After the birth of their daughter, the Mitchell’s financial priorities have changed. How can this couple use the sale proceeds from their rental property to kick-start their new financial goals?
Family Profile
Frank and Tara Mitchell are enjoying a busy family life with 2 ½ year old Lucas and 7 month old baby Mia. Frank (35) works as a public servant earning $83,000 per year. Tara (33) is currently on maternity leave and will make $61,000 as a nurse when she goes back to work four days a week in June.
They are finding that they are in a position to take stock and review their financial priorities.
Residing just outside of Edmonton, the Mitchell’s own their home, worth $600,000. They pay $1,700 per month on their $254,000 mortgage, which comes up for renewal in March. They want to pay off their mortgage as quickly as possible.
Related: Mortgage free at 31: Worth the sacrifices
The Mitchell’s are risk averse when it comes to debt. They want to pay cash for their vacations, cars, and home renovations.
In December they sold a rental property for $260,000 that Frank bought five years ago for $140,000. They’ll net about $130,000 after fees, but before capital gains taxes. They are wondering what to do with the proceeds. Frank has no interest in becoming a landlord again.
They are socially conscious, and their $35,000 in RRSPs is invested in an “ethical” mutual fund that has returned an average of 8 percent a year over the last five years, but comes with a MER of 2.06%.
Frank’s RRSP deduction limit is $51,000 and Tara’s is $24,000.
Both Frank and Tara contribute to their employer’s defined benefit pension plan. Frank will have a full 35 years by the time he’d like to retire in 2036, while Tara will only have 22 years of service by that time and will have to take a reduced pension.
Frank has $10,000 in Canada Savings Bonds that he purchased through a payroll deduction program at work. The bonds have now matured and he’s open to trying a different investment.
Frank and Tara have private term life insurance plans through Manulife with $500,000 coverage each, plus 2 times salary group coverage through their employers.
They do not have wills.
Goals:
- Determine how best to use the proceeds from the sale of their rental property
- To be mortgage free in 10 years.
- Retire by 2036 with 70% of last working year’s salary.
- Max our RESPs for the kids.
- Buy a new vehicle in 2017 (est. $40,000).
- Annual vacations with kids.
The Mitchell’s wonder what steps they can take over the next 12 months to solidify their financial plan and put them on a path to financial freedom.
Financial Plan
By keeping their goals simple the couple can achieve a lot. The proceeds from the sale of their rental property provides a great opportunity to kick-start their finances. Once Tara goes back to work, after expenses, they will have a monthly surplus of $3,300. Here’s what they can do.
Rental property proceeds:
First they’ll need to calculate Frank’s tax liability on the approximately $60,000 capital gain. A rough estimate is $20,000.
They can make a prepayment on their mortgage of the allowable 20%, or $64,000, that their bank allows on the original balance of $320,000.
Related: Should you pay off your mortgage early or invest?
Frank should make a lump sum contribution to his RRSP to help offset the additional tax liability for 2014. A $30,000 contribution could reduce his taxes owing by approximately $11,000.
The Mitchell’s should take $7,000 from the proceeds and have some fun: Frank wants to buy a new bike for $4,000, and Tara wants to start an annual summer vacation tradition for the family.
The remaining $20,000 should be used to start funding their Tax Free Savings Accounts, which have been opened, but no contributions made as yet. For 2015 they’ll each have available contribution room of $36,500.
Mortgage:
After the prepayment their mortgage balance will have reduced nicely – down to $190,000. At renewal in March they should lock-in to these historically low five-year fixed rates (at less than 3 percent) and increase their monthly payment to $2,000 in order to pay off the mortgage even faster.
Related: How to negotiate your mortgage renewal like a pro
The prepayment, coupled with the extra monthly payments means the Mitchell’s will be mortgage-free in just seven years.
RESPs:
The Mitchell’s should continue maxing out their RESP contributions ($2,500 annually per child) in order to take advantage of the 20 percent government grant (CESG).
RRSPs:
Their RRSP is currently invested in the RBC Janzi mutual fund that advocates, “socially responsible investing.” However, the top ten holdings are very similar to the S&P/TSX Composite Index, which is the benchmark.
Compare its MER of 2.06% to the MER of the iShares S&P/TSX Composite Index at 0.05%. While returns are similar at 8% over 5 years, high fees can ultimately erode returns in the long run. The Mitchell’s should consider switching to the lower cost ETF.
TFSAs:
The Mitchell’s should focus on filling up their TFSAs as both a short-and-long term savings strategy. Starting in June, once Tara’s back to work part-time, they can afford to each contribute $1,500 per month to their TFSAs until they’ve exhausted the unused contribution room.
One TFSA should be invested in high interest savings, or other easily cashable products to pay for their annual vacations, new vehicle and future renovations. The other can be invested for the long term to provide additional income at retirement.
Canada Savings Bonds
The Canada Savings Bonds payroll savings program is an easy way to save, but with CSBs paying as little as 0.5 percent, they’re a poor investment even in this low rate environment.
Frank should cash out the $10,000 and place it in a high interest savings account. From there he can decide whether to use the funds to top up his RRSP, make a lump sum mortgage payment, or keep the cash on hand as an emergency fund.
Will and Power of Attorney
This was not one of the Mitchell’s concerns but they should have wills and powers of attorney drawn up. They need to assign a guardian for the children in case both of them die prematurely.
Final thoughts
While a lump sum RRSP contribution helps reduce their taxes owing in 2014, the Mitchell’s don’t need to emphasize their RRSPs for retirement savings going forward. That’s because, with two defined benefit pension plans and a paid-off home in seven years, this couple is well positioned to meet their retirement goals.
Would you like to be featured in the next Boomer & Echo financial makeover? Send us an email with your question or financial dilemma.
The first Canadian ETF was created in 1989 and called the TIP-35, which tracked the TSE 35. Since then, the ETF market has expanded considerably. Currently, according to BlackRock, there are over 3,000 different ETFs available globally.
ETFs started out as a way for investors to tap into the returns of major stock markets using a nice, convenient package that traded like a stock – a miniature index.
With passive investment management, a computer could literally manage the portfolio because all it has to do is hold the same stocks that the market holds in the same proportion. In their purest form, ETFs provide low-cost diversification and efficient access for individual investors to various asset classes, industries and countries.
Related: Here’s my two-fund solution
Your returns equal whatever the index gains or loses minus a fee. These fees look like a bargain compared to conventional mutual fund fees that can charge up to 2.5% or more.
A recent poll found that less than 20% of Canadians are familiar with ETFs, but once told about the benefits 74% said they would consider them.
34% don’t know how to get started or feel they lack the necessary knowledge.
65% would buy if they were as convenient to buy as mutual funds.
Which index?
An index is a group of stocks or bonds used to measure the performance of a particular market. However, there are several different indexes and each performs differently.
Traditional stock indexes select the largest and most frequently traded companies and weigh them by their market capitalization (stock price times outstanding shares). This is called a cap-weighted index and is the cheapest and most common.
Related: How behavioural biases kept me from becoming an indexer
The go-to index for the broad Canadian market has been the S&P/TSX Composite, which includes about 250 stocks.
There is an increasing trend towards creating ETFs using more active strategies designed to beat the market. Managers may deviate from the index and change asset allocations as they see fit.
- Fundamental indexes are based on a company’s total sales, cash flow and dividends.
- Equal-weighted indexes allocate each security to a fixed equal weight.
- Leveraged ETFs use a range of strategies such as derivatives, futures contracts and options to amplify the moves of the underlying index. They attempt to achieve daily returns of 2 or 3 times the index.
- Inverse ETFs are similar, but opposite, meaning they will gain double or triple the loss of a market.
Currency Hedging
When you invest in a fund that holds US or international stocks you must take currency conversion into account. If our dollar rises against US$ or other foreign currency the value will fall. Conversely, a falling loonie will boost Canadian returns.
Currency hedging is designed to smooth out the fluctuations in foreign exchange and deliver the full return of the underlying investments. It will say “Hedged to CAD” in its name and probably cost a bit more. You can also buy ETFs without hedging and this is recommended for long-term investors, as currency ups and downs will cancel each other out over time.
Related: Why investors should embrace simple solutions
Some International equity ETFs simply hold the US-listed ETF rather than buying the underlying stocks directly.
Advantages
ETFs are listed and tradable on stock exchanges and can be bought and sold any time throughout the trading day. Holdings are posted online and updated on a daily basis.
They have improved the investment choices available to individual investors and are generally the lower-cost option versus a comparable mutual fund.
Risks
Look at the nature and purpose of the underlying index. Is it well understood, or is it some obscure “proprietary” or narrowly defined approach that is hard to understand or verify?
Is the ETF leveraged in some way in order to enhance returns? Leveraged and inverse ETFs are often marketed at Bear and Bull ETFs. They are definitely not for long term holders.
Related: Invest like a billionaire? Not with these leveraged ETFs
Actively managed ETFs have the potential for higher taxable distributions.
Management fees
Keeping costs low is an essential part of index investing. There’s currently a price war going on and Canadian ETF management fees are now lower than ever. A diversified portfolio can be held for as little as 0.12% in fees.
Too many investors just look at management fees and overlook their overall strategy and performance. Cutting an extra .10% won’t make that much of a difference and switching can be expensive when your trading commissions wipe out any reduction.
Related: Why TD e-Series funds are not just for beginners
Don’t jump from one to another just because the fee is lower or holdings are larger. Keep in mind transaction costs and possible capital gains.
The bottom line
The original purpose of ETFs was to passively track an index in a low cost, flexible, diverse and tax efficient manner. Investors look for simplicity and transparency. They know and understand what benchmark is being tracked.
The industry has very competent marketers, increasing the number and complexity of choices.
This may encourage investors to use them as part of an active trading strategy. Over-trading incurs unnecessary costs and reduces net returns.
Related: Score one for active management? Check out these index-beating funds
ETFs are not a cure-all. They do bear risks, some of which may not be obvious or well understood. Be sure to properly research any ETFs you are interested in and ensure it fits your purpose.
Carefully determine the appropriate risk level for your portfolio. Make sure you have broad diversification. Be disciplined and stick to your plan.
And, as always, be an informed investor.
I’ve been on holidays since December 12th and the break has been fantastic, giving me a chance to relax with family and recharge my batteries. Unfortunately, the holiday has come to an end and it’s back to work on Monday. I hope you all enjoyed some time off at Christmas and New Year’s as well.
We’ve tinkered with the posting format here for 2015 and so you can expect to see new articles published on Monday’s, Wednesday’s, and Friday’s, in addition to a Weekend Reading update on, you guessed it, the weekend. It amounts to one more article every week, so enjoy the extra content!
This week’s recap:
Every year I enter a stock picking competition over at the Financial Uproar blog. Each contestant submits four stocks at the beginning of the year and the winner gets to gloat in the comments section.
Last year, my picks of Canadian Oil Sands, Agrium, Teck Resources, and (I can’t remember the fourth one) were bad enough to put me in last place with a -15.6% return for the year. Well done, Robb!
On Monday I posted my annual net worth review and was happy to be closing in on $400,000.
On Wednesday, Marie shared her thoughts on some of the more interesting news and events of 2014.
And on Friday I wrote about an easy way to save money this year – by reviewing your annual and monthly subscriptions.
Over on my Rewards Cards Canada blog I looked at what made headlines in the credit card and loyalty program space in 2014 – including Aeroplan’s move to TD and Costco breaking up with Amex and partnering with MasterCard.
Weekend Reading:
Uncomfortable seats, endless fees – here’s why airlines want to make you suffer.
Dan Bortolotti shows why even so called expert predictions are useless in the folly of forecasts.
Downtown Josh Brown looked back at investing in 2014 – the year that nothing worked.
Dan Solin offers his 100% accurate financial predictions for 2015. My favourite is that, “more investors will realize that what correlates most closely with higher expected returns is low cost.”
This entrepreneur started his own business at 21 and just six years later is already pondering retirement.
Episode 25 of the Because Money podcast dealt with budgeting – what is a budget good for, how to keep a budget, and why many people give up on budgets.
Even Santa Claus thinks we need to save more for retirement.
A fascinating read in The Economist about the baseball-card bubble – how a children’s hobby turned into a classic financial mania.
This post looks at the richest people by century, from William the Conqueror to … Muammar Gaddafi?
With life expectancy continuing to rise, the Financial Independence Hub explores the possibility of a 40-year retirement.
Dan Wesley looks back at his first home purchase and suggests some potential pitfalls for new buyers to avoid.
A question we get often – where’s the best place to park short-term savings – is answered perfectly here by MoneySense columnist Bruce Sellery.
Norm Rothery says that adding a low-fee balanced fund is a wise resolution for the new year.
Have a great weekend, everyone!