Boom, trust and echo

It’s a truism in the advisory business that client relationships can very often turn into family affairs. Building a sound relationship with one person can lead to relationships with spouses, close relatives and, eventually, the children.

When we talk about clients, we often focus on baby boomers, the generation with the greatest numbers and the largest wealth accumulation. But we shouldn’t forget their Generation Y children, the so-called echo boomers, born between the late 1970s and the mid-1990s. The oldest among them are around 30, an age when careers and financial futures are really stating to take shape.

In this column, I’m going to talk about one way you can help bridge the generational financial gap between existing boomer clients and their echo boomer kids. Naturally, your first thought is to support your existing client, but you can continue to build and strengthen that relationship while also creating the basis for a future client relationship with the child.

Getting a great start

Let’s consider the example of the daughter of an existing client. We’ll call her Ashley – an appropriate choice since it was the fourth most popular name for girls born during the 1980s. Ashley is in her late 20s, single, and has no dependents. She does, however, have ambitions and a solid base on which to build her dreams.

This year, she obtained an MBA from a well-respected Canadian business program that ranks in the top 100 on The Economist’s prestigious ranking of world business schools. An oil services consultancy in Calgary was sufficiently impressed that it offered Ashley a position earning $80,000 a year. Now she’s looking to buy a condominium, preferably in Calgary’s Mission District, a trendy inner-city neighbourhood close to downtown, replete with cafes and restaurants.

She wants to pay around $250,000, near the low end of the market in this area. More to the point, how can you help her make the purchase in an intelligent way?

Ashley’s basic financial picture is encouraging. She has already paid off her student loans and she’s fervently committed to paying her credit card balance in full each month. The plan is to save $8,000 or 10% of her gross earnings annually which, over three years, will produce about $25,000 for a down payment. As well, her parents have said they will match her savings in order to make a 20% down payment, thus avoiding additional CMHC mortgage insurance.

Two key savings options

Ashley’s goal is achievable, but she will need discipline and sound advice to reach it. The easiest way to set aside the money – and you might suggest this – would be to set up a pre-authorized chequing plan from her bank account and invest the funds in a dedicated investment account. Of course, Calgary is an expensive city and costs like rent could rise substantially over the next three years. While she’s making good money and has the prospect of salary increases, that 20% down payment target could prove elusive if economic growth and rising real estate costs push condominium prices higher. When it comes time to buy the condo, Ashley’s budget will also take a hit from closing costs that could be as much as 2% of the value of the property.

Ashley understands the potential hazards, but she has a dilemma that you can help solve. What type of account should she use to build her savings and reach her goal in a tax-efficient manner? A tax-free savings account and a registered retirement savings plan that would allow her to make use of the Home Buyer’s Plan are the main alternatives, but which would be best?

She already knows the essential differences and similarities between TFSAs and RRSPs. The first isn’t tax deductible while the second one is; the first has an annual contribution limit of $5,000 (linked to inflation) while the second allows annual contributions based on earned income, resulting in higher maximums; the first allows tax-free withdrawals (which add to the next year’s contribution room) while the second taxes withdrawals with no addition to contribution room; the first requires no conversions while the second requires conversion to a registered retirement income fund or annuity at age 71; attribution rules do not apply to the first, but they may to the second if withdrawals are made from a spousal RRSP under certain conditions (although, attribution rules are not currently a concern since Ashley is single); and both permit the same range of eligible investments.

Either choice will work

The first point you could make to her is that both accounts will allow her to reach her savings goal. In the case of a TFSA, Ashley will be able to accumulate $25,000 over three years despite the annual $5,000 a year contribution limit. Here’s how it would happen. In 2009 and 2010, the first years in which TFSAs were available, she didn’t make a TFSA contribution so there’s $10,000 in unused contribution room that she can carry over. Assuming she contributes the maximum allowable $5,000 in each of the next three years, and adds that carried forward amount of $10,000, Ashley will have set aside the desired $25,000. As for a RRSP, Ashley has yet to make contributions since she hasn’t had earned income from previous years. However, in each of 2011, 2012 and 2013, she will at least have contribution room of $14,400 based on 18% of her $80,000 in earned income. While Ashley’s plan is to save $8,000 a year, hypothetically, she would be well over her $25,000 target if she made her maximum contributions in those years. And if she gets a raise, a reasonable assumption, she would have even more RRSP contribution room.

She should also be aware of the differences between the two types of accounts when withdrawals are made. Money withdrawn from a TFSA is not taxed, and the amount withdrawn is added to Ashley’s contribution room for the following year. But there’s no requirement to pay back a TFSA withdrawal. If she uses a RRSP, she’ll be able to withdraw up to $25,000 tax-free through the Home Buyers’ Program. There are certain terms and conditions that must be met to make an HBP withdrawal, one that is often forgotten is that RRSP contributions must remain in the RRSP for at least 90 days before they can be withdrawn under the HBP. Also, Ashley will have to repay that money to her RRSP over a maximum of 15 years; otherwise it will be considered ordinary income and taxed accordingly.

Ashley might also consider the tax implications of these different types of accounts. Normally, you would contribute to a TFSA if your current marginal tax rate is lower than the marginal tax rate expected in retirement. Conversely, a RRSP is preferable if your current marginal tax rate is higher than the rate expected in retirement.

This choice is problematic in Ashley’s case. She is young and will no doubt experience many changes in her work and personal life in coming years, so her retirement income is very difficult to predict with any precision. What we do know is that her current marginal tax rate is 32%, below the top marginal tax rate of 39% that Alberta applies to income of more than $125,000. She’s engaged in a three-year savings plan that aims to set aside $8,000 annually. If she saves in the form of RRSP contributions, she will have yearly tax savings of $2,560 from the RRSP deduction.

The RRSP approach has the edge

While either the RRSP or TFSA approach will work for Ashley, I would advise her lean toward the former. She could save through her RRSP and subsequently withdraw her savings under the Home Buyers’ Program. This way, she gets a tax refund each year based on her RRSP contribution. And when it comes time to buy her condominium, she’ll enjoy a tax and interest-free loan. Using an RRSP to save will also allow her to invest more up-front compared to an equivalent TFSA, assuming she invests the refund and she’s able to set aside more than her target of $8,000 a year. However, Ashley should also anticipate added expenses in her life so she’ll need to build in some flexibility. She could also invest her yearly tax refunds in a TFSA.

A relationship with a future

There are many options for Ashley as she moves toward her first significant savings goal. The main point is that she has a plan and is moving in the right direction, laying the foundation for a solid financial future. If you can participate in the early stages by providing useful advice, that is all the better. You’ve helped the parents; now you can help their child. Think of it as an inter-generational transfer of expertise.