Obviously, there is no point in renewing the contract with a 38-year-old football player, perhaps it will be posible if he wants to play another season in the team, but you are right, the competition in such a team is too high, and it will be more difficult for him in the next years.
For the substitution player, I think it is no problem if Real Madrid extends his contract. Real Madrid must extend for 1 year only with an option of leaving Real Madrid in the end of the season. As long as Modric still can contributed well for Real Madrid, his age shouldn't be a problem. But it will be a problem for Modric, he must expect to have a longer time to play and he doesn't want to sit on the bench in each match.
Any decision will be good for him, if he goes to Saudi Arabia, he will be able to earn very good money, if he stays to work in Real Madrid, he will stay with his favorite club, which is perhaps even better.
Modric must decide anything carefully. If he moves to Saudi League, there is no guarantee to success there. He may end up like Benzema, he may face a problem with fitness and can't play as Saudi club's expectation. It may be a bad ending for his career as a professional footballer. But if he stays in Real Madrid, he may only spend most time in the bench.
Modric leaving wont hurt Real Madrid. Their team is too strong. He's a great player. Though faint, it will leave a mark. Talent loss always has repercussions.
Real Madrid isn't a too strong team, Real Madrid actually has a problem with their defense and attacking line. However, it is true that the departure of Modric won't hurt club because Real Madrid already has some top midfielders. Federico Valverde, Jude Bellingham, Dani Ceballos, and Eduardo Camavinga can replace Modric position. Real Madrid also still has Toni Kroos in their squad.
Those Ancelotti rumors may be true. Its possible Modric has a natural coaching instinct. Many top midfielders do. He reads the game like no one else, which is invaluable for a coach.
Ancelotti offered Modric to begin a new career as a coach by joining Real Madrid coaching staff for the next season. Modric will help Ancelotti in planning the tactics or strategies for Real Madrid. Modric will also help Ancelotti to improve the quality of Real Madrid midfielders skills. He will be very helpful if he wants to accept Ancelotti's offer.