When a Longer Amortization is Better

longer-amortization

Andrew Allentuck

To put their three kids in university and save for retirement, Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., says this couple should beef up retirement savings by stretching out paydown of the mortgage and make the most of tax breaks provided by John’s RRSP, which currently has a balance of just $34,000.

In Toronto, a couple we’ll call John, 39, and Yvette, 40, are raising three children, ages 13, 9 and 7, on John’s $146,000 annual gross salary from his work as an electronics engineer and Yvette’s business as a part-time baby photographer, which pays her $4,800 a year after expenses. They came to Canada 14 years ago with no assets other than their educations and the ambition to do well in a new country.

They have a $519,000 house and financial and other assets of $79,000. They have $254,000 of debt, most of it in their $228,000 mortgage. For a couple that made a late start in building wealth, their net worth, $344,000, is a substantial accomplishment.

John and Yvette worry they need to do a lot more in the next decade to put the three kids through university. Their registered education savings plan is $20,000 — enough to get their eldest child through a year or two at a local university. Burdened by their mortgage, they see a crisis ahead. Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with the couple. His strategy — beef up retirement savings by stretching out paydown of the mortgage and make the most of tax breaks provided by John’s RRSP, which currently has a balance of just $34,000.

The couple has a take-home income of $8,450 a month. Their present allocations include $942 for their line of credit, $300 a month to RESPs and $250 a month to non-registered savings. $500 goes to their RRSP via a loan, and $1,625 goes to their mortgage. It’s the wrong allocation, Mr. Moran says. RRSPs should get top billing and a lot more of John’s savings.

longer-amort
Adjusting cash flows

The first step in reallocating savings should be to cash out their $1,000 tax-free savings account and put the money into the RRSP. After all, the TFSA produces no tax break today, for money going in is tax-paid. Also, it offers at most a $5,000 annual advantage plus whatever growth can be achieved. The RRSP, which has a limit more than five times as high in John’s case, generates a hefty tax break for John at his 45% tax rate.

Next, add non-registered savings of $250 a month to present $300-a-month contributions to the RESP. Take $74 from miscellaneous expenses and add it for a total $624-a-month contribution. That way, each child’s RESP gets about $2,500 a year and qualifies for the full Canada Education Savings Grant, the lesser of 20% of contributions or $500 a year.

John needs to catch up with his retirement savings. In this situation it actually makes sense to extend the amortization of their mortgage, which is 14 years, to 25 years and then use the money freed up by increased contributions to the RRSP. Tax refunds can be used to pay down the $25,000 line of credit and then to pay down the mortgage.

If amortized over 25 years, their mortgage payment will be reduced to $982 a month from $1,625, adding $643 a month to potential RRSP contributions. In turn, the $643 addition plus existing RRSP contributions of $500 a month will allow for total monthly contributions of $1,143 a month, or $13,716 a year. This is the RRSP-building strategy at work. John’s tax refund would then be about $6,200 a year, Mr. Moran estimates. John should direct contributions to a spousal plan for Yvette because pension-splitting, a feature of current tax law, could be impaired in the future by governments hungry for tax revenues, Mr. Moran warns.

John’s $25,000 line of credit has a current cost of $942 a month. That’s $11,304 a year. At this rate of paydown, the debt will be eliminated in about two years and they would then have $11,304 a year to use for the RRSP-maximizing strategy .

They can add the $11,304 a year to the annual $6,000 RRSP contribution they already make and tax refunds of $6,200 for a total contribution of $23,504 a year.The refunds generated will be about $10,337 a year. That money can go to mortgage paydown.

Financing retirement

Assuming a 3% average annual inflation-adjusted rate of growth of RRSP assets, their present savings pattern would see the couple build an RRSP of $235,300 by age 60. This way, their RRSPs could grow to $740,400 by the time John is 60. If they continue to contribute at John’s expanded rate, their RRSP balance would grow to $980,000 at John’s age 65. These are massive increases created by the pension building strategy.

It is reasonable to assume John will earn full CPP credits, currently $11,840 a year, and that Yvette, with a lower income, could qualify for 25% of the maximum or $2,960 a year, Mr. Moran says. At age 65, these benefits would total $14,800 a year.

John came to Canada at age 25. By 65, he will have the 40 years of residence needed for full Old Age Security benefits, currently $6,480 a year. Yvette, with one year’s less residence, would receive 39/40ths of the maximum benefit at 65, or $6,318 at current rates, for a total OAS benefit for the couple of $12,798 a year.

If John retires at age 60, and they spend their RRSP money evenly to his age 90, he and Yvette would have RRSP income of $37,774 a year. They could take CPP early, but that would cut their benefits buy 36% — a high price for early retirement. The implication is that they should work to John’s age 65 and begin retirement with full CPP benefits and OAS. If they do that, their age 65 $980,000 RRSP balance would yield an income of $56,249 for the next 25 years to John’s age 90, after which, all capital would be expended.

Adding up their RRSP distributions at John’s age 65 of $56,249 a year plus $14,800 CPP and $12,798 OAS, the couple will have $83,847 of retirement income before tax in 2012 dollars. If this pension income is split, they will have an average tax rate of perhaps 20%, leaving $67,078 a year, or $5,590 a month, to spend in 2011 dollars.

That’s two-thirds of present after-tax income, but their debts will be paid and the kids on whom John and Yvette currently spend $400 a month for activities, will have finished their first degrees. Their living costs, including food and clothing, will drop by perhaps $4,000 a month, leaving a net retirement cost of living of about $4,450 a month.

“I am confident that John and Yvette and their children will have the money that they need for school and retirement,” Mr. Moran says. “For new Canadians who started with nothing, that will indeed be an achievement.”


(c) 2012 The Financial Post, Used by Permission