable nest egg, a solid investment portfolio and the remaining rental property to boot.

Monthly net income: $11,000.

Assets: House $1,000,000; first rental property $1.4-million; second rental property $500,000; his RRSP $18,000; her RRSP $75,000; his TFSA $70,000; her TFSA $70,000; commuted value of his pension $148,000; commuted value of her pension $190,705; private corporation $1,000,000. Total: $4,470,000.

Monthly distributions: Mortgage $2,215; property tax $455; home insurance $105; electricity $200; heat $100; house maintenance $200; transportation $500; groceries $600; clothing $200; interest on LOC $250; entertainment, dining out, alcohol $500; personal care $200; club memberships $65; sports, hobbies $100; subscriptions $50; internet, phones, TV $200; her pension plan contributions $280; vacation $425; provision for unallocated expenses $1,000. Total: $7,645. Surplus of $3,355 or $40,260 a year going to debt repayment and TFSAs.

Liabilities: Mortgage residence $90,000; line of credit on residence $72,295; mortgage first rental (plus HELOC secured by residence) $690,000; mortgage second rental $270,000. Total: $1.1-million.

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Want a free financial facelift? E-mail finfacelift@gmail.com.

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

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