The Problem: Couple in early 30s about to have first child wants bigger house, RESP and retirement plan. Can they move to the middle class life, educate their brood-to-be and retire in comfort in just a few decades?
The Solution: Defer purchase of a larger house until more savings, save for child?s university and rely on defined benefit pensions, for they will never have enough spare cash to build large savings.
In Western Ontario, two teachers we?ll call Gene, 34, and Karen, 31, are earning enough for a comfortable middle-class life. But years of schooling have taken its toll on their savings. Now expecting their first child later this summer, they dream of a bigger house for their family.
Gene understands the complexity. ?Can we buy that larger house and still be able to retire at a reasonable age?? he asks.
The couple?s combined incomes after tax is $7,194 a month and their net worth is $144,300. They want to borrow another $200,000 to upsize from their 1,500-square-foot, $450,000 house, to one of about 2,000 square feet.
Both Gene and Karen have an ace in the hole ? a defined benefit pension. But their net worth is modest for their ambitions.
Can we buy that larger house and still be able to retire at a reasonable age?
Family Finance asked Graeme Egan, a portfolio manager and financial planner with KCM Wealth Management Inc. in Vancouver, to work with these about-to-be new parents.
Karen plans to go on maternity leave in August. ?She will receive benefits including the Universal Child Care Benefit of $100 a month and the Child Tax Credit as well as employment benefits of about $500 a week. Her employer will top up that money to her normal salary for six weeks. Then, for the next 46 weeks, she will get $2,000 a month before tax or about $1,800 a month after tax. The family?s budget is going to be reduced to about $5,500 a month until Karen returns to full time work in September 2014.
There is not much point in shopping for a new house until their income returns to pre-leave levels, Mr. Egan says.
Setting priorities
With a cash squeeze coming, Gene and Karen have to sequence their investments.? First, they want a bigger house. When the house is secured on affordable terms, they can turn their attention to saving for their child?s post-secondary education. Finally, they can turn their attention to retirement. Time is in their favour for they are at least two decades from retirement.
There is little spare cash in their budget. Karen will have to spend money for child care when she returns to work. ?Assuming that Karen will have to spend at least $500 a month for child care after various government and employer benefits and that the mortgage for larger house may cost $500 more a month or more, the couple will need to find $1,000 extra. They could give up their TFSA savings of $800 a month and cut vacation savings to $200 a month from $400. That would be their $1,000 savings.
The mortgage terms they select can be based on $100,000 equity from their old house used as a down payment. If they add $21,200 in their TFSA balances, they will have $121,200 for a down payment. That is not enough, for they would need $131,000 for a conventional mortgage.? They can save another $10,000 at $6,000 a year for 18 months. If they can save up enough for a $162,500 down payment, they can have a conventional mortgage and avoid the costs of insurance on a high ratio mortgage. By the end of 2014 they would be ready to shop for the larger house.
At present, their fixed rate mortgage costs $1,800 a month at 3.65% with 23 years remaining on their amortization schedule. Rates are rising. Assuming that they can find a 3.0% 5-year floating rate mortgage, they would have to pay $2,300 a month, $500 more than they now pay. With a 4% fixed rate loan at the time they are ready, the monthly cost of the mortgage would be $2,538. Paying that expense on their present take home income would add $700 a month to their costs along with what are likely to be higher property taxes. One alternative, of course, is to cut additional costs in half by moving up to a $550,000 house.
Education savings
If Gene and Karen put aside $208 a month, they can save $2,500 a year in a family RESP. The Canada Education Savings Grant will add the lesser of $500 or 20% of RESP savings, in this case $500, for total annual RESP savings of $3,000. If they can generate a 3% return after inflation, then in 17 years when the child is ready for university, the fund will have $67,250, sufficient for four years at many Canadian universities. Cash will be short if they finance a larger house. They can minimize frills and make it, but it would be good discuss a contribution plan with their own parents for the grandkids-to-be.
Retirement
Gene and Karen would both like to retire at age 56. At that age, each would be entitled to a full pension with no reduction. The formula for pension calculation is age + years of service = 85. They will satisfy that requirement.
At 56, Gene will be entitled to $25,507 in 2013 dollars. If Karen works three more years to her age 56, she would have a pension of $29,267 a year in today?s dollars for total, pre-tax annual pension income of $54,774.? If they add $500 a month to their RRSPs beginning in late 2014 after Karen has ended her year of parental leave, then on top of present $10,100 current RRSP balances, they would have about $250,000 at Karen?s retirement, assuming that they have been able to achieve a 4% after-inflation return.
It is a challenge to do all the things this couple wants, but it can be done with diligent savings and, perhaps, a little help from their own parents for education for their grandchildren
This capital would support $12,300 a year annually before tax until Karen?s age 90. Added to pensions, this would produce total, after tax income of $67,000 a year before tax or about $4,750 a month after 15% average income tax. That will be enough to support expenses with no savings and with their new mortgage paid off.
Gene and Karen would each be entitled to a CPP payout based on terminating work at age 56. That is significantly before the usual age 65 calculation basis for full benefits. Assuming that each qualifies for 75% of the present maximum $12,150 benefit, $9,113, then their combined age 65 CPP payment before tax would be $18,226. If they take benefits when each is 60, then, after a 36% reduction, each would have $5,832 a year. At age 60, therefore, they would have total income of about $78,700 before tax or $5,575 per month after 15% average tax.
Each at age 67 would be entitled to full OAS benefits, about $546 per month.
That would push total family income to $91,800 before tax or $6,120 after 20% average tax. All figures are in 2013 dollars.
?It is a challenge to do all the things this couple wants, but it can be done with diligent savings and, perhaps, a little help from their own parents for education for their grandchildren,? Mr. Egan says.
Financial Post
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