Getty Images Young couple starting family worries costs will limit home upgrade, retirement.
In Vancouver, a couple we'll call Victor, 35, and Elizabeth, 31, work for a construction company. They shepherd net monthly family income of $10,370, saving diligently, living below their means and trying to keep a stake in Vancouver's soaring property market.
They worry that a baby they are expecting in a few months and another two children they would like to have will make it difficult for them to achieve other plans -- buying a larger home, building up RRSP balances and retiring in comfort.
"With starting a family, will we be able to achieve our financial goals while maintaining some semblance of our current lifestyle? Will we be able to afford having Victor take time off with each child? And if he does that, can we buy a larger family home while maintaining our existing home as a rental property?"
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Victor and Elizabeth.
"These professionals are ahead of their group in financial terms," Mr. Moran says. "Their challenge will be to prepare for years of lower household income and potentially higher mortgage interest rates. The solution is to isolate risks and find ways to reduce them."
Maternity benefits usually cover 55% of a claimant's weekly insurable earnings, to a maximum of $413 per week. Claimants can receive 15 weeks of maternity benefits after a two-week waiting period. The total benefits would be $6,195, far less than the $17,738 after-tax income Elizabeth loses by not working during the benefits period.
Yet it is just a small part of the approximately $212,800 total cost of raising a child to age 18, according to estimates by the Vanier Institute of the Family in 1998, and adjusted for inflation at 3% per year.
Victor and Elizabeth need to have a minimum of $500,000 each of life insurance for their family to be financially secure, Mr. Moran says. At their ages, non-smoker's coverage would cost $310 per year for him and $250 for her in a 10-year level-term policy. Rates rise each decade and the policy builds no cash value. The coverage is quite reasonable, given the outstanding debts the couple are carrying and the high cost of raising children.
Buying a Bigger House
For a couple early in their careers and beginning to have children, the Vancouver property market is challenging, Mr. Moran says. However, Victor and Elizabeth already have a position in the market. They have $484,000 equity in their present $700,000 house, and are paying just 1.45% on a variable-rate mortgage due for renewal in April. At that rate, they would have their $216,000 mortgage discharged in 10 years, the planner estimates.
Buying a larger home is not just a lifestyle choice. It's a capital commitment as well. But is it wise? Victor, the legal owner of the present house, could keep it and rent it out for a potential $3,200 per month or $38,400 per year. After $4,170 in taxes, $750 of insurance, $1,500 of maintenance and $3,132 of mortgage interest -- a total of $9,552 -- they would have $28,848 net annual income from the property. That's a yield of 6.0% -- not bad in the present market.
If interest rates rise and Victor winds up paying 6% on his mortgage, he would have to pay $12,960 per year in interest plus taxes, maintenance and other costs. That would cut the yield on the property to 3.9%, all of which would be taxable as income. They could get a 3.9% return with less risk in a basket of utility or bank shares and with potential capital gains as well, the planner says.
Keeping the present house would mean the couple would have to take out yet another mortgage for a new principal residence. There could be an obstacle to deducting interest on the house converted to an income property, but with suitable documentation of transactions, interest would be deductible, the planner says.
While the couple's jobs in the private sector are fairly secure, they are strongly correlated with the real-estate market, adding risk to a highly levered real-estate purchase. So, apart from interest deductibility, there is the issue of risk. In the end, keeping the current home as an income property and adding yet more debt is not worth the risk, Mr. Moran says.
The final question has to be how to prioritize investment purchases. The best order would be the purchase of company shares, then contributing to an RRSP, then -- when that room is filled -- contributing to a registered education savings plan, then funding a TFSA, the planner says. Note that each registered plan allows unused contribution room to be carried forward.
The company shares are RRSP eligible. Should Victor hold them in his RRSP? The shares have a strong history of annual growth, plus a dividend and the high possibility of a tax-exempt sale when Victor sells them. Those tax advantages would be lost in an RRSP, whose payouts are all taxed at high rates as income. Moreover, keeping shares out of his RRSP would allow Victor to use borrowed capital for share purchases and deduct interest costs, using cash to pay down personal debt instead.
Victor and Elizabeth are three decades from retirement, but it's not too early to project what they will have when their careers end. Victor can expect the current Canada Pension Plan payout maximum at age 65 of $11,210 per year. It is not known how many years Elizabeth will work, but one may estimate that she will receive perhaps half that amount, $5,605 per year. Each will receive full Old Age Security benefits of $6,204 per year. All amounts are in 2010 dollars.
The couple's RRSPs currently total $130,000. Victor contributes $1,200 a month and Elizabeth $1,350. If Victor adds $21,000 a year until his age 60 and Elizabeth adds nothing more, and if they can generate a conservative 3% return after inflation, then by the time Victor is 60 the couple will have $813,000 in their RRSPs. That sum would support withdrawals for 34 years from Victor's age 60 to Elizabeth's age 90, of $37,350 a year.
Victor holds shares in his company and purchases $7,000 worth each year. If the shares, which have a current value of $85,000, grow at 4% over the rate of inflation they would be worth $518,120 by the time he is 60. Assuming shares are sold to other shareholders in the company, the resulting cash would provide income of $24,520 a year until Elizabeth's age 90, Mr. Moran estimates.
In total, the couple would have a pre-tax base retirement income of $91,093 per year in 2010 dollars. They would also have whatever they have built up in their TFSAs and in non-registered assets. Their house would be a substantial asset that they could sell, downsizing later in life to something smaller.
"These are conscientious people," Mr. Moran says. "With planning, their children can have their education paid for by parents who will be able to retire comfortably."
Young couple starting family worries costs will limit home upgrade, retirement
Optimize housing costs, reduce financial risk with more insurance
Reduced risk of house upgrade, more money for kids, comfortable retirement
MONTHLY AFTER-TAX INCOME
House $700,000, RRSPs $130,000, TFSA $7,000, Non-registered investments $25,000, Company stock $85,000, Car $22,000, Timeshare $15,000
Mortgage $216,000, Line of credit (for investments) $45,000
Mortgage $2,000, Property taxes $300, Utilities $300, Food $725
Restaurant, entertainment $350, Clothing $150, Travel $325Car, fuel & maintenance $350, Home maintenance $850, Charity, gifts $200, Hobbies $250, Timeshare $15, Line of credit $125, RRSPs $2,550
TFSA $150, Company stock plan $700, Miscellaneous $400, Savings $495
(c) 2010 The Financial Post, Used by Permission