BALANCING EDUCATION WITH DEBT PAYDOWN AND RETIREMENT
Acouple we’ll call Omar and Ruth, 38 and 36, live in B.C.’s Lower Mainland. They have a two-year-old child, Robert, a $630,000 house and a net worth of about $240,000. Though they both have secure jobs with large companies, they are looking for reassurance that they are on track to pay off their house, educate their child and retire when Omar is 62 and Ruth 60. Their home is their largest asset. It carries a $469,000 mortgage, which costs them $2,245 a month. That’s about 30% of their combined take-home income which leaves them with about $6,600 after tax and $1,100 from renting a basement suite. Most of their expenses are modest, though child care costs them $1,105 a month. “We lost $35,000 selling a condo in 2011 and our list of stocks has disappointments,” Omar says. “We would like more security in our investments. We need direction. Maybe we could buy one or two rental properties and use the income for our child’s education when he is ready for university.”
Family Finance asked Graeme Egan, a financial planner and portfolio manager with KCM Wealth Management Inc. in Vancouver, to work with Omar and Ruth. “Their incomes are stable and their finances are solid,” he says. But is it enough to afford an early retirement?
CURRENT MONEY
MANAGEMENT
The couple’s first move should be to cut mortgage costs. They are paying 3.44% now, but locking in a 3.0% rate for five years when the mortgage comes up for renewal in April 2015 would save them about $110 a month. They could accelerate the paydown of the mortgage, but with the possibility of another child, they may prefer to maintain their liquidity, Mr. Egan notes.
Omar and Ruth have $24,000 in cash. Putting $20,000 of that on their mortgage will save them $800 a year. They also hold $13,000 in cash in another country for travel purposes. That cash can be left in place.
Generating a post-secondary education fund for Robert, who has 16 years to go to the time when he can enter university, is already under way with $6,790 in his RESP. The parents contribute $2,500 a year which allows them the full Canada Education Savings Grant of $500 a year. If they maintain this contribution rate for the next 15 years until Robert reaches 18 and earn a 4% rate after inflation, the fund should grow to about $73,000 in 2014 dollars when he is ready for university. That sum would cover tuition and books, though not necessarily room and board, for a four-year degree program anywhere in B.C.
Omar and Ruth wonder if they should give up on financial assets such as stocks and funds and buy rental properties. The tax advantages of real estate investment are substantial. The owner can add to the cost base by making improvements, raise rents if the market will support them, charge reasonable costs against income, and take money out of the income stream or retained earnings without the barrage of rules that govern RRSPs. But rental units take management and expose the owner to unplanned vacancies and tenant damage. A diversified portfolio of financial assets is easier to manage than property. If Omar and Ruth feel they want to be property owners, they could investigate real estate investment trusts that provide diversified holdings such as office buildings or nursing homes, shopping centres, etc., Mr. Egan suggests.
RETIREMENT INCOME
Omar and Ruth have combined RRSP room of $52,000. They are both in definedbenefit pension plans, contributions to which reduce their annual limit on what they put into the RRSPs. They are saving about $1,500 a month, which easily allows a $12,000 RRSP contribution to fill some of their space or they could contribute the same amount to their tax-free savings accounts, of which each has $31,000 of space to fill.
Which to use? New rules for tax management of parents with children under 18 that were announced in October allow Omar, who has annual gross income of $70,500, to average his income with Ruth, who earns $46,000 a year before tax. The tax savings will be about $1,000 a year.
They should use their RRSPs for tax reductions and put tax refunds from RRSP contributions into TFSAs, Mr. Egan suggests. They have no TFSAs now and the value of tax-free growth and payouts in future based on tax refunds today is too attractive to pass up.
The couple currently has $6,428 in RRSPs. If they add $3,000 a year to their RRSPs and obtain a 4% average annual return, the balance would rise to $260,400 when Omar and Ruth are ready to retire. That would provide an annual payout of $14,500 a year or $1,208 a month assuming all capital is paid out over the following 30 years.
By retirement, they should be mortgagefree and should have $37,200 a year or $3,100 a month from their combined definedbenefit pensions. Both have bridges to age 65 when the bridges lapse and are replaced by Canada Pension Plan benefits. Omar may elect to take CPP early at 62 with a penalty of 22% of his age 65 benefit. He will have $850 net a month from CPP. Ruth can take her CPP benefit with a 36% reduction for early application at age 60 and receive $500 a month. When their bridges end at 65, their income will drop to about $4,300 a month, then rise when each is 67 with Old Age Security benefits, which are currently $564 a month, for total sustainable income of $5,428 a month before tax.
Their present expenses of $6,556 a month net of cash savings will shrivel to about $3,000 a month when their mortgage is paid off, Robert’s RESP no longer attracts their contributions and other child-care costs are ended. The large difference between income and expenses, almost $2,500, could support travel, a few good causes, or fund a legacy for Robert.