Seven Factors for Financial Success: The Story of Matthew and Nicole
Matthew and Nicole, both 35, are eager to start a family next year. They’re financially comfortable, with a combined gross income averaging $240,000—but there’s a twist. Matthew’s income fluctuates based on bonuses and sales revenue, leaving them with somewhat unpredictable income. On top of that, they’re renting downtown but want to buy a home in a residential neighbourhood. By focussing on seven essential factors, Matthew and Nicole can optimize their chances of financial success.
The Unpredictable Income Curveball
With Matthew’s income deviating by as much as 25% from the average in any given year, cash flow predictability is a challenge. Every quarter can bring surprises—some good, some stressful. Their financial goals are clear but reaching them without stable income is another story. This is where a disciplined approach to irregular income becomes crucial.
The Barrier to Homeownership and Stability
Renting downtown has been ideal for Matthew and Nicole these last few years as their workplaces are within easy walking distance. However, with thoughts of children increasingly prominent in their minds, they want to move into a more family-friendly neighborhood, ideally purchasing a detached home with a yard that suits their anticipated lifestyle. They are feeling somewhat daunted by the inevitable fluctuations in income, though. An emergency fund that covers a mere three months of living expenses isn’t going to cut it anymore.
Seven Steps to a Financially Sound Future
Here’s how Matthew and Nicole can plan for their goals with these seven factors for financial success. By following these steps, they can compensate for Matthew’s substantial but irregular income and work more effectively toward the future they envision.
Establish a Contingency Fund
Their first step is to establish a contingency fund. This fund, ideally covering nine months to one year of essential expenses, goes beyond the regular purpose of an emergency fund, that is, to address situations when unexpected expenses arise. In addition, this fund will act as a stabilizer to counter the variability of Matthew’s income. Matthew and Nicole have been considering whether to use their Tax-Free Savings Accounts (TFSAs) for this purpose for the tax advantages offered, but given the rules around contributions, withdrawals, and re-contributions in the same year in TFSAs, they’ve decided that a non-registered high-interest savings account is the better option.
Build a Stable, Flexible Financial Plan for Savings
Using the “pay yourself first” approach, Matthew and Nicole can prioritize automated contributions to their tax-advantaged accounts like FHSA, RRSP, and TFSA. Here’s how they can make the most of each:
- FHSA (First Home Savings Account): Both contributed the maximum of $8,000 each earlier this year and plan to continue that pattern annually until they have reached their contribution limit of $40,000. This account type is tax-deductible, like an RRSP contribution, and grows tax-free, allowing them to efficiently save for their goal of homeownership. When they have found their qualifying home, they can withdraw the accumulated assets tax-free, like a TFSA withdrawal, and apply it to their home down payment. Ideally, Matthew and Nicole hope to buy a house before five years have elapsed, so with that timeline in mind, they intend to invest in assets that are not subject to potential capital losses.
- RRSP (Registered Retirement Savings Plan): Their employer-matched RPP contributions cover 10% of their salaries, but they can contribute an additional 8% to maximize their RRSP limits—$12,800 for Matthew and $6,400 for Nicole. Based on their incomes and the consequent tax deductions, it is a “no-brainer” to prioritize this account type. They are also aware of the Home Buyers’ Plan (HBP), which has not only been expanded to $60,000 but can be combined with the FHSA. Given the sizes of their respective RRSPs, $210,000 for Matthew and $105,000 for Nicole, they feel that they can manage using the HBP to withdraw from their accounts to help fund their down payment.
- TFSA (Tax-Free Savings Account): For flexible savings and investments, TFSA contributions offer liquidity and tax-free growth. Automating monthly contributions here allows them to build a fund that’s adaptable to short- or long-term needs. Nicole and Matthew have automated contributions from the beginning of their careers. Initially, they used mutual funds, which allowed them to automate both the contributions and the purchases, but a few years ago they switched to Exchange-Traded Funds (ETFs) to lower their costs which meant they had to manage the actual purchases on their own. Anticipating a significant withdrawal from their TFSAs to add to their home down payment, which are each worth $180,000 right now, they have gradually lowered their asset allocation from 100% equity to 50% equity/50% fixed income as of this year.
Prioritizing Financial Goals with Separate Flexible Accounts
For Matthew and Nicole, aligning each account with specific goals helps them stay organized and focused, but maintaining flexibility across accounts provides the adaptability they need for life’s inevitable changes, especially in the face of Matthew’s variable income. Here’s a breakdown of their approach:
- FHSA as the Primary Home-Buying Fund: Since the FHSA offers tax-deductible contributions, tax-free growth, and tax-free withdrawals when funds are used for a home purchase, dedicating it solely to their home-buying goal is a smart strategy. Both Matthew and Nicole can maximize contributions to this account until they’re ready to buy, taking advantage of both tax deductions and growth. This account will serve as the first place they draw from for their down payment, ensuring tax-efficient use of these funds.
- RRSPs and the Home Buyers’ Plan (HBP): Matthew’s and Nicole’s RRSPs provide another opportunity to support their home-buying goal through the HBP, which allows them to each withdraw up to $60,000 tax-free for a home purchase. Given Matthew’s current balance of $210,000 and Nicole’s $105,000, they have the necessary funds to maximize their use of the HBP without exhausting their retirement savings. To protect their accounts against market volatility, they’ve already adjusted their RRSP portfolios to 50% equity, reducing the risk of an HBP withdrawal taking place during a significant market downturn.
This approach keeps their RRSPs focussed on retirement savings, allowing the balance of the RRSP not withdrawn for the HBP to grow and provide long-term value for retirement. After they complete their home purchase, they will resume maximizing their RRSP contributions – alongside their intentions to repay the HBP according to the prescribed schedule – to take advantage of tax deferrals for retirement savings, especially once the FHSA funds have been utilized.
- TFSAs for Medium- and Long-Term Goals: With each of their TFSAs currently worth $180,000 and their asset allocation set at 50% equities, this account offers tremendous flexibility. By using the TFSAs as a medium- to long-term growth vehicle, they gain the benefit of tax-free growth while keeping funds accessible for future life events, whether for their anticipated home purchase, possible home renovations, anticipated child-related expenses, or even early retirement if desired.
Importantly, maintaining a diverse mix of investments in their TFSAs allows Matthew and Nicole to adapt to various life goals without tax implications on withdrawals, giving them the flexibility to decide as their goals evolve.
- Contingency Fund in a Non-Registered High-Interest Savings Account (HISA): Their jointly owned non-registered HISA, dedicated solely to contingency savings, provides quick, easy access to support living expenses when Matthew’s income dips. Since they’ve set a goal of holding 9 to 12 months of expenses here, they will be well-prepared for the inevitable fluctuations, and having this fund outside of tax-advantaged accounts preserves room in their FHSAs, RRSPs, and TFSAs.
Managing Debt Wisely
Although they don’t have debt at the moment, given Matthew and Nicole have plans to purchase a home that will likely be worth close to $1 million, they’ll want to make wise choices to limit stress and ensure the long-term viability of their cash flow (income and spending). Considerations include:
- Prioritize affordability over the maximum loan amount: Part of the reason that Matthew and Nicole were able to accumulate significant balances in their RRSPs and TFSAs is that they were able to stay in the same apartment for several years under a regime that capped annual increases in the rent. However, if they go ahead and purchase a new home, they will have to overhaul their expectations about their cash flow. At current interest rates, they expect monthly mortgage payments of about $3,700 per month, and when property taxes, insurance, etc., are factored in, they expect close to $4,400 per month.
- Choose the right mortgage terms: The reality is that Matthew and Nicole will almost certainly have to take on a mortgage with a 25-year amortization. They prefer fixed-term mortgages, too, for the reliability of the payments, but given the recent trend toward lower interest rates, they plan to take a shorter-term mortgage in hopes that they can renew at an even lower rate when the initial term is done.
- Build in prepayment options: When Matthew’s income is trending toward his long-term average or higher, they expect to be able to make lump-sum payments to the principal to allow them to pay off their mortgage faster. However, if that opportunity happens when interest rates are back near their lows of just a few years ago, they may choose to increase the amounts they dedicate toward investing as expected investment returns may exceed the likely benefit from a mortgage principal paydown.
Practicing Conscious Spending
With a high combined income, it’s easy for lifestyle creep to set in. One classic response is the “50/30/20 rule”: 50% of income for needs, 30% for wants, and 20% for savings. However, Matthew and Nicole prefer the “pay yourself first” approach. They aim to maximize their savings and use the balance for their needs and wants. In their view, the contingency fund can be drawn on when income is lower and replenished when their income increases. This has been their habit until now, but with a new home purchase increasingly prominent in their thinking, they wonder how their current pattern will adapt to this anticipated new reality. They are counting on their thoughtful approach to spending to help them avoid overextending themselves.
Optimizing Tax Efficiency
Matthew and Nicole’s RRSP contributions lower taxable income and support long-term retirement goals. Additionally, contributions to the FHSA and TFSA provide both flexibility and tax-free growth. The FHSA is particularly flexible, allowing funds not used for a home purchase within 15 years to be rolled over into an RRSP without affecting the contribution room. It also offers tax deductions for contributions, tax-free growth, and tax-free withdrawals for qualifying home purchases, similar to the TFSA. The TFSA allows for withdrawals at any time, has no age limit for contributions, and its withdrawals are tax-free. By prioritizing these accounts, they maximize tax savings and free up cash flow for other priorities.
Investing for Long-Term Growth
Once their contingency fund and short-term savings are secure, Matthew and Nicole focus on low-cost, diversified investments within their RRSPs and TFSAs. Assuming they proceed with their plans to buy a home, they will withdraw substantial amounts from these accounts. As they rebuild their savings with new contributions and repay the HBP, they plan to use ETFs invested in a balanced mix of stocks and bonds. This strategy offers potential growth over time while supporting their goal of a stable financial future. They are also considering the savings needed for their future children’s post-secondary education. When the time comes, they will likely open a Registered Education Savings Plan (RESP) that follows a similar balanced approach.
The Path to Homeownership and Financial Confidence
With a structured plan in place, Matthew and Nicole can confidently work toward their homeownership goal. By setting up a contingency fund, automating savings, and prioritizing tax-advantaged accounts, they will be prepared to handle unexpected financial challenges as well as their regular expenses.” This combination of planning and adaptability allows them to move steadily toward a financially secure future and soon, a new home.
Anticipating the Results
Imagine the reward: money toward a down payment saved up in their FHSAs, a contingency fund to handle any income fluctuations, and a solid foundation for retirement in their RRSPs and TFSAs. With their short- and long-term goals supported by this comprehensive financial plan, Matthew and Nicole won’t just be managing finances—they’ll be living a lifestyle supported by the stability and freedom they worked hard to build.
The steady progress toward their home and family goals brings not just financial security but also the confidence to face the future. By addressing each of these seven factors, they are not only setting themselves up for financial success but also laying the groundwork for a fulfilling life filled with the possibilities they envision for themselves and their future family.
This is the 266th blog post for Russ Writes, first published on 2024-10-28
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