Speeding up mortgage payments will make retiring at 60 more comfortable
EVALUATE AFTER-TAX RETURNS ON MORTGAGE PAYDOWN AND OTHER USES, CUT INVESTMENT COSTS
In Ontario, a couple we’ll call Sam, 45, and Tess, 42, are raising two preschoolers, ages three and five. They take home $ 8,654 a month from their jobs. Sam is a manager for the Government of Canada and Tess manages sales for a high-tech company. They receive non-taxable Canada Child Benefit cheques of about $ 488 a month for total after-tax income of about $9,000 a month.
Their problem, in a nutshell, is to know whether they can retire when they are approaching 60 and their kids are grown and gone. In retirement — starting in 15 years, when Sam is 60 — they would, they say, like to have $70,000 a year before tax, or about $5,200 a month after tax.
“We’d l i ke $ 40,000 to $ 50,000 per child in RESPs by the time they are ready for university,” Sam says. “We need to save for that. We could pay down the mortgage faster, or add to our registered savings. What should we do?”
Family Finance asked Benoit Poliquin, chief investment officer of Exponent Investment Management Inc. in Ottawa, to work with Sam and Tess.
“The couple’s data show t hey currently generate about $ 21,800 a year of savings in addition to present RRSP, RESP, TFSA and other savings that total $ 9,000 a year. The $ 20,000 has gone to Montessori schools for the kids. But that is over. The children are now in conventional kindergarten and primary school programs as of the fall, so the surplus can be shifted to other ends such as mortgage paydown or registered savings.
ASSET MANAGEMENT
Mortgage reduction is a vital goal. Their present payments of $1,645 a month for their 25- year mortgage with a present interest rate of 2.94 per cent will cost them about $ 116,000 in interest payments over the term of the loan. That’s assuming that interest rates do not rise. The couple’s present mortgage allows up to $ 20,000 in annual pre- payments. If Sam and Tess add just $ 10,000 to their annual mortgage payments once a year, they will have the mortgage paid off in 13 years and save about $ 52,000 in interest over the remaining life of the mortgage. If they add $20,000 to their mortgage payments, they would have it paid in nine years and save $72,340 in interest.
The interest that would have had to be paid would have been in after- tax dollars. The savings are thus worth, in that sense, 30 to 50 per cent more — depending on whether the savings are calculated at the average tax rate or Sam’s or Tess’ marginal tax rate. Accelerated paydown is a profit centre, Poliquin concludes.
At present, the family RESP has a balance of $ 32,162. Grandparents contributed $ 2,500 per child per year and qualified for the Canada Education Savings Grant limit of 20 per cent of contributions or $ 500 per year. Currently, Sam and Tess add $ 200 per child per month to the RESP. The CESG is an instant 20 per cent profit, though it has a cap of $7,200 per beneficiar y, which works out to about 14 years of top- ups at $ 500 per child per year.
The CESG bonuses, which each child has received for two years, will end when each child is about 14, assuming the rate of contribution does not change. The parents can continue to add money to the RESPs without CESG bonuses until they hit the $ 50,000 per beneficiary RESP contribution limit. If the accounts grow at three per cent per year after inflation, they will provide about $ 60,000 per child — a little less for the elder, a little more for the younger, with the parents evening out the sums. That will cover four years of tuition and books at any university in Ontario, Poliquin says.
RETIREMENT PLANS
At retirement, Sam will be entitled to a definedbenefit pension of about $ 60,000 a year at age 60, with a drop to about $47,000 when his CPP benefits, worth $ 13,110 in 2016, begin at 65. Tess has no company pension, but can expect full CPP benefits at 65. Both will receive full Old Age Security benefits, currently $ 6,846 per year, at age 65.
On top of that, they will have i ncome f rom their RRSPs, which currently total $ 135,000. They add $ 3,600 a year. At three per cent growth after i nflation, the plans will have $ 291,377 when Sam is at the end of his 60th year. If Tess retires at the same time, that capital, still growing at three per cent a year after inflation, would generate $12,600 a year in payouts for the 38 years to Tess’ age 95.
Tess and Sam also contribute $ 200 a month to their tax- free savings accounts. If they maintain that rate of savings and add it to the present balance of $ 6,500, then in 15 years when Sam is 60, the accounts, growing at three per cent a year after inflation, will have a balance of $ 56,100. If the TFSAs are paid out over the next 38 years to Tess’ age 95, they would generate $ 2,420 a year.
Adding it all up, their retirement incomes will begin at $ 75,020 a year before tax when Sam is 60. After 12 per cent average income tax, they would have $ 5,500 a month to spend. When Sam is 65, their combined annual incomes would rise to about $ 81,900. When both are 65, their annual incomes would rise further with Tess’ CPP and OAS to $ 101,900. Allowing for splits of eligible i ncome, no tax on TFSA payouts and tax at an average rate of 12 per cent, they would have $ 7,500 a month to spend. At each age, they will make and beat their wish for $ 5,200 a month after tax.
BOOSTING RETURNS
Sam and Tess can have a higher retirement income at every stage by doing a few things to adjust their savings. First, because Sam is in a defined- benefit pension plan, he is subject to the pension adjustment, which reduces his RRSP limit by the amount of contributions to his DB plan. However, at retirement, his income will be higher than Tess’ income. Accordingly, he can make spousal contributions for Tess.
Sam and Tess make relatively little use of TFSAs. They should use them for surplus income with the understanding that they are not to be tapped thoughtlessly.
If Sam and Tess shift their high cost mutual funds with management fees of perhaps two per cent on average to an account managed at a portfolio management company for a fee as low as one per cent to 1.5 per cent per year, they can save a few thousand dollars a year in fees.
“Living modestly, saving and watching after- tax investment returns should make it possible for the couple to meet all their financial goals for their kids’ educations and for their own retirement,” Poliquin concludes.
WE COULD PAY DOWN THE MORTGAGE FASTER, OR ADD TO OUR REGISTERED SAVINGS. WHAT SHOULD WE DO?