Kids should be no hurdle for couple

Kate is an accountant earning $180,000 a year plus bonuses – which usually are $20,000 a year – and her job provides a benefits package. This includes a defined-contribution pension plan, which has a current value of $200,000. She also has $150,000 in RRSP assets, $100,000 in a non-registered account and $33,000 in a tax-free savings account (TFSA).

Ethan owns his own incorporated business, through which he provides information-technology consulting services and draws an annual salary of between $180,000 and $200,000. He has a disability insurance policy that would pay $8,000 a month. His business holds $300,000 in cash while he has personally accumulated $190,000 in RRSP assets, $31,000 in a TFSA and $260,000 in non-registered assets. He has $30,000 in unused RRSP room.

Kate and Ethan have a cohabitation agreement that specifies that: the house remains Kate’s and she pays the mortgage and all major repairs; their financial assets remain separate and not part of their joint assets if they break up; and they split all living and travelling expenses 50/50.

The couple spend about $120,000 after taxes each year: $60,000 on living expenses and $60,000 on three major trips a year. They would like to continue to work until age 65 and want to be able to continue to spend the same amount in today’s dollars when they retire.

Kate is planning to take a year off work with each child. The couple expect the children to cost an additional $20,000 each a year, with an additional $20,000 a year to send them to private school from kindergarten through to Grade 12.

The recommendations: Both Butchart and Shoemaker say that Kate and Ethan should have no problem achieving their goals. Butchart’s projections suggest that the couple would pretty much run out of financial assets by age 95, but would still have Kate’s house.

In contrast, Shoemaker believes the couple have more leeway and could continue to spend $40,000 per child to age 25 should the children pursue higher education that lasts that long.

Butchart assumes a 6% average annual return; 2% a year official inflation, as measured by the consumer price index (CPI); and 3% personal inflation. CPI inflation is used for indexing old-age security and Canada Pension Plan benefits, while personal inflation is how much the prices of what the couple purchases would rise.

Shoemaker assumes a 5% average annual return and 2% for both official and personal inflation.

Both advisors assume that Kate’s house and Ethan’s investment property, if he purchases one, will rise in line with the 2% official inflation rate. However, neither advisor is enthusiastic about Ethan buying an investment property. Not only would he have the burden of being a landlord who has to be on call when anything goes wrong, but both advisors doubt that the returns would be higher than sticking with financial investments.

When calculating potential returns, you have to assume that the investment property periodically will be vacant for several months; recognize that it will have to be kept in good repair and repainted for new tenants; and make sure the capital gains tax liability when the building is sold is subtracted when calculating the return.

If Ethan insists on buying an investment property, Butchart strongly recommends that he buy an office building to minimize evening and weekend calls from residential tenants – and Ethan also could use some of the space as an office for his business.

Butchart suggests Ethan buy the property in his firm’s name, using the $300,000 it holds in cash. Butchart notes that companies are not supposed to have that much cash sitting on the sidelines and that Ethan is too young for an individual pension plan (IPP).

IPPs not only may allow for larger annual contributions than RRSPs, but the company may be able to fund prior years’ service for Ethan, allowing for even more tax-deductible contributions into the plan. The ideal age to set up an IPP is around 60. Until then, RRSP contributions are a simple and better way to go because of the costs of maintaining an IPP, which involve actuarial assessments and triannual reviews.

On the other hand, Shoemaker advises personal ownership of the investment property because the rental income may be considered investment income for corporate tax purposes and thus be subject to higher corporate tax rates. Shoemaker suggests that if Ethan buys a property, he should use $100,000 of his non-registered assets as a down payment and take out a mortgage – at least, while interest rates are low. When interest rates rise, Ethan may want to re-evaluate this strategy.

Shoemaker uses the same argument regarding Kate’s mortgage, but Butchart suggests that Kate pay it off now. Kate has the cash – on which she probably isn’t making a good enough after-tax return to offset the mortgage interest. In addition, it’s better for Kate to be debt-free – especially as she’s expecting to take time off work to have children.

If Ethan decides against buying an investment property, Butchart recommends that he invest some of the $300,000 cash being held in his business and start taking dividends so that the excess assets don’t attract the Canada Revenue Agency’s attention. Corporations are supposed to get all or most of their income from “active” business – and investment income doesn’t qualify.

On the other hand, Shoemaker suggests that Ethan should avoid dividends at this point because Ethan doesn’t need the income and is in the highest tax bracket. Instead, Shoemaker recommends corporate-class mutual funds, which defer taxes and thus will keep investment income low.

Whatever is decided about issuing dividends now, Butchart says, Ethan’s business should be set up so that both he and Kate are shareholders – although with different classes of shares so that dividends could be declared in the most tax-efficient way.

For example, in the years in which Kate is at home with a new baby, she could receive quite a bit in dividends and still be in a low tax bracket.

Butchart strongly recommends that Ethan use up his unused RRSP room with the cash he has on hand. Thereafter, the couple should continue to make maximum RRSP and TFSA contributions and set up a registered education savings plan as soon as the first child has a social insurance number. The couple should make contributions of $2,500 a year per child in order to get the annual federal government grant of $500.

Both advisors urge the couple to buy term insurance before the first child arrives. Shoemaker suggests term-20 policies of $1.25 million for Kate (at a cost of about $105 a month) and $1.75 million for Ethan (about $150 a month).

Butchart suggests coverage of $1.6 million for each partner as that will cover the additional costs of two children for 20 years. Butchart recommends that each partner should be both the owner and the beneficiary of the other’s insurance. Assuming there are no health issues, the monthly premiums for 20-year term policies would be around $129 for Kate’s policy and $136 for Ethan’s policy.

Butchart doesn’t think the couple need critical illness (CI) insurance, given their level of assets.

However, Shoemaker suggests CI insurance of $200,000 for Kate, at a cost of about $350 a month, and $200,000 for Ethan at a monthly cost of $280. Shoemaker suggests return-of-premium riders for both Kate and Ethan, as they have the cash flow for the premium.

Both advisors would leave the question of whether the couple should get long-term care insurance coverage until they’re older.

Kate and Ethan need up-to-date wills and powers of attorney. And, once they have a child, they will need to appoint a guardian and trustee in case they both die before the children turn 18 years old.

Butchart suggests a portfolio target of 55% equities/45% fixed-income; Shoemaker recommends 60% equities/40% fixed-income. Both advisors suggest equities that are broadly diversified geographically, with Butchart suggesting a Canadian equities component of 35% while Shoemaker suggests 40%. Both advisors suggest using actively managed mutual funds.

For the fixed-income component, Shoemaker recommends a mixture of government bonds, investment-grade corporate bonds, high-yield bonds and mortgage mutual funds – specifically, Investors Group’s unique Real Property Fund.

Butchart is more conservative and suggests the couple stick with short-term government and corporate bonds, mainly through exchange-traded funds.

Butchart charges $250 an hour for financial plans. One like this would cost $2,500-$3,500.

Shoemaker is paid by trailer fees on the mutual funds his clients hold, plus a commission for new business.

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