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Financial Facelift

A young family looks for room to grow Add to ...

At 31, Louisa and Fred are at a financial crossroads.

She wants to cut the hours she works in the health-care field from five to 3.5 days a week to care for their two-year-old child. He has just started his own renovation company after studying for two years. He had to borrow to buy a truck for his business and his schooling left him with a student loan.

“We would like to know if we can still save for retirement with the uncertainty of being self-employed and [Louisa] having a part-time income,” Fred writes in an e-mail. They also want to build a rainy-day fund and save for their child’s education. They would like to have another child but aren’t sure if they can afford for Louisa to take another parental leave.

Fred figures he’ll gross about $45,000 a year in his first couple of years, while Louisa’s income will drop to $56,000 if she works part time. As an entrepreneur, Fred will have no company pension and will have to pay for his own life and disability insurance. Louisa will qualify for a reduced pension of $24,495 (in 2011 dollars) at 55, indexed to half the rate of inflation. She will have a bridge benefit of $6,370 from 55 to 65, at which time her work pension and her Canada Pension Plan benefits will be integrated.

Short term, Fred will be striving to build his business. Eventually, he hopes to expand it so that he can hire other people to work with him. Then there’s the $240,000 mortgage on their Toronto home to pay off.

We asked Michael Cherney, a certified financial planner in Toronto, to look at Louisa and Fred’s situation.

What the expert says

Louisa and Fred are in a good position because they are young and their spending, apart from mortgage payments, is low, Mr. Cherney says. Assuming Louisa works 3.5 days a week, their take-home pay will be $5,870 a month.

“After accounting for their mortgage payment of $1,372, and all their other expenses, they still have about $1,425 left over for RRSPs, RESPs and loan repayment,” the planner notes.

The planner suggests Fred and Louisa allocate their $1,425 surplus cash flow as follows: $400 to a tax-free savings account (TFSA) for a rainy-day fund because Fred’s income will be uncertain for the first couple of years; $500 to Fred’s RRSP because Louisa has a work pension plan; $300 to a registered education savings plan for their child; and $225 to repaying debts. In time, as Fred’s business grows, the TFSA money could be diverted gradually to retirement savings.

As for debt repayment, Mr. Cherney recommends that Fred and Louisa target his student loan first because of its relatively high interest rate. Once the student loan is out of the way, they can focus on paying down the truck loan and the mortgage.

If they put away $300 a month in an RESP, and collect an annual $500 government grant on those contributions, they should have about $109,470 by 2027 (the year their child turns 18), assuming a 4-per-cent rate of return. “This will just about cover a four-year education away from home,” Mr. Cherney estimates. The full cost would be $112,380 in 2027 dollars.

Fred and Louisa are willing to work to 65, but Mr. Cherney assumed they retire at 55 and earn an average annual return of 4 per cent on their RRSPs and TFSAs. They will draw enough income from their registered savings to supplement her pension income and, when they are 65, their CPP and OAS benefits. At 71, they will convert their RRSPs to RRIFs and draw the minimum required from that point forward. Inflation will average 2.5 per cent.

“The result is that Fred and Louisa will be able to retire at age 55 on an income of $40,000 (before tax) in 2011 dollars,” Mr. Cherney says. They could, of course, work longer and bolster their savings if they want a higher retirement income. The plan’s flexibility is large enough to allow for their having additional children, Fred’s business not being as lucrative as projected, their investment returns being lower than expected and inflation being higher.

Unexpected developments will be covered by the savings in their TFSAs. “As their debt gets paid off, they will have more to devote to their savings plans and the margin for error gets bigger,” the planner says. Their investments tend to be a bit on the aggressive side – all but one of their funds are focused on equities – so Mr. Cherney suggests they balance them with more income-based funds and reduce their exposure to sector and regional funds such as India, Asia and resources. And costly though it may be, Fred should get a disability insurance policy, he recommends.

Client Situation

The people: Fred, Louisa and their two-year-old child.

The problem: Can they weather the uncertainty of Fred’s new business and Louisa’s reduced income without jeopardizing their financial future?

The plan: Build a solid emergency fund in TFSAs, pay down the student loan first, start saving for their child’s education and then direct any surplus funds to the mortgage.

The payoff: Financial security both now and in future.

Monthly net income: $5,870

Assets: Bank accounts $4,900; RRSPs $55,593; RESP $4,325; employer pension plan $14,135; residence $430,000. Total: $508,953

Monthly disbursements: Mortgage $1,372; property tax $230; utilities $198; home insurance $67; vehicle expenses $320; groceries $550; child care $480; gifts $25; charitable $500; entertainment, subscriptions $80; pets $20; dentists $60; life insurance $56; telecom, cable $87; educational needs $100; professional association $75; loan payments $125; other $100; RRSPs $200; Total: $4,645

Liabilities: Mortgage $240,000; line of credit $15,260; student loan $6,250. Total: $261,510

Special to The Globe and Mail

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