In Montreal, a couple we'll call Hubert, 34, a civil engineer, and Claudette, 36, a stay-at-home mom for now, are raising two children ages 3 and 1. Their combined income, $4,000 per month after tax including $500 child tax and care benefits, should rise when Claudette returns to work in advertising in a few years. For now, they are walking a financial tightrope, balancing their children's needs with their own.
They live on the first floor of a $400,000 duplex. They want to rent out their apartment for $1,200 per month and buy a house. Rental of their apartment will augment the $565 monthly rent they already receive from their tenant and push rents to $1,765 per month.
When Claudette returns to full-time work, she could earn $3,750 per month before tax, but, after tax, she would have $2,625. She would have to spend $600 per month for daycare, leaving added disposable income of $2,025.
Their questions are whether to sell their duplex or keep it as an income property and how to balance the needs of their children for eventual post-secondary education with their own needs to retire on an income of the $150,000 they expect to earn before tax when Hubert is 55. That works out to an expected after-tax income in retirement of about $70,000 in 2011 dollars.
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Hubert and Claudette. "It will take solid planning work to satisfy the needs of the kids and their own retirement needs," he says.
The couple's largest asset is their duplex. If they decide to keep it rather than sell it, the combined cash flow before expenses of the two apartments would be $1,765. Take off mortgage interest of $607, taxes of $250 and insurance and maintenance charges of $150 per month and the net rent is $758 per month or $9,096 per year. That works out to a 2.3% cash yield. For all the trouble that being a landlord entails, they could do better with stocks with a 4% to 5% dividend. Of course, the house could appreciate, but then so could stocks.
If the duplex was sold, the couple would realize $400,000 less their present $232,000 mortgage or a net $168,000 — disregarding selling costs and potential capital gains taxes on the part of the house used for rental. That money could be used to pay off the mortgage on the second property that they will purchase. The result would be $1,007 per month liberated from debt service. Those funds plus $5,000 from their tax-free savings accounts could be used to fill Hubert's $29,000 RRSP space, Mr. Moran says. That would generate a 30% tax refund in his bracket. It could fund next year's RRSP contribution. Once RRSP space is filled, they could contribute to TFSAs, ensuring that gross contributions in any year are within the $5,000 per person limit.
Educating the Kids
Hubert and Claudette think that their children should have some responsibility for paying for their own educations. Accordingly, their target would be modest support for two years of education at a Quebec CEGEP, a sort of junior college that is part of higher education in Quebec, and support of half the costs of attending university for three years. They will need $56,000 for the bills, they think. There is already a $20,000 bequest in the family's accounts for higher education.
That $20,000 should be added immediately to a family RESP at a rate of $5,000 per year. That will support both the maximum Canada Education Savings Grant of the lesser of $500 or 20% of amount supported per child and the Quebec Education Savings Initiatve grant of the lesser of 10% of RESP additions or $250 per year.
If they start education savings now when the kids are 1 and 3, then after four years, by which time the bequest will have been fully invested in the RESPs, then, including 30% grants and 3% growth over inflation, they will have $27,194.
Assuming that grants continue to be available, then for the following 10 years, they would have to save a further $1,305 per year (that's $1,697 including grants) to meet the $56,000 goal when their first child turns 18.
Retirement at age 55 would require that they live on their investment income and principal for 10 years until they begin to receive benefits from the Quebec Pension Plan and Old Age Security. In the 10-year gap to age 65 or, given the two-year gap in ages, 63 for Hubert and 65 for Claudette or 65 for Hubert and 67 for Claudette (we'll just use an average), they would need $2.3-million at 3% returns after inflation. If they are willing to consume capital, then $690,646 would sustain them for 10 years allowing for a 100% drawdown of funds at the end of the period. If they wait to age 65 to retire, they would need only $636,200 savings at age 55 plus 10 years of growth to get to $855,000 with gains but no further savings at age 65.
To build up $690,646 + $636,200 = $1,326,846 in the next 19 years to Claudette's age 55, the couple would have to save $4,053 per month or $48,638 per year on top of their present balance of $60,500 in RRSPs. The mortgage for the house they will buy could be paid off with an inheritance they expect in the near future. They could sell the duplex, releasing $1,030 per month in mortgage payments and $168,000 of capital for investment in more productive things. Hubert's income could rise in the next two decades as well. If rising salaries materialize, they may be able to achieve the required savings, Mr. Moran suggests.
At age 65, Hubert would be entitled to 85% of the maximum Quebec Pension Plan payment, currently $11,520 per year, or $9,792 and 80% of the maximum for Claudette or $9,216. When each reaches age 65, Old Age Security would pay $6,456 at current rates. Their total income from public pensions would be $31,920. The shortfall between $81,000 before tax ($70,000 after tax) would be $49,080. It would have to come from investments. At her age 90, capital and all investment income would have been paid out. They would be left living on public pensions and the equity in their home which they could downsize to capture equity.
(C) 2011 The Financial Post, Used by Permission