Chapter 3
Getting Your Financial House in Order
IN THIS CHAPTER
Saving money for emergencies
Managing your debt and setting financial goals
Funding retirement and university savings plans
Understanding tax issues
Exploring diversification strategies
Before you make any great, wealth-building investments, you should get your financial house in order. Understanding and implementing some simple personal financial management concepts can pay-off big for you in the decades ahead.
You want to know how to earn healthy returns on your investments without getting clobbered, right? Who doesn’t? Although you generally must accept greater risk to have the potential for earning higher returns (see Chapter 2 in Book 1), this chapter tells you about some high-return, low-risk investments. You have a right to be skeptical about such investments, but don’t stop reading this chapter yet. Here, you find some easy-to-tap opportunities for managing your money that you may have overlooked.
Establishing an Emergency Reserve
You never know what life will bring, so having a readily accessible reserve of cash to meet unexpected expenses makes good financial sense. If you have a sister who works on Bay Street as an investment banker or a wealthy and understanding parent, you can use one of them as your emergency reserve. (Although you should ask them how they feel about that before you count on receiving funding from them!) If you don’t have a wealthy family member, the ball’s in your court to establish a reserve.
Make sure you have quick access to at least three months’ to as much as six months’ worth of living expenses. Keep this emergency money in a high-interest savings account or a Tax-Free Savings Account (TFSA). You may also be able to borrow against your home equity should you find yourself in a bind, but these options are much less desirable.
If you don’t have a financial safety net, you may be forced into selling an investment that you’ve worked hard for. And selling some investments, such as real estate, costs big money (because of transaction costs, taxes, and so on).
Consider the case of Warren, who owned his home and rented an investment property on the west coast. He felt, and appeared to be, financially successful. But then Warren lost his job, accumulated sizable medical expenses, and had to sell his investment property to come up with cash for living expenses. Warren didn’t have enough equity in his home to borrow. He didn’t have other sources — a wealthy relative, for example — to borrow from either, so he was stuck selling his investment property. Warren wasn’t able to purchase another investment property and missed out on the large appreciation the property earned over the subsequent two decades. Between the costs of selling and taxes, getting rid of the investment property cost Warren about 15 per cent of its sales price. Ouch!
Evaluating Your Debts
Yes, paying down debts is boring, but it makes your investment decisions less difficult. Rather than spending so much of your time investigating specific investments, paying off your debts (if you have them and your cash coming in exceeds the cash going out) may be your best high-return, low-risk investment. Consider the interest rate you pay and your investing alternatives to determine which debts you should pay off.
Conquering consumer debt
Borrowing via credit cards, auto loans, and the like is an expensive way to borrow. Banks and other lenders charge higher interest rates for consumer debt than for debt for investments, such as real estate and business. The reason: Consumer loans are the riskiest type of loan for a lender.
Many folks have credit card or other consumer debt, such as an auto loan, that costs 8, 10, 12, or perhaps as much as 18-plus per cent per year in interest (some credit cards whack you with interest rates exceeding 20 per cent if you make a late payment). Reducing and eventually eliminating this debt with your savings is like putting your money in an investment with a guaranteed tax-free return equal to the rate that you pay on your debt.
For example, if you have outstanding credit card debt at 15 per cent interest, paying off that debt is the same as putting your money to work in an investment with a guaranteed 15 per cent tax-free annual return. Because the interest on consumer debt isn’t tax-deductible, you need to earn more than 15 per cent by investing your money elsewhere in order to net 15 per cent after paying taxes. Earning such high investing returns is highly unlikely, and in order to earn those returns, you’d be forced to take great risk.
Consumer debt is hazardous to your long-term financial health (not to mention damaging to your credit score and future ability to borrow for a home or other wise investments) because it encourages you to borrow against your future earnings. People often say such things as “I can’t afford to buy most new cars for cash — look at how expensive they are!” That’s true, new cars are expensive, so you need to set your sights lower and buy a good used car that you can afford. You can then invest the money you’d otherwise spend on your auto loan.
However, using consumer debt may make sense if you’re financing a business. If you don’t have home equity, personal loans (through a credit card or auto loan) may actually be your lowest-cost source of small-business financing.
Mitigating your mortgage
Paying off your mortgage more quickly is an “investment” for your spare cash that may make sense for your financial situation. However, the wisdom of making this financial move isn’t as clear as paying off high-interest consumer debt because mortgage interest rates are generally lower. When used properly, debt can help you accomplish your goals — such as buying a home or starting a business — and make you money in the long run. Borrowing to buy a home generally makes sense. Over the long term, homes generally appreciate in value.
If your financial situation has changed or improved since you first needed to borrow mortgage money, you need to reconsider how much mortgage debt you need or want. Even if your income hasn’t escalated or you haven’t inherited vast wealth, your frugality may allow you to pay down some of your debt sooner than the lender requires. Whether paying down your debt sooner makes sense for you depends on a number of factors, including your other investment options and goals (in other words, your “opportunity cost”).
When evaluating whether to pay down your mortgage faster, you need to compare your mortgage interest rate with your investments’ rates of return (which is defined in Chapter 2 of Book 1). Suppose you have a fixed-rate mortgage with an interest rate of 6 per cent. If you decide to make investments instead of paying down your mortgage more quickly, your investments need to produce an average annual rate of return, of about 6 per cent to come out ahead financially. If this money is being invested outside of a tax-deferred Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA), you’ll need to earn anywhere from 8 to 12 per cent — depending on the type of investment — so that after taxes, you have earned 6 per cent.
Besides the most common reason of lacking the money to do so, other good reasons not to pay off your mortgage any quicker than necessary include the following:
- You contribute instead to your RRSP or other retirement plan, especially if your employer matches your contribution. Paying off your mortgage faster has no tax benefit. By contrast, putting additional money into a retirement plan can immediately reduce your income tax burden. The more years you have until retirement, the greater the benefit you receive if you invest in your retirement plans. Thanks to the compounding of your retirement plan investments without the drain of taxes, you can actually earn a lower rate of return on your investments than you pay on your mortgage and still come out ahead. (The various retirement plans are discussed in detail in the later section “Funding Your Registered Retirement Savings Plan.”)
-
You’re willing to invest in growth-oriented, volatile investments, such as stocks and real estate. In order to have a reasonable chance of earning more on your investments than it costs you to borrow on your mortgage, you must be aggressive with your investments. As discussed in Chapter 2 of Book 1, stocks and real estate have produced annual average rates of return of about 8 to 10 per cent. You can earn even more by creating your own small business or by investing in others’ businesses. Paying down a mortgage ties up more of your capital, and thus reduces your ability to make other attractive investments. To more aggressive investors, paying off the house seems downright boring — the financial equivalent of watching paint dry.
You have no guarantee of earning high returns from growth-type investments, which can easily drop 20 per cent or more in value over a year or two. - Paying down the mortgage depletes your emergency reserves. Psychologically, some people feel uncomfortable paying off debt more quickly if it diminishes their savings and investments. You probably don’t want to pay down your debt if doing so depletes your financial safety cushion. Make sure that you have access — through a high-interest savings account, money market fund, or other sources (a family member, for example) — to at least three months’ worth of living expenses (as explained in the earlier section “Establishing an Emergency Reserve”).
Don’t be tripped up by the misconception that somehow a real estate market downturn, such as the one that most areas experienced in the mid- to late 2000s, will harm you more if you pay down your mortgage. Your home is worth what it’s worth — its value has nothing to do with your debt load. Unless you’re willing to walk away from your home and send the keys to the bank (also known as default), you suffer the full effect of a price decline, regardless of your mortgage size, if real estate prices drop.
Establishing Your Financial Goals
You may have just one purpose for investing money, or you may desire to invest money for several different purposes simultaneously. Either way, you should establish your financial goals before you begin investing. Otherwise, you won’t know how much to save.
For example, when Eric was in his twenties, he put away some money for retirement, but also saved a stash so he could hit the eject button from his job in management consulting. Eric knew that he wanted to pursue an entrepreneurial path and that in the early years of starting his own business, he couldn’t count on an income as stable or as large as the one he made from consulting.
Eric invested his two “pots” of money — one for retirement and the other for his small-business cushion — quite differently. As discussed in the later section “Choosing the Right Investment Mix,” you can afford to take more risk with the money you plan on using longer term. So, he invested the bulk of his retirement nest egg in stock mutual funds.
With the money he saved for the start-up of his small business, he took an entirely different track. He had no desire to put this money in risky stocks — what if the market plummeted just as he was ready to leave the security of his full-time job? Thus, he kept this money safely invested in a money market fund that had a decent yield but didn’t fluctuate in value.
Tracking your savings rate
To accomplish your financial goals (and some personal goals), you need to save money, and you also need to know your savings rate. Your savings rate is the percentage of your past year’s income that you saved and didn’t spend. Without even doing the calculations, you may already know that your rate of savings is low, non-existent, or negative and that you need to save more.
Part of being a smart investor involves figuring out how much you need to save to reach your goals. Not knowing what you want to do a decade or more from now is perfectly normal — after all, your goals and needs evolve over the years. But that doesn’t mean you should just throw your hands in the air and not make an effort to see where you stand today and think about where you want to be in the future.
An important benefit of knowing your savings rate is that you can better assess how much risk you need to take to accomplish your goals. Seeing the amount that you need to save to achieve your dreams may encourage you to take more risk with your investments or find other sources of income if you are not willing to take on more risk.
During your working years, if you consistently save about 10 per cent of your annual income, you’re probably saving enough to meet your goals (unless you want to retire at a relatively young age). On average, most people need about 75 per cent of their pre-retirement income throughout retirement to maintain their standards of living.
If you’re one of the many people who don’t save enough, you need to do some homework. To save more, you need to reduce your spending, increase your income, or both. For most people, reducing spending is the more feasible way to save.
To reduce your spending, first figure out where your money goes. You may have some general idea, but you need to have facts. Get out your chequebook register, examine your online bill-paying records, and review your credit card bills and any other documentation that shows your spending history. Tally up how much you spend on dining out, operating your car(s), paying your taxes, and on everything else. After you have this information, you can begin to prioritize and make the necessary trade-offs to reduce your spending and increase your savings rate. Earning more income may help boost your savings rate as well. Perhaps you can get a higher-paying job or increase the number of hours that you work. But if you already work a lot, reining in your spending is usually better for your emotional and economic well-being.
If you don’t know how to evaluate and reduce your spending or haven’t thought about your retirement goals, looked into what you can expect from the Canada Pension Plan (or Quebec Pension Plan) and social security, or calculated how much you should save for retirement, now’s the time to do so. Pick up the latest edition of Personal Finance For Canadians For Dummies (written by Eric Tyson and Tony Martin, and published by Wiley) to find out all the necessary details for retirement planning and much more.
Determining your investment tastes
Many good investing choices exist: You can invest in real estate, the stock market, mutual funds, exchange-traded funds, or your own or some else’s small business. Or you can pay down mortgage debt more quickly. What makes sense for you depends on your goals as well as your personal preferences. If you detest risk-taking and volatile investments, paying down your mortgage, as recommended earlier in this chapter, may make better sense than investing in the stock market.
To determine your general investment tastes, think about how you would deal with an investment that plunges 20 per cent, 40 per cent, or more in a few years or less. Some aggressive investments can fall fast. (See Chapter 2 in Book 1 for examples.) You shouldn’t go into the stock market, real estate, or small-business investment arena if such a drop is likely to cause you to sell low or make you a miserable, anxious wreck. If you haven’t tried riskier investments yet, you may want to experiment a bit to see how you feel with your money invested in them.
A simple way to “mask” the risk of volatile investments is to diversify your portfolio — that is, to put your money into different investments. Not watching prices too closely helps, too — that’s one of the reasons real estate investors are less likely to bail out when the market declines. Stock market investors, on the other hand, can get daily and even minute-by-minute price updates. Add that fact to the quick phone call or click of your computer mouse that it takes to dump a stock in a flash, and you have all the ingredients for short-sighted investing — and potential financial disaster.
Funding Your Registered Retirement Savings Plan
Saving money is difficult for most people. Don’t make a tough job impossible by forsaking the tax benefits that come from contributing money to — and investing inside — a Registered Retirement Savings Plan (RRSP).
Understanding RRSPs
The only condition you have to meet to be able to contribute to an RRSP is you have to have what the government calls earned income. You work hard for any kind of dollars that flow into your household, but it doesn’t all qualify. For most people, their earned income is their salary, along with any bonuses or commissions. If you’re self-employed or an active partner in a business, it includes any net income from your business. Earned income also includes any taxable alimony and maintenance payments as well as any research grants, royalties, and net rental income.
If you have any earned income in a year, you can contribute up to 18 per cent of that total to your RRSP in the following year. That is only one of three limitations that put a ceiling on how much you can contribute. There is a straight dollar ceiling set, plus your maximum may be further reduced if you belong to a company pension plan. Here are the specific rules:
- Regardless of how much earned income you have, there is an absolute maximum dollar amount you can contribute for any one year. For 2020 the maximum RRSP contribution limit was $27,230.
- The maximum amount you are allowed to contribute may be further reduced if you belong to a company pension plan. The government calculates the value of contributions made to your employer-sponsored pension plan, called a pension adjustment (PA), and deducts this from whichever is less — the absolute dollar maximum allowed for the year or 18 per cent of your earned income — to arrive at your allowable contribution.
Your pension adjustment for a given year should appear in that year’s T4 slip you receive from your employer. (It should also be stated on the Notice of Assessment you receive in the spring after you file your tax return for the previous year.)
Gaining tax benefits
RRSPs should be called “tax-reduction accounts” — if they were, people may be more motivated to contribute to them. Contributions to these plans are tax deductible. Suppose you pay about 36 per cent between federal and provincial income taxes on your last dollars of income. (See the later section “Figuring your tax bracket.”) With an RRSP, you can save yourself about $360 in taxes for every $1,000 you contribute in the year that you make your contribution.
After your money is in a retirement plan, any interest, dividends, and appreciation grow inside the account without current taxation. You defer taxes on all the accumulating gains and profits until you withdraw your money down the road. In the meantime, more of your money works for you over a long period of time.
Understanding deductions and contributions
It pays to understand the language around RRSPs, which can be confusing. Not understanding the basics can leave you missing out on some of their benefits.
The key danger comes from the use of two phrases. The first is “contribution limit.” One might assume this refers to just how much money you can put into your RRSP in any one year. Not so. The second phrase is similar: “deduction limit.” Again, you might understandably think this refers to how much of your RRSP deduction you can claim in any one year. Wrong again.
In both cases, what is actually being addressed is how much your earned income in any one year gives you in terms of a dollar amount you can contribute to your RRSP. But you aren’t required to contribute that money in that same year. Further, in prior years, you may not have put in the maximum for each individual year. These unused sums — often called “contribution room” — are carried forward, and can be both contributed to your RRSP and deducted from your income in future years. As a result, the amount you contribute to your RRSP, and subsequently claim as a deduction on your tax return, can be far in excess of your “contribution limit” or “allowable deduction” for that same year.
Say that based on your last year’s salary, your new allowable contribution is $5,000, but you only contribute $2,000. Next year, your new allowable contribution is another $5,000, based on your income this year. This means the amount you can put into your RRSP will then be the sum of $5,000 and the $3,000 of allowable contribution you didn’t use this year, for a total of $8,000.
When it comes to your RRSP contribution, it’s not a case of “use it or lose it.” If you don’t put in the full amount you’re allowed to in any given year, you can carry forward that amount — your RRSP deduction limit — and use it in the future. Think of it as having an ongoing allowable contribution account. Any time you have earned income, the next year you can add to your allowable contribution account the difference between the amount that year’s earned income gave you the right to contribute and what you actually put into your RRSP.
Starting early for maximum profits
Failing to take full advantage of registered retirement plans early in their working lives is one of the single most common mistakes investors make when it comes to RRSPs and RPPs (Registered Pension Plans). Often this is because of their enthusiasm to spend or invest outside of registered retirement plans. Not investing inside tax-sheltered retirement plans can cost you hundreds, perhaps thousands, of dollars per year in lost tax savings. Add that loss up over the many years that you work and save, and not taking advantage of an RRSP or RPP can easily cost you tens of thousands to hundreds of thousands of dollars in the long term. Ouch!
To take advantage of registered retirement plans and the tax savings that accompany them, you must first spend less than you earn. Only after you spend less than you earn can you afford to contribute to a registered retirement plans (unless you already happen to have a stash of cash from previous savings or inheritance).
If you enjoy spending money and living for today, you should be more motivated to start saving sooner. The longer you wait to save, the more you ultimately need to save and, therefore, the less you can spend today!
The sooner you start to save, the easier it will be to save enough to reach your goals because your contributions have more years to compound. Each decade you delay saving approximately doubles the percentage of your earnings that you need to save to meet your goals. For example, if saving 5 per cent per year in your early 20s gets you to your retirement goal, waiting until your 30s to start may mean socking away 10 per cent to reach that same goal; waiting until your 40s, 20 per cent. Beyond that, the numbers get truly daunting.
Taming Your Taxes in Non-Retirement Accounts
When you invest outside of tax-deferred retirement plans, the profits and distributions on your money are subject to taxation. So, the non-retirement investments that make sense for you depend (at least partly) on your tax situation.
If you have money to invest, or if you’re considering selling current investments that you hold, taxes should factor into your decision. But tax considerations alone shouldn’t dictate how and where you invest your money. You should also weigh investment choices, your desire and the necessity to take risk, personal likes and dislikes, and the number of years you plan to hold the investment (see the later section “Choosing the Right Investment Mix” for more information on these other factors).
Figuring your tax bracket
You may not realize it, but even though you only see one income tax deduction on your pay statement, you pay both federal and provincial income tax. And in any year, you pay less tax on the first dollars of your earnings and more tax on the last dollars of your earnings. To make things even more complicated, each province uses different tax rates and applies them at different income levels.
For example, consider someone who is single and had a taxable income totaling $60,000 during 2020. They would pay 15 per cent federal tax on their first $48,535 of income. On the remaining $11,465 ($48,535 up to $60,000) they would pay 20.50 per cent federal tax.
In addition, the province in which they live would also charge taxes in a similar tiered or laddered fashion, but using different rates and tax brackets. To make matters even more complicated, no two provinces use the same brackets or rates. For example, if our $60,000 earner lived in B.C., they would pay 5.06 per cent provincial tax on the first $41,725 of income, and 7.70 per cent on the remainder. If they called Nova Scotia home, their provincial taxes would be 8.79 per cent on the first $29,590, 14.95 per cent on the next $29,589 (the income from $29,591 up to $59,180), and 16.67 per cent on the last $819 (the income from $59,181 to $60,000).
One further wrinkle is that, thanks to a tax credit called the basic personal amount, Canadians effectively do not pay any federal tax on the first $12,296 of income they earn in a year. Each province also has its own basic personal amount, meaning there is no provincial tax on anywhere from your first $9,498 to $19,369, depending on where you live.
Your marginal tax rate is the rate of tax you pay on your last, or so-called highest, dollars of income. Knowing your marginal tax rate allows you to quickly calculate the following:
- Any additional taxes that you would pay on additional income, like interest income from investments
- The amount of taxes that you save if you contribute more money into retirement plans or reduce your taxable income (for example, if you choose investments that produce tax-free income)
Table 3-1 shows the federal marginal brackets and tax rates for 2020.
Table 3-2 shows the approximate combined federal and provincial marginal tax brackets for B.C. residents. Your actual rates will vary, depending on the province you live in. Note that not only does each province have its own, different rates for different income ranges for calculating your taxes, they have many more marginal tax rates and different levels of tax credits.
TABLE 3-1 2020 Federal Income Tax Rates
|
Taxable Income |
Tax Rate |
|---|---|
|
Up to $48,535 |
15% |
|
48,536 to $97,069 |
20.5% |
|
$97,070 to $150,473 |
26% |
|
$150,474 to $214,368 |
29% |
|
$214,369 and higher |
33% |
TABLE 3-2 Example of Approximate 2020 Combined Federal and Provincial Income Tax Rates for B.C. Residents
|
Approximate Taxable Income |
Approximate Marginal Tax Rate |
|---|---|
|
$0 to $41,725 |
21% |
|
$41,725 to $48,535 |
23% |
|
$48,535 to $83,451 |
28% |
|
$83,451 to $95,812 |
31% |
|
$95,812 to $97,069 |
33% |
|
$97,069 to $116,344 |
38% |
|
$116,344 to $150,473 |
41% |
|
$150,473 to $157,748 |
44% |
|
$157,748 to $214,368 |
46% |
|
$214,368 and higher |
50% |
Knowing what’s taxed and when to worry
Interest you receive from bank accounts, guaranteed investment certificates (GICs), and bonds is generally taxable. It’s treated just like your regular income, and taxed at the same marginal rate. (We discuss bonds in Chapter 5 of Book 3.)
If you sell stocks, bonds, rental property, or a position in a small business for more than what you paid, the profit is called a capital gain. Taxation on your capital gains, which is the profit (sales minus associated costs) on an investment, works under a unique system. You have to include half (50 per cent) of your net gain in your income, which is then taxed at your marginal tax rate. The result is that the tax rate you effectively pay on capital gains — your effective tax rate — will be half of your marginal tax rate.
Suppose that you’re in a marginal tax bracket of approximately 24 per cent (note that exact tax rates and marginal tax brackets vary from province to province). Your effective tax rate on capital gains will be 12 per cent. If you are in the next tax bracket, where your salary is taxed at 36 per cent, your effective tax rate on capital gains is 18 per cent, while those in the 42 per cent marginal tax bracket will have an effective capital gains tax rate of 21 per cent. Finally, those in the top 46 per cent marginal tax bracket will have capital gains taxed at 23 per cent.
Any eligible dividends you receive from Canadian corporations are taxed at the lowest effective rate. (Dividends from foreign corporations are treated and taxed just like your regular income.) A rather strange formula is used to determine the tax rate on Canadian dividends. This is because dividends are the distribution of a company’s after-tax profits, so you receive a special tax credit (the dividend tax credit) to prevent the same profits being taxed twice.
First, the amount of the dividend actually received is increased — grossed up — to reflect what the corporation is assumed to have made pre-tax. The gross-up percentage, which is regularly adjusted, was 38 per cent in 2020. This inflated number is what you show on your tax return as the amount of your dividend income. To offset this, you then get a federal dividend tax credit, which in 2020 was 15.0198 per cent. Combined with a provincial tax credit, this means the top tax rate on dividends from public Canadian companies, depending on the province, will be approximately 30 to 40 per cent.
The levels of the provincial tax credits for dividends range widely, as do the levels of income at which they apply. That said, in most provinces you can receive just shy of $40,000 in income from eligible dividends before you have to pay any tax on that income. Table 3-3 shows the approximate tax rates for dividends.
TABLE 3-3 2020 Approximate Eligible Dividend Income Tax Rates
|
Approximate Taxable Income |
Approximate Effective Tax Rate on Eligible Dividends |
|---|---|
|
$16,000 to $20,000 |
–14% to 6% |
|
$20,000 to 47,000 |
10% to 15% |
|
$47,000 to $93,000 |
6% to 20% |
|
$93,000 to $144,000 |
15% to 30% |
|
$144,000 to $206,000 |
22% to 36% |
|
$206,000 and higher |
30% to 40% |
The lower your overall income level, the lower the tax rate for any dividends you receive. But there’s more. In most provinces, if your income is below certain levels, not only is your dividend income not taxed, the tax you owe on income from other sources, including your regular job, is reduced. How? For lower-income earners, the marginal tax rate for eligible dividends is actually negative. When there is a negative marginal tax rate for dividends, the dividend tax credit you earn not only offsets any tax due on the dividend income, but also reduces tax payable on other income.
Use these strategies to reduce the taxes you pay on investments that are exposed to taxation:
- Invest in tax-friendly stock funds. Mutual funds that tend to trade less tend to produce lower capital gains distributions. For mutual funds held outside tax-sheltered registered retirement plans, this reduced trading effectively increases an investor’s total rate of return. Index funds are mutual funds that invest in a relatively static portfolio of securities, such as stocks and bonds (this is also true of most exchange-traded funds). They don’t attempt to beat the market. Rather, they invest in the securities to mirror or match the performance of an underlying index, such as the S&P/TSX Composite Index or the Standard & Poor’s 500. Although index funds can’t beat the market, the typical actively managed fund doesn’t either, and index funds have several advantages over actively managed funds, such as lower fees.
- Invest in tax-friendly stocks. Companies that pay little in the way of dividends reinvest more of their profits back into the company. If you invest outside of a retirement plan, unless you need income to live on, minimize your exposure to stocks with dividends. Be aware that low-dividend stocks tend to be more volatile.
- Invest in small business and real estate. The growth in value of business and real estate assets isn’t taxed until you sell the asset. However, the current income that small business and real estate assets produce is taxed as ordinary income.
Choosing the Right Investment Mix
Diversifying your investments helps buffer your portfolio from being sunk by one or two poor performers. This section explains how to mix up a great recipe of investments.
Considering your age
When you’re younger and have more years until you plan to use your money, you should keep larger amounts of your long-term investment money in growth (ownership) vehicles, such as stocks, real estate, and small business. As discussed in Chapter 2 of Book 1, the attraction of these types of investments is the potential to really grow your money. The risk: The value of your portfolio can fall from time to time.
The younger you are, the more time your investments have to recover from a bad fall. In this respect, investments are a bit like people. If a 30-year-old and an 80-year-old both fall on a concrete sidewalk, odds are higher that the younger person will fully recover and the older person may not. Such falls sometimes disable older people.
A long-held guiding principle says to subtract your age from 110 and invest the resulting number as a percentage of money to place in growth (ownership) investments. So, if you’re 35 years old:
110 – 35 = 75 per cent of your investment money can be in growth investments.
If you want to be more aggressive, subtract your age from 120:
120 – 35 = 85 per cent of your investment money can be in growth investments.
Note that even retired people should still have a healthy chunk of their investment dollars in growth vehicles like stocks. A 70-year-old person may want to totally avoid risk, but doing so is generally a mistake. Such a person can live another two or three decades. If you live longer than anticipated, you can run out of money if it doesn’t continue to grow.
These tips are only general guidelines and apply to money that you invest for the long term (ideally for ten years or more). For money that you need to use in the shorter term, such as within the next several years, more-aggressive growth investments aren’t appropriate.
Making the most of your investment options
No hard-and-fast rules dictate how to allocate the percentage that you’ve earmarked for growth among specific investments like stocks and real estate. Part of how you decide to allocate your investments depends on the types of investments that you want to focus on. As discussed in Book 2, diversifying in stocks worldwide can be prudent as well as profitable.
Here are some general guidelines to keep in mind:
- Take advantage of your registered retirement plans. Unless you need accessible money for shorter-term non-retirement goals, why pass up the free extra returns from the tax benefits of an RRSP or Registered Pension Plan (a company or corporate plan)? Find out more about RRSPs earlier in this chapter.
- Take advantage of a Tax-Free Savings Account (TFSA). The capital gains, dividends, and interest you earn on money inside these accounts are tax-free, as are any withdrawals. Put short-term money such as your emergency funds into a TFSA. Also consider sheltering savings in a TFSA if you’re already contributing the maximum to your RRSP.
- Don’t pile your money into investments that gain lots of attention. Many investors make this mistake, especially those who lack a thought-out plan to buy stocks.
- Have the courage to be a contrarian. No one likes to feel that he is jumping on board a sinking ship or supporting a losing cause. However, just like shopping for something at retail stores, the best time to buy something of quality is when its price is reduced.
- Diversify. As discussed in Chapter 2 of Book 1, the values of different investments don’t move in tandem. So, when you invest in growth investments, such as stocks or real estate, your portfolio’s value will have a smoother ride if you diversify properly.
- Invest more in what you know. Over the years, many successful investors have built substantial wealth without spending gobs of their free time researching, selecting, and monitoring investments. Some investors, for example, concentrate more on real estate because that’s what they best understand and feel comfortable with. Others put more money in stocks for the same reason. No one-size-fits-all code exists for successful investors. Just be careful that you don’t put all your investing eggs in the same basket (for example, don’t load up on stocks in the same industry that you believe you know a lot about).
- Don’t invest in too many different things. Diversification is good to a point. If you purchase so many investments that you can’t perform a basic annual review of all of them (for example, reading the annual report from your mutual fund), you have too many investments.
- Be more aggressive with investments inside retirement plans. When you hit your retirement years, you’ll probably begin to live off your non-retirement plan investments first. Allowing your retirement accounts to continue growing can generally defer your tax dollars. Therefore, you should be relatively less aggressive with investments outside of retirement plans because that money may be invested for a shorter time period.
Easing into risk: Dollar cost averaging
Dollar cost averaging (DCA) is the practice of investing a regular amount of money at set time intervals, such as monthly or quarterly, into volatile investments, such as stocks and stock mutual funds. If you’ve ever deducted money from a paycheque and pumped it into a retirement savings plan that holds stocks and bonds, you’ve done DCA.
Most people invest a portion of their employment compensation as they earn it, but if you have extra cash sitting around, you can choose to invest that money in one fell swoop or to invest it gradually via DCA. The biggest appeal of gradually feeding money into the market via DCA is that you don’t dump all your money into a potentially overheated investment just before a major drop. Thus, DCA helps shy investors psychologically ease into riskier investments.
DCA is made to order for skittish investors with large lump sums of money sitting in safe investments like guaranteed investment certificates (GICs) or savings accounts. For example, using DCA, an investor with $100,000 to invest in stock funds can feed her money into investments gradually — say, at the rate of $12,500 or so quarterly over two years — instead of investing her entire $100,000 in stocks at once and possibly buying all of her shares at a market peak. Most large investment companies, especially mutual funds, allow investors to establish automatic investment plans so the DCA occurs without an investor’s ongoing involvement.
Of course, like any risk-reducing investment strategy, DCA has drawbacks. If growth investments appreciate (as they’re supposed to), a DCA investor misses out on earning higher returns on his money awaiting investment. Finance professors Richard E. Williams and Peter W. Bacon found that approximately two-thirds of the time, a lump-sum stock market investor earned higher first-year returns than an investor who fed the money in monthly over the first year. (They studied data from the U.S. market over the past seven decades.)
York University business professor Moshe Arye Milevsky came to the same conclusion in his book Money Logic. According to Milevsky’s research, if you invested a $10,000 lump sum in a Canadian equity mutual fund, you would likely have $11,000 after a year had passed. In short, his research showed that two-thirds of the time, your initial investment would be worth between $9,500 and $12,500. In contrast, if you invested the money in equal amounts over 12 months, by the end of that year your initial investment would likely be worth $10,748. More specifically, two-thirds of the time you could anticipate having somewhere between $9,898 and $11,598. However, knowing that you’ll probably be ahead most of the time if you dump a lump sum into the stock market is little solace if you happen to invest just before a major plunge in the stock market. In the fall of 2008, the Canadian stock market, as measured by the S&P/TSX composite index, plummeted 30 per cent in just over four weeks. From late 2007 to the fall of 2008, the market shed 42 per cent of its value.
Investors who fear that stocks are due for such a major correction should practise DCA, right? Well, not so fast. Apprehensive investors who shun lump-sum investments and use DCA are more likely to stop the DCA investment process if prices plunge, thereby defeating the benefit of doing DCA during a declining market.
What’s an investor with a lump sum of money to do?
- First, weigh the significance of the lump sum to you. Although $100,000 is a big chunk of most people’s net worth, it’s only 10 per cent if your net worth is $1,000,000. It’s not worth a millionaire’s time to use DCA for $100,000. If the cash that you have to invest is less than a quarter of your net worth, you may not want to bother with DCA.
- Second, consider how aggressively you invest (or invested) your money. For example, if you aggressively invested your money through an employer’s retirement plan that you roll over, don’t waste your time on DCA.
DCA makes sense for investors with a large chunk of their net worth in cash who want to minimize the risk of transferring that cash to riskier investments, such as stocks. If you fancy yourself a market prognosticator, you can also assess the current valuation of stocks. Thinking that stocks are pricey (and thus riper for a fall) increases the appeal of DCA.
If you use DCA too quickly, you may not give the market sufficient time for a correction to unfold, during and after which some of the DCA purchases may take place. If you practise DCA over too long of a period of time, you may miss a major upswing in stock prices. Consider using DCA over one to two years to strike a balance.
As for the times of the year that you should use DCA, mutual fund investors should use DCA early in each calendar quarter because mutual funds that make taxable distributions tend to do so late in the quarter.
Your money that awaits investment in DCA should have a suitable parking place. Select a high-interest savings account or a high-yielding money market fund that’s appropriate for your tax situation.
One last critical point: When you use DCA, establish an automatic investment plan so you’re less likely to chicken out. And for the more courageous, you may want to try an alternative strategy to DCA — value averaging, which allows you to invest more if prices are falling and invest less if prices are rising.
Suppose, for example, that you want to value average $500 per quarter into an aggressive stock mutual fund. After your first quarterly $500 investment, the fund drops 10 per cent, reducing your account balance to $450. Value averaging suggests that you invest $500 the next quarter plus another $50 to make up the shortfall. (Conversely, if the fund value had increased to $550 after your first investment, you would invest only $450 in the second round.) Increasing the amount that you invest requires confidence when prices fall, but doing so magnifies your returns when (if) prices ultimately turn around.
Treading Carefully When Investing for University or College
There’s no doubt that having kids is one of — if not the — most expensive decisions you’ll ever make. From paying for diapers to having to buy a heck of a lot more groceries when your kids become teenagers, having children is a costly affair. But it can feel downright punitive when you start thinking about what it will cost to get them a post-secondary education.
That’s not exactly welcome news for those already trying to pay off their mortgage and save for retirement. What can you do? Surprisingly, one of the best tactics is often to only focus on your first two goals and ignore the third. If you work hard and knock down your mortgage, you’ll have a good chance of being able to reduce or even eliminate your mortgage payments by the time the little ones are ready to go to university. If you’ve knocked a good deal off of your mortgage, you’ll also be in the position to borrow against the equity you’ve built up in your home to pay for educational expenses.
By working hard to grow your RRSP, hopefully you’ll accumulate a good-sized sum that has built up some compounding steam. If you’re accustomed to “paying yourself first” — regularly diverting a portion of your income to your RRSP — you can turn your financial sights away from your old age and toward your children’s educational bills while they’re at school, and resume your RRSP contributions after they graduate. Some people feel that education is so important that they don’t feel comfortable unless they’re putting away some dollars specifically earmarked for that purpose. Others may be in the enviable position of being able to set aside savings for future educational costs while also taking care of their mortgage and building up their RRSP. If you want to start an education savings program, you have two basic ways to do it, each with some distinct benefits and drawbacks you need to consider. The approach that works best for you will be determined by your family circumstances, your outlook, and your sense of where your children are heading.
Making the most out of a Registered Education Savings Plan
If you’ve already got a basic understanding of how RRSPs work, then you’re already halfway to making sense of Registered Education Savings Plans (RESPs). However, there are also some key differences to be aware of. Much like an RRSP, a RESP lets you set money aside and defer tax on the gains you make on that money while it’s inside the plan. When you put money into an RRSP, you also get a tax deduction for your contribution. In contrast, you don’t get to deduct money you put into a RESP from your income when figuring out your tax bill for the year.
And, as with your RRSP, when you withdraw money from a RESP it is treated as income and taxed accordingly. But the big difference is it’s treated as income for your child. Given that their other income — if they have any — will be low, the amount of tax they’ll have to pay will be negligible or non-existent.
You can set up a RESP for each of your children, with a lifetime maximum contribution ceiling of $50,000. When RESPs were first introduced, there was also an annual limit on how much you could contribute, but that has been eliminated.
What makes RESPs financially friendly is that the government tops up your contributions. Under the Canada Education Savings Grant (CESG), the federal government will put in another 20 per cent of any contribution you make, to a maximum of $500 a year. The grant is available every year the beneficiary of the RESP is under the age of 18, up to a maximum of $7,200. (The grant amounts aren’t included when calculating your contribution limits.) In addition, children from middle- and low-income families may be eligible for an extra 10 per cent or 20 per cent grant on the first $500 contributed to an RESP each year.
If you don’t make the most use of the CESG in any one year by contributing $2,500 and receiving the maximum annual grant of $500, don’t worry. If you put in less in any one year, you can earn the untapped grant in future years. However, in any one single year, the CESG grant per beneficiary is limited to the lesser of $1,000 or 20 per cent of the unused CESG room.
Like RRSPs, you can invest money inside a RESP in a wide choice of investments, including the many types of mutual funds and even individual stocks. (Be sure to opt for a self-directed RESP, not one of the group plans that have higher fees and more restrictions.) If you have more than one child, you can set up a family plan that makes it simpler and easier as you can use a single RESP for all of your children.
If your child does not pursue a further education that allows him or her to use the money inside the plan, you can take out the original contributions without any penalty. However, you’ll have to return any grants you’ve received under the CESG. In addition, the money you’ve made on any grants as well as on your own contributions may be taxable.
If the beneficiary is not a post-secondary student by age 21 and the plan has been running for at least ten years, you can transfer up to $50,000 of the plan’s profits to your own or your spouse’s RRSP. However, you must have sufficient unused RRSP contribution room available. (The result is that the RRSP deduction you receive will offset any taxes including the RESP’s earnings in your income). Any of the plan’s profits that don’t get sheltered in this way are taxed at your full marginal tax rate. In addition, you pay an extra 20 per cent penalty. On top of your tax bill, that could mean giving up as much as 65 per cent of the profits. Ouch!
Allocating university investments
If you keep up to 80 per cent of your university investment money in stocks (diversified worldwide) with the remainder in bonds when your child is young, you can maximize the money’s growth potential without taking extraordinary risk. As your child makes his way through the later years of elementary school, you need to begin to make the mix more conservative — scale back the stock percentage to 50 or 60 per cent. Finally, in the years just before he enters college, whittle the stock portion down to no more than 20 per cent or so.
Diversified mutual funds (which invest in stocks in Canada and internationally) and bonds are ideal vehicles to use when you invest for college. Be sure to choose funds that fit your tax situation if you invest your funds in non-retirement plans.
Protecting Your Assets
You may be at risk of making a catastrophic investing mistake: not protecting your assets properly due to a lack of various insurance coverages. Manny, a successful entrepreneur, made this exact error. Starting from scratch, he built up a successful million-dollar business. He invested a lot of his own personal money and sweat into building the business over 15 years.
One day, catastrophe struck: An explosion ripped through his building, and the ensuing fire destroyed virtually all the firm’s equipment and inventory, none of which was insured. The explosion also seriously injured several workers, including Manny, who didn’t carry disability insurance. Ultimately, Manny had to file for bankruptcy.
Decisions regarding what amount of insurance you need to carry are, to some extent, a matter of your desire and ability to accept financial risk. But some risks aren’t worth taking. Don’t overestimate your ability to predict what accidents and other bad luck may befall you.
Here’s what you need to protect yourself and your assets:
- Adequate liability insurance on your home and car to guard your assets against lawsuits: You should have at least enough liability insurance to protect your net worth (assets minus your liabilities/debts) or, ideally, twice your net worth. If you run your own business, get insurance for your business assets if they’re substantial, such as in Manny’s case. Also consider professional liability insurance to protect against a lawsuit. You may also want to consider incorporating your business.
- Long-term disability insurance: What would you (and your family) do to replace your income if a major disability prevents you from working? Even if you don’t have dependents, odds are that you are dependent on you. Most larger employers offer group plans that have good benefits and are much less expensive than coverage you’d buy on your own. Also, check with your professional association for a competitive group plan.
- Life insurance, if others are dependent on your income: If you’re single or your loved ones can live without your income, skip life insurance. If you need coverage, buy term insurance that, like your auto and home insurance, is pure insurance protection. The amount of term insurance you need to buy largely depends on how much of your income you want to replace.
- Estate planning: At a minimum, most people need a simple will to delineate to whom they would like to leave all their worldly possessions. If you hold significant assets outside retirement plans, you may also benefit from establishing a living trust, which keeps your money from filtering through the hands of probate lawyers. Living wills and medical powers of attorney are useful to have in case you’re ever in a medically incapacitated situation. If you have substantial assets, doing more involved estate planning is wise to minimize taxes and ensure the orderly passing of your assets to your heirs.
In our work, we’ve seen that although many people lack particular types of insurance, others possess unnecessary policies. Many people also keep very low deductibles. Be sure to insure against potential losses that would be financially catastrophic for you — don’t waste your money to protect against smaller losses. (See the latest edition of our book Personal Finance For Canadians For Dummies, published by Wiley, to discover the right and wrong ways to buy insurance, what to look for in policies, and where to get good policies.)