With financial demands pressing, as they do on most young families, Nettie and Harold are wondering how to allocate the surplus income they have to paying down their mortgage, saving for their children's education and saving for their own retirement.
Nettie is 31, Harold 36. They have four young children. Harold and Nettie are shareholders in a holding company that owns a big chunk of the firm Harold works for. He takes a salary of $86,000 a year while she takes $36,000 in dividends. She brings in another $6,000 a year with part-time work.
They have scant savings and a home in a major Canadian city valued at about $600,000 and mortgaged to the tune of $313,000.
Their goals, long and short, include building up an emergency fund, paying down their mortgage and getting their registered retirement savings plans (RRSPs) and registered education savings plans (RESPs) "up to where they should be," Harold writes in an e-mail. Longer term, they wonder how much income they will need when they retire at the age of 65.
We asked Matthew Sears, a certified financial planner at T.E.Wealth in Toronto, to look at Harold and Nettie's situation. Mr. Sears also holds the Chartered Financial Analyst (CFA) designation.
What the expert says
Harold and Nettie are contributing $50 a month to their children's RESPs, $50 to their TFSAs and $2,000 a month to an emergency fund, for a total of $2,100, Mr. Sears notes. In addition, Harold is contributing $265 a month to his work RRSP to take advantage of the company's matching program.
"In an ideal world, we would be able to max out contributions to RRSPs, TFSAs and the RESP accounts each year along with making additional payments toward the mortgage," he says. Because this is not always possible, people have to set priorities.
Priority No. 1 for Harold and Nettie should be catching up with RESP contributions for their first child by contributing $5,000 a year, the planner says. The Canadian Education Savings Grant (CESG) provides an immediate 20-per-cent return on contributions up to a maximum grant of $7,200 each child. The only benefit of making additional contributions after getting the maximum grant is the tax-free growth, which is later taxed in the beneficiaries' hands.
"There is enough time remaining before their first child goes to university for them to max out the CESG benefit if they start in 2017," Mr. Sears says. (It takes $36,000 of contributions to get the maximum grant of $7,200.) Once they have taken full advantage of the grant for the eldest child, the $5,000 a year contribution can then be allocated to the other children so they, too, can get the full grant, the planner says.
"Note these RESP savings will not cover all of the children's education costs." The children will have to borrow, work part-time, or their parents will have to help them with education costs out of their cash flow, the planner says.
The next priority should be tucking away $1,000 a month toward their emergency fund. They already have $13,000 in the bank, so if their goal is three months' pretax income, they will need another $19,000. Rather than leaving the funds in a bank savings account, they should transfer them to a tax-free savings account, he says. "You can take money out of your TFSA at any time for any purpose without losing the contribution room."
The third priority is to put any remaining surplus toward RRSP contributions each year. They could contribute about $8,200 a year for now (based on $25,200 a year of available cash flow, with $12,000 going to the emergency fund and $5,000 to RESP savings, leaving $8,200).
Once the emergency fund goal is met, estimated in March, 2019, they could use $625 of the $1,000 a month they were saving to start contributing to the RESP account for their other three children, the planner says. The remaining $375 a month could be used to catch up on RRSP contribution room, if they have any, to contribute to their TFSA accounts, or to pay down the mortgage more quickly.
Contributing to their RRSPs will provide tax savings that will come back to them as a tax refund. They can then use that refund to pay down their mortgage. They can review this strategy as time goes by to ensure it still makes sense, Mr. Sears says. "Typically, you're generally better off to pay off your mortgage first if your mortgage rate is equal to or higher than the rate of return you could earn on your RRSP," he says.
Once the mortgage is fully paid off, the freed-up funds should be reallocated to retirement savings.
How much income will Nettie and Harold need to retire?
Harold and Nettie's goal is about $5,000 a month after tax in today's dollars, which would maintain their current lifestyle into retirement, the planner says.
By the time they retire, their mortgage will be paid off. They will no longer be paying child care expenses and spending on groceries and clothing will likely fall as well, Mr. Sears says. This will cut their lifestyle spending to about $65,000 a year after tax. Assuming a 2-per-cent inflation rate, that $65,000 will have risen to $115,500 a year by the time Harold is 65.
Based on what they are saving now, they would not meet this target, the planner says. To meet their goal, they would have to make RRSP contributions of $15,480 a year starting in 2019, including Harold's group RRSP at work.
As time goes by, and shorter-term goals are met, they will have more money to direct to their longer-term goals, Mr. Sears says. This money could go to their TFSAs, or to help make up the shortfall in their education savings.
When their mortgage is paid off in about 23 years, they could shift the surplus cash flow to RRSPs, TFSAs and non-registered savings, in that order. Mr. Sears assumes an annual rate of return on investments of 5 per cent and lifestyle expenses of $65,000 a year in today's dollars until Nettie is 95. He assumes Harold gets full Canada Pension Plan and Old Age Security benefits while Nettie's CPP would be lower.
Now for the elephant in the room. A "big factor in their monthly cash flow is that Nettie can still continue to receive dividends from the company at a very low tax rate or essentially tax-free," Mr. Sears says. The federal government has announced measures to prevent professionals from "sprinkling" income to family members in lower tax brackets, he notes.
"Under the proposed new rules, an adult family member will be expected to contribute to the business, either in labour or capital, in order be exempt from the tax on split income received. In other words, the amount received by such adult family members must be reasonable." If it is not, then a top rate of tax would apply.
The People: Harold and Nettie
The Problem: How to allocate their resources to meet their competing goals.
The Plan: Set priorities and as they are met, redirect funds to longer-term goals.
The Payoff: Financial security
Monthly net income: $9,750
Assets: His RRSP $2,000; RESP $2,700; his TFSA $960; cash in bank $13,000; residence $602,000. Total: $620,660.
Monthly outlays: Mortgage (including taxes) $1,980; condo fee $120; home insurance $45; heat, electricity $160; security $50; maintenance $120; transportation $200; groceries $1,000; child care $400; clothing $150; gifts $150; charity $1,535; vacation, travel $185; other discretionary $280; dining, entertainment $500; miscellaneous personal $30; subscriptions $35; health care $50; life, disability insurance $215; cellphone, Internet $180; RRSP contributions $265; RESP $50; TFSA $50; emergency fund $2,000. Total: $9,750.
Liabilities: Mortgage $313,025.
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