Plenty saved, but where to put it?
Couple earning $125,000 per year collectively have long-term plans for house, child and retirement
Mike, 30, and Constance, 45, rent an apartment in Toronto. Mike, who works in IT, and Constance, an administrative assistant, collectively earn $125,000 a year and live well within their means. They have no debt and save $2,000 a month. Usually, this extra money goes toward travel or other discretionary expenses, but they now want to give up those pursuits and save toward buying a home in the $650,000 range. They may possibly adopt a child.
The problem While the couple has thought about long-term goals such as saving for retirement, they’ve put little money toward such aspirations. Constance plans to work for another 20 years, and her pension is worth $42,400. Mike has no pension and $3,000 in his Registered Retirement Savings Plan.
The particulars Savings: Joint savings account: $13,600 Constance’s pension plans: $42,400 Mike’s RRSP: $3,000 Income: Money available to invest: $2,000 a month Constance’s salary: $55,000 a year Mike’s salary: $70,000 a year
The plan Mike and Constance find themselves in a situation that perfectly illustrates why a multifaceted financial plan is needed, says Robyn Thompson, president and financial planner at Castlemark Wealth Management in Toronto. The couple has many goals, but don’t have a clue how or where to begin.
The $24,000 a year they save could go toward any of their objectives (buying a home, adopting a child or saving for retirement). But if they desire all three things, they’ll need more of a cushion.
Fortunately, Constance has received offers for jobs that pay more than her current salary, though she has not followed up on them. Mike also feels that he could find a higher-paying job. Essentially, the couple needs to maximize their “human capital,” which is the economic value they bring to the marketplace, Thompson says. “As a consequence, they are leaving money on the table that could be used to boost their net worth during their prime earning years.”
If a home purchase is the couple’s top priority, Thompson would divvy up the spending and savings this way: All household bills should be paid by Constance, while the $2,000 saved each month should go into Mike’s RRSP. Because Mike is in a higher tax bracket, the annual $24,000 contribution will trigger a tax refund of $10,420 for him, Thompson notes. With Mike making the RRSP contribution instead of Constance, the couple will also save $2,900 in taxes, she says. The RRSP contributions (and tax refund) can then be used toward the home’s down payment through the federal government’s Home Buyers’ Plan (HBP), Thompson says.
The HBP lets first-time homebuyers borrow a maximum of $25,000 from their RRSPs without penalty, and repay the withdrawal in equal installments over 15 years.
Assuming the couple borrows $25,000, Thompson says Mike and Constance would repay a minimum $1,666 annually over the next 15 years, or more if they can afford to do so.
“In this way, they would be both building equity in their home and contributing to tax-sheltered growth in their RRSP,” she says. To keep their monthly mortgage payment similar to what they currently pay in rent ($1,500 a month), they would have to purchase a home or condo in the $300,000 range, with a down payment of $35,000, at a 4-per-cent interest rate amortized over 25 years. To find a home in this price range, they would need to move to the outside perimeter of the city or into the neighbouring suburbs, where real-estate costs are lower.
However, the couple is looking to purchase a home in the $650,000 range. With a $35,000 down payment and 25-year amortization at the same 4 per cent, their mortgage will cost them $3,230 a month. Thompson says that’s more than double what they are spending now, leaving only $270 monthly, or $3,240 a year, for investment savings or to help offset the costs of adopting and taking care of a child.
“This is a classic case of being house-poor,” she says.
Let’s say the couple saved their excess annual cash flow of $24,000 for five years. That would give them a down payment of $120,000.
But with a 25-year amortization at 4 per cent, the monthly mortgage payment would still be $2,800 a month. “That’s a long way from the $1,500 a month they are paying now. It all comes down to priorities,” Thompson says.
The couple also would like to adopt a child. Depending on the type of adoption, costs range from $0 to $60,000-plus. Constance and Mike need to make decisions about the child they may want to adopt and allocate funds accordingly.
Thompson suggests placing savings for adoption in a tax-free savings account (TFSA). The couple can invest in a low-risk portfolio and withdraw from the account whenever the money is needed without penalties.
Since Mike and Constance are also serious about starting a family, Thompson recommends they both purchase individual life insurance policies. “Purchasing a home and possibly having a family is expensive, and they will need to put some protection in place now in the event of the sudden death of one of the partners,” she says. With insurance, the younger and healthier you are, the cheaper the cost. For Constance, the premium for a $500,000 term 20-year policy with a large financial institution will cost around $625 a year, and for Mike it would be around $385 a year.
As for retirement planning, the couple needs to assess their tolerance for risk. If they are moderate investors, a balanced portfolio consisting of 50-per-cent fixed income and 50-per-cent equity investments could be best, Thompson says.
With a balanced portfolio, the couple can expect an average annual rate of return of around 7 per cent.
So if they invest $20,000 each year for the next 20 years, their portfolio will grow to $877,000, assuming a 7-per-cent rate of return, Thompson calculates. “These assets will not be taxed on the growth of assets until their RRSP matures,” Thompson says. “And, of course, there is no tax at all on income or growth from assets held in a TFSA.”