Reader Case Study: B in Alberta

A week or two ago I was contacted by B in Alberta about doing a case study on his financial situation. I really love B's situation because he has made some classic mistakes often made by many higher income professionals, and he has lots of opportunity to achieve his goals.

This is Case Study is a first for me; I generally talk about financial and investment strategies at large, with a healthy dose of my personal journey.

I'm open to doing more Case Studies on other people in unique financial situations. Although I'm not a financial advisor and don't want to pretend to be one, I hope Case Studies can offer some perspectives on my strategy applied to different circumstances.

B in Alberta: The Goal & Current Situation

B's goal is pretty simple: a paid off house with a $1.25 million portfolio by the age of 40.

That's just 10 years from now, but B is well on his way.

Thanks to B's Alberta-sized income of $200,000 per year, B and his wife have massive savings capacity. They're also running a pretty tight household budget, spending just $50,000 a year after mortgage costs.

B also says his wife is planning to go back to work in a few years, maybe when their two kids are in full-time school. B figures she will earn about $70,000 per year. Oh, and she's under the reach of Uncle Sam's big tax umbrella, so there's a few wrinkles for her courtesy of the IRS.

Right now, B and the wife are worth a hair under $500,000. Here's the breakdown:

Personal Residence:  $450,000
Rental Property:  $300,000
His RRSP (Work Plan):  $140,000
His RRSP:  $90,000
Her RRSP (Work Plan):  $30,000
His TFSA:  $70,000
Total Assets:  $1,080,000

Personal Residence Mortgage:  $300,000 (Prime-0.55% VRM)
Rental Property Mortgage:  $290,000 (2.95% FRM)
Total Debt:  $590,000

Current Net Worth:  $490,000

As for the investment breakdown, B says he is following the Canadian Couch Potato—a popular lazy portfolio strategy—with a 20 percent allocation to bonds. His TFSA is only invested in equity ETFs for maximum growth, while his RRSP account are a mix of bonds and equities.

Like many high income Canadians, B is also a real estate investor—though admittedly a bad one. Not only has his rental property declined in value significantly (he paid $420,000), it is also cash flow negative. B puts in an extra $600 a month just to pay the basic bills.

That's right, B is one of thousands of very generous amateur landlords in Canada who I have mentioned repeatedly in my blog. He is generously willing to subsidize the rent of poor, landless tenants like myself. Thanks B!

I suspect B has long avoided taking a massive paper loss on the sale of his property, hoping things will turn around in the oil business thereby lifting the value of his rental property. A classic case of if I could only sell it for the price I paid, then... syndrome.

Thankfully, B says he has finally come to his senses and realizes the rental property has got to go. Smart move!

Sell the perpetual money losing property, book the six figure capital loss to offset future capital gains, and invest in something that actually makes money without the midnight text messages about leaking roofs or broken stove burners.

If I Was in Their Shoes

This case study is pretty mild because B already has his spending under control relative to his income. While anyone can argue there is always room to cut expenses, I think $50,000 a year plus a mortgage for a family of four is fairly reasonable.

B's total spending lands around $65,000 total. He also pays income taxes costing him over $40,000 per year. Naturally we will try to find ways to keep that down.

Step 1: Deal with Rental Property

B has already identified the first correct move. He needs to sell that rental property and book the massive six-figure tax loss.

If B's valuation estimate is correct, after selling costs I suspect B will probably be able to pay off the rental property mortgage. I doubt there will be anything left after these costs.

I would dive more into the reasons to sell the property if B was determined to keep it, but I won't because he's already realized this move is necessary.

On the bright side, he will no longer be supplementing the costs of running the condo property (which I suspect are actually much higher than B thinks after factoring vacancies and maintenance costs). That's more money available for investing.

Step 2: Maximize Tax Advantaged Accounts

In Canada we have two primary tax advantaged accounts for retirement savings: the TFSA and the RRSP. These accounts should always be maximized first to make the most of tax savings.

In B's situation, his tax advantaged accounts are currently full. He's got no more TFSA room and basically no more personal RRSP room.

B should continue making contributions to his workplace RRSP to take advantage of the company match. They match up to 6 percent of B's gross salary, so B should also contribute 6 percent to this account.

Always invest to get the maximum company match! It's an immediate 100 percent return on your money.

The workplace RRSP plan has two options: fancy mutual funds or passive funds. B has already moved his investments over the lower-cost passive fund option. Not surprisingly, it has outperformed the fancy funds.

For the rest of the RRSP contribution room up to the statutory maximum, B needs to shift his strategy. Instead of investing in a personal RRSP benefiting himself, B needs to open a Spousal RRSP benefiting his wife.

A Spousal RRSP will help B shift assets on paper towards his wife. This can offer significant tax advantages, now and later.

With a Spousal RRSP setup, B will still get the tax deduction he needs right now. But B's wife will legally be able to make the withdrawals in her name later.

Of course B should continue maxing his TFSA contributions each year.

Step 3: Set up a Smith Manoeuvre

If my math is correct, B has the earning capacity to save nearly $80,000 per year beyond his 6 percent workplace RRSP contribution.

If he puts about $12,000 in a spousal RRSP and $5,500 in his TFSA each year, that leaves $60,000 per year in additional savings.

At this massive savings rate, B should set up a Smith Manoeuvre on his personal residence. Although the Smith Manoeuvre sounds complex, once set up it requires just a few hours a month to maintain.

First, B needs to set up a readvanceable HELOC mortgage on his primary residence. The HELOC will be split into two portions.

The current mortgage can be locked into regular mortgage terms and we call this Portion 1 of the HELOC. The interest on this portion is not tax deductible.

There will also be a readvanceable line of credit that provides additional borrowing capacity up to 65 percent of the house value. This available money grows with each mortgage principal repayment made. We call this Portion 2 of the HELOC.

Given B's aggressive savings potential, he should use 1-year fixed mortgage terms with double-up pre-payment privileges on Portion 1 of the HELOC. B should double each mortgage payment penalty free.

At the end of each year, before he renews his 1-year fixed mortgage on Portion 1, B can deposit all the rest of his additional savings against the mortgage balance.

The goal is to get Portion 1 paid down penalty-free as fast as possible. Five years is a realistic goal!

In Portion 2 of the HELOC, B would have a readvanceable line of credit where outstanding balances are charged at Prime + 0.5 percent. B will take this available money for investment purposes.

Using this borrowed money to invest in a dedicated Smith Manoeuvre investment account (non-registered), he will be able to deduct all of the interest costs on Portion 2 of the HELOC from his annual income. That will save him thousands of dollars on tax each year.

Once Portion 1 of the HELOC gets paid off and the HELOC is fully utilized for investing, B will reach an annual tax deduction of more than $12,000 at current interest rates. At his current income level, this will save him $5,100 a year in taxes.

B should open a Smith Manoeuvre investment account in his own name so he can fully benefit from the tax deductions on the Portion 2 interest expenses. He should use this account to invest in ETFs or stocks which pay a very low dividend yield.

Approximately 5 Year From Now

If B follows the plan, at around year 5, when B's wife is ready to consider going back to work, B will have his entire mortgage (Portion 1 of the HELOC) paid off. Assuming 6 percent growth rates, they will be in the following situation:

Personal Residence:  $450,000
His RRSP (Work Plan):  $325,000
His RRSP:  $120,000
Her RRSP (Work Plan):  $40,000
Her RRSP (Spousal):  $70,000
His TFSA:  $130,000
SM Investments:  $350,000
Total Assets:  $1,485,000

SM HELOC (Tax Deductible):  $292,000
Total Debt:  $292,000

5 Year Potential Net Worth:  $1,193,000

At this point, B's wife only should go back to work if she really wants to. It's certainly not a "must do" to reach their financial goals. In five more years of saving on B's income alone, they will easily be over their target investment net worth of $1.25 million.

In fact, they will be comfortably over $1.5 million in their investment accounts. Plus, they will have a tax deduction of $12,000+ for the rest of their life if they choose to continue the investment loan.

Once Portion 1 of the Smith Manoeuvre HELOC is paid off, B and his wife will have to make some more investment account decisions. He will continue to invest in his matching workplace RRSP, the Spousal RRSP for her, and his TFSA.

With the mortgage out of the way, B and his wife should consider opening a family RESP account for the kids. Since B's wife is a tax subject of Uncle Sam, he should open the RESP so Uncle Sam doesn't tax it as a trust. They want the money to go to their kids, not Washington, D.C..

The kids will still be quite young in 5 years, giving them about 10 years of RESP savings for college. Investing just enough to get the maximum CESG grants, they should be able to save around $70,000 before the oldest heads off to college.

That, along with a few scholarships and a part-time job, should easily be enough for junior 1 and junior 2  to go to school without racking up debt.

If B's Wife Goes to Work

If B and his wife decide to goose their savings, or if she's bored at home, his wife's potential $70,000 salary will go a long way to sending the family into the upper stratospheres of wealth.

Saving an additional $50,000 a year (rough adjustment for taxes), they will have a net worth of nearly $2 million in addition to their house, after adjusting for the SM HELOC.

B's wife should immediately begin contributing to her RRSP. With the rest of the money, she should open a non-registered investment account in her name and invest 100 percent of her gross income into this account. She saves everything she makes.

On paper, B will pay all the household bills including his wife's tax bill, RRSP contributions, benefits, and other workplace deductions.

B's wife should invest with tax efficiency in mind, but given her potential income level, she could consider standard ETFs which pay moderate distribution yields. It would still be a good idea to use swap-based ETFs for any bonds in the non-registered account.

If B's Wife Decides to Stay Home

As I stated above, there really is no financial need for B's wife to go to work. They could easily achieve their financial goals by their desired timeline with B's income alone.

If B's wife stays home, they should also open a new non-registered investment account, separate from their Smith Manoeuvre investment account.

They will continue saving that $60,000+ a year they were plowing into their mortgage. B, as the only income earner, will be the sole contributor to this account.

Given B's high income, this account should be invested in tax efficient ETFs like swap-based ETFs for no distribution income.

In B's situation particularly, he is much better off deferring capital gains than receiving dividends each year and paying tax on those at punishing rates.

Other Considerations

I am a big fan of splitting a total portfolio into two unique strategies—as long as they use low-cost ETFs. We know that different investment strategies can provide benefits that a Couch Potato can't. This includes downside protection, or a different sequence of returns.

Using a systematic, rules-based timing strategy like my Time Averaged Dual Momentum model is easy for self-directed investors to manage and has performed well.

I would introduce a second investment strategy to complement the current Couch Potato. Put half of the portfolio into TADM and keep the other half in the buy-and-hold 80 percent equities Couch Potato model.

Since B will have a big $120,000+ capital loss booked with the CRA on the sale of the rental money pit, a timing strategy like TADM could be fantastic in the Smith Manoeuvre investment account. While he is working and in a high tax bracket, B can offset years of realized capital gains.

Less than twice per year on average, the TADM strategy will signal a change in your portfolio holding. This usually means realizing a capital gain on the position. Utilizing the deferred capital loss will keep the TADM portfolio very tax efficient.

As soon as B quits his job, he should explore options to take control of his own money. This means transferring the balance of his workplace RRSP plan to his personal RRSP. The fees are likely to be lower and outweigh any transfer costs.

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