Caught in financial vise

Making the decision to quit her job as a flight attendant to raise her two children was not easy for Denise and her airline pilot husband, Henry (not their real names). “We chose to raise a family and to de-emphasize my career,” Denise explains.

They accepted that her income would drop from $45,000 a year when she was flying. But they weren’t so clear on making a corresponding cut in their expenses. Today, she brings home $1,020 a month from her job in a retail clothing store, adding to Henry’s $5,400 monthly take-home pay. But instead of reducing costs, they bought a bigger house, going from a $190,000 mortgage to a $285,000 debt and raising their monthly payments by almost a third to $1,166 a month. That’s almost $14,000 a year, 18% of their take-home income. Even though that is just one of their debtservice costs, the couple is hoping to add another $37,000 to their lines of credit to finance two new cars.

“Since Denise retired from her job as a flight attendant a few years ago to raise our kids, it has been a continual struggle to keep expenses down and revenue coming in,” Henry says. “The debts are draining us.”

They have a $49,000 secured line of credit, another $10,000 line of credit that costs them 6.75%, and a $2,000 Visa card that they use as a cash substitute. Each month, their expenses are paid by one of these credit lines.

Today, they live from month to month on credit with interest rates as high as 6.75%. Nevertheless, with two children, one in kindergarten and one in elementary school, they have to build up education savings, pay off debts and save for retirement. The family’s $6,420 monthly take-home income is so stretched that they are able to make what amounts to token contributions to their kids’ educational savings plans and their own retirements. Both are 44 and both feel they have slipped far behind where they should be in middle age.

Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Henry and Denise. He says catching up to where others are at their stage of life requires some rebalancing.

“They are nearly broke at a time of life when others are building up their savings,” Mr. Moran says. “If they tighten up their finances, they can reduce their stress. In a few years, their problems will pass.”

Henry has a defined-benefit pension plan, so it makes sense to build up Denise’s side of the family balance sheet, Mr. Moran says. Today’s tax laws make it easy to split pen- sion income, but that could be reversed by governments hungry for tax revenues. This is why it makes sense to use contributions to spousal RRSPS.

Cutting Costs, adding Cash flow

First, Henry should put $4,500 of non-registered cash into Denise’s spousal RRSP. The refund, about 40% of the contribution, or $1,800, can be used to pay down debts.

Second, use $10,000 of non-registered stock for an in-kind contribution to Denise’s spousal RRSP. That will produce a 40% tax refund, or $4,000, for debt reduction.

Third, Denise’s 2012 income from part-time work will be low, perhaps $10,000. So she can cash out the entire balance of her $35,000 of regular RRSPS in increments of less than $15,000 a day. The withholding will be 20%. That is close to what she will owe when she files her 2012 tax return. The net $28,000 can be contributed to a new spousal RRSP via a gift of the money to Henry, who then contributes to the spousal plan for Denise.

Fourth, the couple’s home has a value of $480,000 less a $236,740 mortgage and a $49,000 secured line of credit. That gives them equity of 41% of the home’s value. They can use their secured line of credit at a cost of 3% to pay off other, more expensive lines of credit, such as their $10,000 line that costs them 6.75%. This move will save $375 a year and simplify matters. Then use the lowinterest line of credit to pay off the $2,000 Visa bill with its 19% rate of interest.

If the refunds for RRSP contributions are used to pay down debt, they will shorten the amortization on the $236,400 debt on their house to 21 years and 10 months from 24 years and save $15,250 in interest charges, Mr. Moran estimates.

RESPS and Retirement

The couple’s two RESPS need attention. One has a balance of $2,000. The other is a group pool. The two children will be ready for post-secondary education in a decade. The theoretical deficit based on their ages is $30,000 of contributions they have not made and $6,000 of Canada Education Savings Grants they have not obtained. Without sufficient cash or generous grandparents, the deficit is not likely to be filled, the planner says.

At retirement, the couple will have Henry’s non-indexed company pension with an estimated payout of $67,000 a year. Henry should get full Canada Pension Plan benefits, now $11,840 per year. Denise’s CPP can be estimated at 40% of the maximum, or $4,736 a year. Each will qualify for full Old Age Security, currently $6,480 a year at age 67. The total, $96,536 a year, will be about 30% indexed. After an average 20% tax, they will have $77,230 a year to spend, or $6,436 a month, in 2012 dollars. That will be more than they have to spend now, especially if they eliminate perhaps $2,000 a month of debt-service charges, retirement savings and childcare costs. Pension splitting will eliminate any OAS clawback, which now starts at an income of $69,562 per person per year.

If Denise returns to full-time work, she could add perhaps $20,000 after tax to the family’s income. That would cover the RESP deficit, enable a rapid paydown of debts, and leave some cash for the pleasures of life, Mr. Moran suggests.

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