For Melody and Dave, it was a Christmas present to remember from his grandparents: the full discharge of their $250,000 mortgage. “We are still reeling from their generosity,” Melody writes in an e-mail from Kingston, Ont. The grandparents, who had been holding the mortgage, effectively put an extra $800 a month – or $9,600 a year – into Dave and Melody’s pocket. The gift could not have been more welcome because the couple were getting a bit behind. Dave, a teacher, is 39. Melody, who works part-time in financial services, is 40. They have two children, who are 3 and 6. They have unused contribution room in their registered retirement savings plans (RRSPs) and have lagged in saving money for their children’s education through “This is an incredible gift that has opened up doors to many opportunities that we just couldn’t even consider before,” Melody writes. The question is what to do first: Pay off debt or save and invest? And, how do they make their savings and investments tax effective? We asked Michael Cherney, a Toronto-based financial planner, to look at Melody and Dave’s situation.

What the Expert says

A sudden increase in cash flow is the perfect time to seek financial planning advice, Mr. Cherney says. Dave and Melody haven’t had a chance to get used to having more money so it will be easy for them to save.

First, they need to catch up. From now to 2013, Dave should contribute $10,000 a year to a spousal RRSP for Melody so they can split their income when they retire. He will get the tax deduction. By spreading the contribution over four years instead of making a lump-sum contribution, Dave will “optimize” his tax refund at about 40 per cent a year.

As well, the couple should contribute $10,000 a year to an RESP for their children for the next four years.They will get $500 per child in government grants for each of the four years. And, since they have not maximized their RESP contributions, they can carry forward an extra $500 per child in unused government grants each year.

From 2014 until 2031, when Dave plans to retire, he should continue making contributions to Melody’s spousal RRSP, although the allowable amount will drop to about $2,000 a year once he has exhausted his unused contribution room. They should also continue contributing to their children’s RESP, although this amount, too, will drop over time.

The lower outlays after the first four years will free up money for Melody to open a tax-free savings account (TFSA).

Unlike Dave’s situation, Melody’s retirement savings should go into a TFSA rather than an RRSP because she is in a much lower tax bracket, Mr. Cherney says. With income of $32,000, she is likely to be taxed at the same rate or even higher after she retires, and withdrawing money from a TFSA won’t affect her eligibility for other benefits or trigger a claw-back of Old Age Security.

TFSAs are also more flexible. If, in the meantime, the family’s cash needs to increase, they can withdraw the money from the TFSA without tax or penalty and their contribution room will be restored.

But wait: The $20,000 in new outlays exceeds the $9,600 in new cash flow. Mr. Cherney says about $4,000 of the shortfall will come from Dave’s income tax refund each year. The couple have already been socking away $2,400 a year in savings and can divert that money to the new savings plan. Mr. Cherney suggests they borrow the remaining $4,000 a year ($16,000 in total), adding it to their $13,500 in existing debt.

“I don’t usually counsel clients to borrow funds unless there is a good reason,” the planner says. “Here, there is.”

They could use a home equity line of credit to lower the interest rate they are paying on their $9,000 car loan. As for Melody’s $4,500 student loan, the interest is deductible, so she should not roll it over into a larger loan because she would lose the deductibility.

When Dave and Melody retire – which they hope will be when he turns 60 – they will start drawing payments from the Canada Pension Plan and Dave’s teacher’s pension. In addition, they will convert Melody’s spousal RRSP to a registered retirement income fund (RRIF) and start gradually drawing from it and Melody’s TFSA to supplement their income.

Dave’s pension payments will qualify for income splitting as soon as he retires, allowing them to reduce their average tax rate immediately, “which is a huge benefit, especially for a couple whose incomes were not previously even,” Mr. Cherney says.

The planner estimates their retirement income will be $70,000 a year and that their savings will last until Melody is 95 and Dave is 94. That assumes a 5-per-cent rate of return on their investments and a 2.5-per-cent annual inflation rate.