If you are under the age of 40 and looking for direction on how and when to save your money, ask yourself this important question: “What’s my ‘potential income’?” Knowing that answer can lighten future financial worries, so you can escape the work world when you want and enjoy your healthy, golden years.
So, what is “potential income”? It is the sum of income realized today and the income that will be generated in the future from your personal net worth (that is, assets minus liabilities). When you take into account the “annuitized value” of your future net worth, you can better assess your potential retirement income. You’ll also be better able to choose an “order of investing” that will deliver that income from your net worth — that is, you’ll be able to invest any new money in investment accounts in the order in which it will create the best after-tax results now and in the future. (Knowledge Bureau Report, Aug. 15.) For example, what should come first: a home, a Tax-Free Savings Account (TFSA) or a Registered Retirement Savings Account (RRSP)? It’s a common question because TFSAs and RRSPs are important sources of potential income; one is tax exempt later, the other is tax preferred now.
Investing more dollars in ways that protect them from tax erosion and keeping those dollars invested longer in tax-efficient accounts such as RRSPs and TFSAs is a winning recipe, especially when home ownership is included in your potential income. The equity in your home can significantly enhance your retirement fortunes, according to Statistics Canada’s research paper, Income Adequacy in Retirement: Accounting for the Annuitized Value of Wealth in Canada.
For example, the paper shows, the mean before-tax income per adult in households headed by seniors aged 65 to 74 is 75% of the income of households headed by those 45 to 64. However, when the wealth in the home is considered, income replacement potential increases to 88% of working income.
More important, when these numbers are calculated after taxes, your income replacement potential increases to 105%. You’ll actually be wealthier in retirement because of the contributions from the tax-exempt gains accruing in your principal residence.
An RRSP investment can help because its Home Buyers’ Plan allows you to withdraw up to $25,000 in a calendar year from your RRSPs to buy or build a qualifying home. However, don’t ruin your potential income by paying too much interest on “too much home.” Mortgage interest costs are non-deductible and, if you pay off your mortgage over a long period of time, can erode your equity.
It’s Your Money. Your Life. Buying a home you can afford and paying down your mortgage quickly is an important cornerstone of a sound retirement income plan. Together with tax-efficient financial assets and a healthy net worth — more assets than liabilities — your wealth will grow exponentially, building sound income potential in retirement.