Edmonton couple asks how to use freed-up funds

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With her law-school loans and divorce paid off, Daniella* is looking for advice on how to best put these freed-up funds to work for her family.

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“This is my first year of having money that wasn’t directed to paying off debt and I want to invest and grow my net worth,” she said. “I feel I’m behind my peers but I’m overwhelmed when it comes to investing.”

Daniella is 45 and remarried with two children (ages 11 and 14) from her first marriage. Her husband John,* 43, also has two children (nine and 12) from his first marriage.

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The Edmonton-based couple have merged their lives and bank accounts, but their financial priorities are different. In the short term, Daniella is focused on building up cash reserves to cover up to six months of expenses and beyond that, she wants to build their savings, buy a cottage and start looking at investing in a vacation property outside Canada.

“My ideal retirement is moving to the vacation property and working from home part-time before fully retiring when I’m 60.” John is squarely focused on paying off the $400,0000 mortgage on their $800,000 home and is not worried about saving for retirement because of the healthy government defined benefit pension he will receive. That pension will pay 75 per cent of his $300,000 annual income (before tax) if he retires in 15 years and 60 per cent if he retires in 10 years – his target timeline.

“I think I want to increase my registered retirement savings plan (RRSP) and tax-free savings account (TFSA) contributions, but John wants to put all our ‘extra’ money on our mortgage. What do the experts think?”

Daniella is also interested in other investments that are good for someone who can’t consistently contribute the same amount each month. She earns on average $200,000 after tax each year. Her capital account/investment in her law firm is about $320,000. When she leaves, she will receive all the funds in the account. She does not make Canada Pension Plan (CPP) contributions, has just over $140,000 in RRSPs, $3,000 in stocks, $21,000 in a registered education savings plan (RESP) for her kids and recently opened two TFSAs – one for long-term savings and the other for short-term expenses. She has a personal line of credit and $20,000 in a high-interest savings account that she doesn’t touch.

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The couple’s monthly expenses are about $13,400 including $3,500 in biweekly mortgage payments and $1,700 in car loans.

“Should I use my line of credit and my savings to maximize my TFSAs and RRSPs?” asked Daniella. “I feel that I have never been given a straight answer on what I should be doing financially — for retirement, for investments, for my kids — and I would appreciate some direction.”

What the expert says

Daniella and John are in an enviable position, despite Daniella’s concerns, said Ed Rempel, a fee-for-service financial planner, tax accountant and financial blogger. With John’s pension and Daniella’s investments (assuming an eight per cent annual return) they can retire sooner than they’re thinking. And this doesn’t take into account the additional $14,000 a month they have after meeting their expenses.

Rempel breaks down the math. Daniella and John are living comfortably spending $161,000 a year (about $13,400 a month) after tax. If they do buy an overseas vacation property and a cottage and plan to travel, which would add up to $25,000 in yearly costs, they will need $175,000 a year before tax in today’s dollars, or $290,000 a year in 15 years, assuming they split their income effectively.

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No problem, according to Rempel. “Their primary residence should be paid off in 13 years at their current mortgage payment, so there is no need to make extra payments. John’s large pension and CPP together should give him about $225,000 a year. John can split his pension income with Daniella to save tax, but they will likely both have their OAS (Old Age Security) clawed back,” he said. “Overall, they will need an investment portfolio of about $1 million to generate income in future dollars of about $65,000 a year. Daniella’s existing investments, which seem to be in stocks, plus the $550 a month she is investing, should grow to about $1,950,000 in 15 years.”

Rather than focusing on RRSPs and TFSAs, Rempel suggests the most tax-effective place to invest is inside Daniella’s corporation — something she is not currently doing — which means she is missing out on the ability to defer 25 per cent in tax. His advice: Instead of drawing $200,000 a year in dividend income, which results in a $57,000 personal income tax bill, Rempel suggests Daniella can pay $40,000 a year less tax by withdrawing only $100,000 and investing the remaining $100,000 inside her corporation.

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“This is an optimal income level that keeps all her income in low tax brackets of 22 per cent or less. This is more tax-efficient than a TFSA, since she would have to pay tax on money from her corporation to contribute to her TFSA. This means she can invest $100,000 a year inside her corporation, and only have their cash flow reduced by $60,000. She could take a one-time additional dividend from her corporation to maximize her RRSP room with a net tax savings of about eight per cent. This would be her last RRSP contribution, since she does not get new contribution room.”

Or, Daniella could contribute her $20,000 savings account and stocks to her RRSP first and then TFSA, and use her line of credit as her emergency fund, said Rempel. “Using the line of credit to invest may not be much benefit, since her interest rate would be higher, and likely not much less than her investments would earn over time.”

When it comes to saving and investing to buy a cottage and vacation property, “Having three paid-off properties is a lot of dead equity that could be worth $2 million altogether,” Rempel said. “Having two properties instead would give them significant additional investments – a more effective use of their money.”

* Names have been changed to protect privacy.

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