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(John Ulan/John Ulan/Epic Photography.ca)
(John Ulan/John Ulan/Epic Photography.ca)

Financial Facelift

Mortgage? RRSPs? RESPs? Get a grip on what comes first Add to ...

Since they came to Canada a decade or so ago, Reg and Rhonda have done well for themselves. They have three children, ages 10, 8 and 7, a new home that they are moving into this month and an existing house that they plan to put up for rent.

They both work in the health care field and have partly indexed defined benefit pension plans with the Alberta government. Reg is 42, Rhonda 37.

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While they have built up modest retirement savings, they have been focusing intently on paying down their mortgage first. Once their previous home is rented, the rental income will go toward paying off the mortgage on it. (The mortgage on the new home is 2.99 per cent for four years, while the rental property mortgage is prime minus 0.85 percentage points for five years.)

“Our plan is to pay off the mortgage as fast as possible, then continue to build savings and perhaps retire early if all goes well,” Reg writes in an email. “But is this the right approach?”

They also want to set aside $50,000 for each of their three children’s post-secondary education.

Reg can retire at age 60 with no reduction in pension. Rhonda, who is five years younger, could retire at age 55 with a reduced pension. They figure they will need $70,000 a year after tax, which would allow them to do a bit of extra travelling.

We asked Ron Graham, financial planner at Ron Graham and Associates Ltd. in Edmonton, to look at Reg and Rhonda’s situation.

What the expert says

As long as Reg and Rhonda are getting a higher return on their investments than the interest rate on their mortgages, they are better off contributing to their registered retirement savings plans and tax-free savings accounts, Mr. Graham says. Even so, they should aim to be debt free by the time they retire. Once the mortgage on the rental property is paid off, it should generate rental income of about $10,800 a year in 2012 dollars.

How much they will have to save to achieve their retirement target depends on the rate of return on their investments, the planner notes. If their current investments plus future savings earn a rate of three percentage points above inflation (6 per cent when inflation is 3 per cent), then they will have enough to meet their retirement goal of spending $70,000 a year and still leave an estate.

If they get only one percentage point above inflation, they will need to save another $500 a year in TFSAs or another $700 a year in RRSPs to accomplish their goal.

“This would allow them to spend $70,000 a year, but they would have no financial assets left at age 90.”

Mr. Graham assumes the couple will use their non-registered savings for goals other than retirement.

To make the $26,000 they have in registered education savings plans for their children grow to $150,000 in 10 years, they will have to save a little more than $9,000 a year based on a return of inflation plus one percentage point.

“They can save the $9,000 by contributing $2,500 per child to the RESP and getting the matching grants totalling $1,500 per year.”

So how should they arrange their priorities?

Build up the RESPs first to take advantage of the 20 per cent government grant. Second, continue to make RRSP contributions, with Reg contributing to a spousal RRSP for Rhonda. Third, contribute to their TFSAs.

“Saving for vehicles and other short-term goals is fourth, extra payments on their personal mortgage fifth, and finally extra payments on their rental mortgage,” interest on which is deductible against income for tax purposes.

Assuming they both work for another 18 years, they should have no trouble achieving their goals, Mr. Graham says. In the first year of retirement, Reg’s pension income will be $32,000 in 2012 dollars and Rhonda’s (if she retires at age 55) $11,412. If Reg begins collecting his CPP at age 60, he will get $505 a month. Rental income will add another $10,800 a year. Rhonda can supplement her pension by withdrawing about $12,000 a year from her RRSP. That leaves a shortfall of $9,000 a year that will come from the couple’s TFSAs.

Rhonda can begin collecting CPP when she turns 60, and they will both get Old Age Security benefits at age 67, reducing the amount of money they will have to draw from their savings.

Client Situation

The people

Reg, 42, Rhona 37, and their children

The problem

How to set priorities when it comes to saving and paying down debt.

The plan

Contribute first to RESPs for the children since that is the shorter term goal. Then save for retirement in registered plans. Once those are caught up, focus on paying down mortgage on the principal residence.

The payoff

Achievement of their saving and retirement goals with enough income to allow them a comfortable retirement and possibly a little something left over for the children.

Client situation

Monthly net income

$9,450

Assets

New home $450,000; rental property $277,000; TFSAs $18,800, stocks $1,800; index funds $2,800; other savings $23,480; RRSPs $65,200; present value of defined benefit pension plans (combined) $250,000. Total: $1.09-million

Monthly disbursements

Home insurance $180; car insurance $165; life insurance $150; utilities $350; telephone, cable $210; transportation $300; entertainment $50; home improvements $400; food, clothing $800; auto expenses $400; furniture $200; gifts $100; kids camp, sports $100; vacations $400; help for family back home $500; mortgage on principal residence $1,455; CSBs (saving to pay down mortgage) $1,250; RRSPs $400; other savings $300; TFSAs $700; RESP $325. Total: $8,735 Surplus: $715

Liabilities

Mortgage on new home $243,000; rental property mortgage $219,000. Total: $462,000

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