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Millennials’ top 3 financial priorities

Pay debt, own home, fund retirement

According to the Ontario Securities Commission (OSC)*, millennials – people born in the 1980s & 90s – are the largest contingent in today’s labour force.  Roughly aged 18 to 38 today, this demographic cohort spans those deciding what interests to pursue, to those now hitting stride in their chosen field.

At the personal financial level, it runs the spectrum from emerging from full dependence on your parents, through your own independence, and on to being someone on whom others depend.

The OSC recently surveyed Ontario millennials to get a sense of their investment practices, attitudes and behaviours.  On a high level, here is what came out.

The pre-priority: Saving 

Millennials do save, or at least 80% do.  That doesn’t explain much on an individual basis, but it reinforces the collective wisdom.  From there, the top three financial priorities are reducing debt, buying a home and saving for retirement.

Like any journey, managing finances can be overwhelming to tackle all at once. The necessary first step is to manage spending so that you have savings to work with.

1.  Get that debt

Debt allows you to obtain things you need at times in your life when you don’t have the immediate financial resources to afford them.  Eventually though, you must pay it back, and in the meanwhile pay the cost of carrying that debt.  More than 80% of millennials see this as very or extremely important, with it being the top priority for 1 in 5.

Whether it’s student debt as a headstart, a consumer loan to get ahead, or a credit card that has gotten ahead of you, these types of debt are costly.  With the exception of some regulated student loans, interest payments are not tax-deductible.  That means you have to earn income, pay tax on it, then use what’s left over to pay your interest – and that’s even before you pay down the principal, which is also non-deductible.

Of the three financial priorities, you should make debt reduction proportionately the largest priority in your mind, if not your wallet.  This will free up your cash and concentration to address the other two priorities more effectively.

2.  A home of your own

Homeownership can provide stability, though renting often aligns better with a mobile/flexible lifestyle, especially early in life.  Carefully consider your motivations and financial capacity before deciding if and when to take the plunge as a homeowner.

For millennials in the last half decade, ownership fell four percentage points, which still kept it in line with rates in the 1980s & 90s, at around 40-45%.  This time it has been fueled by low interest rates and by almost half of first-time homebuyers receiving gifts or loans from parents.  However, close to 2/3 are left feeling cash poor after housing costs, with half concerned about meeting mortgage payments if interest rates rise.

If you are a would-be owner, you should stress test your capability by researching and analyzing the full financial commitment of ownership.  Once you have determined that figure, set aside the difference above and beyond your rent every month.  Your expected down payment (less existing savings) divided by that difference is roughly the number of months until you’re financially ready to commit.  If you find yourself having to dip into those savings, then you need to reassess your resources and timing expectations.

3.  Moving from saving to investing

While it appears that millennials are ready to save, the same blanket statement cannot be made about investing.  Less than half are investing those savings.  Of non-investors, the majority are held up by other financial commitments and debt repayments.  Even without those constraints, almost 60% say they delay because they don’t understand investing.

All hope is not lost though: the OSC survey shows that as millennials age, investment understanding rises.  By regularly gathering information, you not only build your store of knowledge, but also the comfort and confidence to know when and how to use it.

On that last point, among your millennial peers 46% have no plan as to how they will meet their financial goals. And of those who claim to have a plan, only 13% have it in writing.

Understanding investing may be a long haul, but understanding yourself is always within reach.  Take the time to sort through your own financial priorities, and put that into a written plan, even a simple one.   As your knowledge grows, you can get more sophisticated, but for the time being the task at hand is to get started.

The principal residence exemption

Tax relief on the home front

Whether you live in a region of galloping growth or more modest increases, rising real estate value can be a double-edged sword for an owner.  Obviously it is comforting as a store of wealth, but can carry with it a stiff tax bill in the form of a taxable capital gain on disposition.

However, if that property is your home, the principal residence exemption (PRE) offers some of the most generous tax relief we have – in simple terms, eliminating the tax on that capital gain.  Indeed, apart from the comfort, stability and control on a personal level, for many the PRE is one of the most appealing aspects of home ownership.  

Principles of being “principal”

To qualify for the PRE, a property must be “ordinarily inhabited” in the year by the taxpayer, his or her current or former spouse or common-law partner (CLP), or a child.  It is a question of fact whether a property is ordinarily inhabited, and in this respect there is no minimum period of time required.

The property in question (generally including land up to one-half hectare) may be in the form of:

  • a house;
  • a cottage;
  • a condominium, apartment unit or part of a duplex;
  • a share in a co-operative housing corporation;
  • a life lease arrangement or similar disposable leasehold interest; or
  • a trailer, mobile home, or houseboat.
    (Consult a lawyer in all cases, but especially in this last category.)

Whatever the form, the fundamental condition is that it must be owned, as opposed to a periodic rental.   Usually the taxpayer must be the owner, though it may also be available to a personal trust of which a qualifying taxpayer is a beneficiary.  Neither a corporation nor a partnership can claim the PRE, though a member of a partnership may be able to use the PRE to reduce or eliminate a gain allocated from a partnership.

Calculating and claiming the PRE 

Only one property may be designated as a taxpayer’s principal residence for a particular taxation year.  Furthermore, since 1981 only one property per family unit can be designated as a principal residence; this precludes the previous ability to multiply the PRE, for example by having one spouse/CLP on title to the house, and the other on the cottage.

Pursuant to Income Tax Regulation 2301, the designation is made using Form T2091, to be filed with the taxpayer’s income tax return for the year in which the property is disposed.  This includes a deemed disposition such as when there is a change in title.  It also applies if there is a change in use, such as converting a property to rental or business purposes.  

The taxpayer is allowed to elect the number of years to apply the PRE.  That said, it is not a matter of choosing specific calendar years, but rather a proportional decision using the following formula:  

 Capital gain TIMES [ 1+ elected-number-of-PRE-years DIVIDED BY number-of-years-owned ]

The purpose of the “1 +” in the numerator is to accommodate for the common situation when there is a sale and purchase of property in the same year.  This assures continuity such that the second property does not lose a year of claim, but does not confer any extra benefit as the PRE can only reduce the tax on a calculated gain to zero. 

Provisos and pitfalls 

Bear in mind that this article is intended as an overview.  A lawyer should always be consulted when contemplating acquisition, disposition or change of use of real property.  Here are a few more issues that could come up in those consultations:

Legal and beneficial ownership

The tax results usually follow from beneficial ownership, which may not be the same as the legally recorded title.  Even so, the taxpayer has the onus to prove entitlement to any tax benefit, so where legal and beneficial ownership diverge there should be a clear record.  This distinction only exists in common law provinces, whereas ownership is a unitary concept under Quebec civil law.

Renting a property

Despite the “ordinarily inhabited” requirement, there is a concession allowing for conversion to rental use for no more than four years.  This may extend beyond four years if employment relocation (taxpayer or spouse/CLP) is the reason for the property being rented. 

Property outside Canada 

Interestingly, the property need not be located in Canada, though the taxpayer would have to be a Canadian resident to make use of the PRE.  

Non-resident owners 

A non-resident holding a Canadian property could technically meet the qualifying criteria (for example if a resident child was the ordinary inhabitant), but would typically be prevented from using the PRE to eliminate a gain on disposition.

Former spouses

In addition to division of assets, a written separation agreement should address ongoing property dealings.  If the PRE is claimed by one party on a post-relationship disposition, the other party’s PRE entitlement will be limited or eliminated on his/her property if the two properties had been concurrently owned during the relationship.

Elections for a deceased person

An executor may use Form T1255 to make the designation for a deceased. In addition to the impact this could have on a surviving or former spouse as outlined above, the executor’s designation could affect estate distribution if properties devolve to different beneficiaries.

Saving for a home – Debate between HBP and TFSA heats up

It is an age-old debate in personal finance whether it is more cost-effective to rent or buy a home — then add in the emotional element.  Assuming the ultimate decision is to buy, attention then turns to assembling the downpayment.  

Looking past the bank of mom and dad, traditionally that meant building up a reserve in a non-registered account beginning years ahead of the intended purchase.  As such deposits are after-tax savings subject to annual taxation on earnings, that could make for a slow exercise.  

Since 1992, accumulation in a registered retirement savings plan has been available for this purpose through the Home Buyers’ Plan (the HBP).  And since 2009, the multi-purpose tax-free savings account has provided another avenue.

While RRSP and TFSA both offer tax-free accumulation, the pre-tax RRSP allows greater gross accumulation, which would seem to favour usage of the HBP.  On closer look however, the choice is neutral at best, and in my opinion instead leans toward employing the TFSA.  

The simplicity of TFSAs

The TFSA became available for deposits in 2009.  The initial $5,000 annual contribution limit increased through indexing to $5,500 in 2013, and earlier this year was moved up to $10,000 (though it will no longer be indexed).  Depending on the outcome of the current federal election, TFSA room may be further adjusted, but there is no suggestion that either the program itself or its tax functioning are at risk.

The TFSA is funded out of after-tax money, so less money is available to go into a TFSA compared to an RRSP deposit.  To illustrate, a person at a 35% marginal tax rate who had a dollar to put into an RRSP (assuming available room), would have only 65 cents to go into a TFSA.  This is a double-edged sword for the RRSP though, as all deposits and all growth will eventually be taxable.

On the other hand, TFSA withdrawals are not taxed.  Thus the amount available for a downpayment is simply the value of the TFSA at any given time.  Once a withdrawal is made, there is no service cost or repayment obligation, and the taxpayer is entitled to a dollar-for-dollar credit for re-contribution the year following withdrawal.

HBP accessing RRSPs

At its core (without getting into all the minutia), the HBP allows a first time home buyer to make a withdrawal from an RRSP without facing current taxation.  The original withdrawal limit of $20,000 per person (or as much as $40,000 for a couple) was increased to $25,000 in 2009, and there is now an election proposal to further increase it to $35,000.

The quid pro quo is that the withdrawn amount must be returned to the RRSP over the 15 years following the home purchase (or sooner if the person is able, and wishes to do so).  Those future replenishing payments are not deductible. 

For a renter anxious to enter into home ownership, the HBP opens the door to a larger pot of money to achieve a desired downpayment.  This could be particularly helpful in getting past the threshold below which an insurance premium would be payable for the mortgage to be covered by the Canadian Mortgage and Housing Corporation.  And obviously a larger downpayment means a smaller amount being financed.

This last point is critical, as larger annual interest charges eat into a household budget for years, and often decades.  But what is the trade-off cost of using the HBP for that downpayment?  

Just as mortgage payments are non-deductible, again so too HBP repayments.  Put another way using our 35% taxpayer once more, roughly $1.50 of the person’s pre-tax income would be required to fund each repayment dollar.  To derive a truer cost of financing, an aspiring  homeowner would be advised to budget based on the combined cost of mortgage and HBP.  

Still, whereas mortgage payments are mandatory (in a practical sense), couldn’t a person simply forego one or more HBP repayments if things get tight?  The answer is yes, but then the un-repaid amount is taken into taxable income – And remember, no cash comes available at that time, as it was spent years earlier to buy the home.  The tax payment itself is not deductible, costing our erstwhile 35% homeowner almost 75 cents of pre-tax income to pay the roughly 50 cents of tax.  And unlike TFSA room, spent RRSP room is non-recoverable.

It is also bears mentioning that likely our homeowner will have higher income in future.  While plainly positive on its own, as household costs ascend that could have an impact on the cost of HBP repayment or tax on un-paid instalments.  The net effect is ambiguous at best.

Transparency trumps 

Perhaps the picture offered here is a bit cynical.  Well-informed, well-disciplined purchasers may very well be able to navigate the HBP rules without harm, and possible to their advantage. Indeed, a couple planning a family could strategically manage the program so some future income is recognized by a low-bracket stay-at-home parent.  

Even so, the true cost of the HBP remains opaque and uncertain – an uncomfortable position to be in for the largest financial transaction of a person’s life.  For my money, the nod should go to the greater transparency and certainty of the TFSA, maybe with the HBP playing a minor supporting role.

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SIDEBAR/CALLOUT

According to Statistics Canada, 180,750 taxpayers did not pay their HBP instalment in 2012 (the last year for which data is available), collectively taking $812 million into income that year.