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Liz and Tom.

Glenn Lowson/The Globe and Mail

At 25 years of age, Liz and Tom have a $1.2-million house in Toronto and a mortgage of nearly $750,000. Tom earns $80,000 a year plus overtime as a skilled tradesman; Liz earns $66,000 a year in marketing.

Helping to pay for the new house was Tom’s condo, which he bought in 2016 for $300,000 and sold for $570,000, “so it helped tremendously with our down payment,” Tom writes in an e-mail.

They still have $42,000 in the bank and will soon get “a very unexpected inheritance of about $50,000,” Tom writes. They are planning about $35,000 worth of work on their house over the next few years and a trip to Europe later this year.

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So they have questions. “We are wondering what we should be doing with the money we have saved and are inheriting,” Tom adds. “Should we pay the mortgage down faster? RRSP? TFSA? Renovate the house more significantly?”

Adds Tom: “Neither of us has any financial training or schooling, and we figure the decisions we make now will have a large impact on our finances down the road.”

We asked Matthew Sears, a vice-president at T.E. Wealth in Toronto, to look at Tom and Liz’s situation. Mr. Sears holds both the certified financial planner (CFP) and the chartered financial analyst (CFA) designations.

What the expert says

Their first step should be to establish an emergency fund of three to six months of expenses, Mr. Sears says, or between $18,000 and $36,000. For this they could use a bank savings account, a tax-free savings account or a line of credit. “In Tom and Liz’s case, I would suggest a bank savings account or TFSA,” he says. “I wouldn’t rely on a line of credit based on their current mortgage balance.” They could set aside some of their existing cash for the emergency fund and use their monthly surplus to save for their European vacation and renovations. Or they could build up the emergency fund gradually using their surplus cash flow.

“Setting a goal of when they would like to renovate their house, and setting aside a monthly amount to contribute toward that, would also be advisable,” Mr. Sears says.

Should they use the inheritance to pay down debt or invest for the future?

“There is no right or wrong answer to this question,” the planner says. “It comes down to how they feel about carrying this amount of debt, along with their risk tolerance toward investing.” Typically, you are better off paying down the mortgage faster if the interest rate is greater than the expected return you would earn by investing, he notes. “Paying off mortgage debt is a form of saving.” Any extra mortgage payments they might make would go toward the principal balance of the loan. Paying down the debt sooner frees up cash flow that can be redirected to retirement savings or higher spending, he notes.

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If they decide to invest, the question is how: in TFSAs or registered retirement savings plans?

Generally speaking, contributing to an RRSP makes sense if you are in a higher tax bracket now than you will be after you retire, Mr. Sears says. “In addition, the compounding of investment returns, and starting earlier in life, means you will require lower annual contributions to meet your retirement spending goal than if you were to start at age 40 or 50 to reach the same goal.” Any tax refund flowing from the RRSP contribution could be used to top up the RRSP further if you have available room, or to contribute to a TFSA, he says. Any additional savings above the RRSP limit would go to the TFSA.

In their case, Tom would be better off putting funds into an RRSP, especially in years where he works a lot of overtime. Liz, because she works in marketing, could end up earning significantly more money later on. In that case, she’d be better off with the TFSA now because it adds a fair degree of flexibility, Mr. Sears says. She could use the TFSA funds to contribute to an RRSP in the future if she does start making more money.

If they want to put money into RRSPs for them both, Tom could contribute to his own RRSP and then open a spousal RRSP for Liz to which he would also contribute. “This allows them to utilize deductions from his higher salary while building retirement assets in Liz’s name,” Mr. Sears says. They could direct tax refunds to their TFSAs.

As for the inheritance, it’s worth noting that in Ontario, inheritances received during marriage are excluded from the division of property upon separation or divorce, Mr. Sears says. But the money has to be kept separate rather than spent on the family home. “It would be better used toward a contribution to their own RRSP or TFSA.”

With retirement a long way off, Tom and Liz understandably find it difficult to come up with a target spending goal. Over the years, their spending needs will change a number of times, Mr. Sears says. But there is something the couple can do now. ”A good start would be to begin saving something toward retirement, which they currently aren’t doing.” They both have defined contribution pension plans available at work to which they can contribute 3 per cent of their salary. This amount would be matched by their employer. This would cost them $365 a month ($200 for Tom and $165 for Liz) and is well within their means, he says.

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If, for example, Tom saves $4,800 a year ($2,400 of his own and $2,400 employer match) and earns a 5-per-cent rate of return, he would have $547,656 at age 65. If Liz contributes $3,960 a year (half of her own and half from her employer), she would have $451,816 at her age 65, Mr. Sears says.

To illustrate the value of their work plans alone – not including any future TFSA or RRSP savings – the planner ran a retirement projection (hypothetical) based on savings of $4,800 a year for Tom; $3,960 a year for Liz; an inflation rate of 2 per cent; full Canada Pension Plan benefits at age 65; Old Age Security benefits also at age 65; life expectancy to age 95; and a 5-per-cent rate of return.

“The result of the projections is that their sustainable spend (from the above sources alone) would be $67,821 a year in 2021 dollars throughout retirement,” Mr. Sears says. They would also still have their house at age 95.

There are some other gaps in their plan, Mr. Sears says. The mortgage expense accounts for 45 per cent of their monthly outlays. “If their goal is to continue living in the house in the event one of them were to die, they would need additional life insurance,” he says. Liz only has $25,000 on her life while Tom has two times his salary. “Liz does not have disability insurance, and in the event of her disability, Tom’s salary would not cover all of their living expenses,” the planner says. Also, preparing wills and powers of attorney “should be top priority on their to-do list.”

Client situation

The people: Tom and Liz, both age 25

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The problem: How should they use their cash and inheritance money? Should they pay down their mortgage or contribute to an RRSP or TFSA?

The plan: Set up an emergency fund, start saving for the home renovation. Take full advantage of their company pension plans with the employer’s matching contributions.

The payoff: A map to help them chart their financial course as the years go by.

Monthly net income: $8,900

Assets: Bank account $42,000; pending inheritance $50,000; house $1,226,000. Total: $1.3-million

Monthly outlays: Mortgage $2,755; property tax $450; home insurance $130; utilities $315; maintenance, garden $370; transportation $460; groceries $475; clothing $50; gifts, charity $40; vacation, travel $165; dining, drinks, entertainment $295; personal care $30; club membership $15; pets $90; sports, hobbies $150; health care $120; phones, TV, internet $120; miscellaneous $35. Total: $6,065. Surplus: $2,835

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Liabilities: Mortgage $746,926

Want a free financial facelift? E-mail finfacelift@gmail.com.

Some details may be changed to protect the privacy of the persons profiled.

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