Category Archives: Money

rrsp retirement saving money

How to legally avoid taxes by making optimal RRSP contributions

It is that time of the year again. As many of you already know I’m a big advocate of RRSP accounts and believe them to be the best wealth building vehicle available to salaried Canadians. However, the benefits of contributing, and the optimal amount of the contribution, vary greatly from person to person. Below I will try to help you make the optimal choice for your situation.

How much you should optimally contribute depends mostly on your marginal tax bracket.

Marginal Tax Brackets

(Note: to see the exact income ranges and marginal tax rates I suggest you head to taxtips.ca)

The key observation to take away from the above chart is that marginal tax rates do not go up in an even step like pattern. They’re flat for the first 40K of your income, then jump very quickly from 42 to 46K (blue box above), go flat again from 46 to 74K, then again jump really quickly from 74 to 91K (red box) just to level out and go up very slowly afterwards.

The way to think about an RRSP contribution is as a reduction of your taxable income. Think about the red line as the per-$ value of your contribution. The higher the line the bigger the value of the contribution. In fact the per-$ value of the contribution is equal to the marginal tax bracket, so 43.41% simply means you get back 43.41 cents in tax reduction for every dollar contributed. To determine your own optimal contribution amount you can follow these steps:

  • Find where your 2016 income fits on the graph
  • Move left until you find a large drop in the graph
  • Calculate the amount of RRSP contribution you need to make to reduce your income from your starting point (your actual income) to the large drop in the graph (where you want your taxable income to be)

This approach gives you the best bang for your buck in terms of RRSP contributions because it ensures you max out your contribution room with the largest per-$ benefit in terms of a tax refund. You will still get a benefit if you choose to contribute more, but that benefit will get smaller very quickly on a per-$ contributed basis.

Example #1 – Sarah

Sarah made 95K last year so she is just right of the steep drop at 91K

Each dollar Sarah contributes to her RRSP moves her taxable income down or left on our chart above. The per-$-benefit or value of this contribution is equal to the marginal tax rate she happens to be in.

Since she starts on the 43.41% marginal tax rate line for every dollar she contributes she gets back 43 cents tax free but only for the first 4K contributed (green arrow above). This is because contributing 4K drops her taxable income down to 91K at which point any further contributions are at a lower marginal tax rate.

The next 4K of contributions will earn her only 38 cents per dollar contributed (blue arrow)

The next 3K of contributions will earn her only 34 cents per dollar contributed (yellow arrow)

The next 10K of contributions will earn her only 32 cents per dollar contributed (purple arrow)

I hope you can see how quickly the value of her contributions deteriorates after that initial 4K, which means Sarahs optimal contribution would be 4K and would net her approx. a $1,700 tax refund.

Career Stage

Simple right? Well, ok, there is a bit more to it. If you truly want to maximize the benefit you get from your RRSP contributions, over your entire working career, you need to consider what stage of your career you’re at. In the Sarah example above we implicitly assume she is in the middle of her career and is likely to increase her salary at a slow and steady pace until she retires.

Example #2- John

John is in his 20’s and has an entry level job in his field paying him 55K, but is hopeful to progress quickly up the ladder. The average salary for an intermediate level employee in his field is 95K.

Since John is currently making 55K, based on the marginal tax analysis alone, it would seem he should contribute 9K to bring his taxable income down to 46K  (green arrow). This would ensure he receives a tax refund of 30 cents per dollar contributed, or $2,700 for the entire 9K contribution.

However, since John is in his 20’s, in an entry level job in a lucrative field, it may actually make sense for him to forego his contribution entirely this particular year. This is because RRSP contribution room is cumulative and rolls over to the next year if you don’t use it.

Let’s say John salary goes up to 100K next year, his contribution maximum would be based on his previous tax assessment of 18% of 55K income, which would be around 9K. Therefore, if he contributed in the prior year, he could bring his taxable income down to 91K with this 9K contribution for a total refund of $3,900 (blue arrow).

If John contributes in both years he will receive a total net tax refund of $2,700 (year one) + $3,700 (year two) = $6,400.

However, if John foregoes his contribution in year 1, he would now have 18K worth of contribution room in year 2. If he contributes the entire 18K in year 2 he would lower his taxable income to 82K (purple arrow). This would net him a total tax refund of 9K * 41.43% + 4K * 37.92% + 3K * 33.89K + 2K * 31.48% = $6,900, which is an extra $500 in his pocket.

To summarize:

Year 1 contribution Year 2 contribution Chart Arrow Colors Total Refund over 2 years
$9,000 $9,000 Blue + Green $6,400
$0 $18,000 Purple $6,900


Example #3- Brad

Brad is in his early 40’s and an experienced veteran in his field.  The average salary for someone with his qualifications is 65K and he is making exactly this average. Since his salary did not change very much since last year his contribution limit is 12K.

Since Brad does not expect to move into an appreciably higher tax bracket, he should probably try to max out his contribution every year. Even if Brad ends up getting a raise to 74K he would still be in the same tax bracket, so the extra contribution room would not help him next year any more than it does today. In fact he would have to get a raise in his salary above 85K before he would start to see any noticeable difference in his marginal tax rate (and his per-$ contribution value).

Putting it all together

Most people follow an upside down U curve through their life when it comes to Marginal Tax Rates. They start out at a low marginal tax rate early in their careers, go up the curve to a maximum sometime before retiring, and then go back down to a low tax rate in their retirement. Understanding this is key to good RRSP contribution planning.

The general rule is to contribute as much as possible during high earning years, and contribute less, nothing at all, or even withdraw during low earning years. This makes the RRSP an excellent rainy day fund in addition to being a great retirement vehicle. The times you are taxed the least on your withdrawals are also the times when you need money the most. It also makes it a pretty good vehicle for saving for an extended time away from work. This could be a maternity/paternity leave, change of careers, return to school or a round-the-world trip of a lifetime. The withdrawals in “lean” years will be taxed at far lower tax rates than the same amount of income would have been taxed at in the high earning years.

I hope this helps you find an optimal contribution amount for your situation, and as always, I invite you to to subscribe to the blog by entering your email on the right side of the page, or use one of the buttons below to follow me on social media.

Note: Do not confuse RRSP withdrawal ‘penalties’ with tax rates. The ‘penalty’ is only a temporary withholding tax, and in a low earning year, you will get most of that money back when you file your taxes.

Note #2: An interesting observation is how slowly tax rates inch up for incomes over 91K. This basically ensures that contributing down to 91K or the maximum allowed (whichever is less) is the optimal strategy for any income over 91K.


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Investing your politics is guaranteed to lose you money

Investing your politics is one of the biggest mistakes individual investors make. If you listened to republican media over the past 8 years you would think the economy was always on the verge of falling apart and Obama was killing American businesses. It was time to get out of the stock market and put all your money under a mattress.

Instead this happened to the US stock market:

2016-11-18_8-32-03

The bottom line is that if you are a republican (or Canadian supporter of them) who invested their politics (stayed out of the market) over the past 8 years you missed out on more than doubling your money.

We now have a new president in the US and he is just as hated by democrats as Obama was hated by republicans. Even before his election there were warnings that the stock market would immediately crash 10%-20% if he was elected and that the world economy will collapse. No such thing happened nor is likely to happen.

Like everyone else I have my own views on Trump as a man and as a political force. However, this blog is not a political blog, it is a blog on personal finance and investing for retirement. Therefore on here I am only concerned with the effect of likely Trump policies on the economy as a whole, and what that means to your investments. The reality is there are good and bad proposals/policies from both sides of the political divide, and many market friendly policies may not be ones you agree with ideologically. You can’t change these policies, they will happen whether you like them or not, so the only thing you can do as an investor is take advantage of them.

Therefore, if you are a democrat, be careful about assuming that everything Trump proposes will be an economic/market disaster. On the other hand, if you are a republican, be careful not to confuse the recent market rally with support for Trump policies. The market always rallies after a presidential election because some uncertainty is lifted. Namely we know who the president will be for at least 4 years and we can start to plan for that.

My next blog post will try to make some predictions as to which Trump policies are likely to pass senate and congress and what effect they will have on various stock markets.


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What’s going on with the economy? part1 – oil

I got a text message from a friend recently asking me “soo should I be taking all my money out of the banks?” This was a response to the stock markets particularly nasty drop that day. I reassured my friend he need not convert all his money into gold bullion or stock up on guns or canned food.

While my friend’s reaction was over the top for comedic value I think many people are wondering the same thing. What the heck is going on with the economy, Canadian dollar and oil prices, and how is it all related? While my main focus on this blog is personal finance, I realize at times like these everyone, even people who could not care less about markets, start to pay attention. This sporadic attention is dangerous to their financial health, because if they haven’t been paying attention, and suddenly focus on the latest media hysteria, it’s easy to blow things out of proportion. This post needs to be split up into parts because of the complexity of the subject but I hope I can cut through some of the smoke screen and help you understand what is really going on.

Part 1 – Oil

Any discussion about what is happening in the world right now has to start with oil. Most of you know that oil prices have collapsed over the past year but maybe not everyone knows why they’ve collapsed or why it’s such a big deal for Canada.

You may remember from school that prices are set by supply and demand. If 10 people each want an apple, and there are only 5 apples available, then the price of the apple will be bid up until only 5 people can actually afford to buy an apple (or one really rich person buys all 5, but I digress). On the other hand if 10 people want to sell an apple each, but only 5 people want buy an apple each, then the sellers will keep dropping their price as far as they can, so that theirs is one of the 5 apples that actually gets bought. This is what people mean when they say prices adjust to balance supply and demand.

When demand exceeds supply prices go up until demand = supply

When supply exceeds demand prices go down until demand = supply

The following chart shows oil demand with a black line and supply with a blue line.


Do you see how the blue line gets far ahead of the black line around the middle of 2014? It is not coincidence that around the end of 2014 oil prices started their historic slide losing approx. 80% of their value. The green bars illustrate the difference between supply and demand to make it easier to see just how much supply exceeded demand from mid-2014 on. It’s this divergence with supply far exceeding demand that explains why oil prices had to fall.

Supply of oil increased far faster than demand for oil

Why did this happen? Aren’t we supposed to hitting “peak oil” and scavenging for energy left overs by now? The answer lies in something called “fracking” which, aside from damaging the environment, has made the US one of the biggest oil producers in the world.

The chart below shows how non-OPEC oil producers (that’s us, the US and Canada) drastically increased oil production since 2013 and how that coincides with the oil price (green line) falling.


It turns out technologies such as fracking and oil sand extraction have made the US and Canada some of the top oil producers in the world.


https://en.wikipedia.org/wiki/List_of_countries_by_oil_production

This may come as a surprise to you but the US is actually the top oil producer in the world and Canada is not far behind at #5.

Since 2011 this happened to US oil field production:


The production almost doubled in a span of 4 years. To put things in perspective the increase is equivalent to an entire new second Canada (the #5 largest producer of oil in the world) appearing out of nowhere and pumping oil full speed.

If the US is a larger oil producer, then why does Canada seem so much more affected by the oil price decline? Part of it has to do with the relative size of the economy. While we are producing only 30% as much oil as the US, our economy is also at least 10 times smaller. This means we are at least 3 times as dependant as the US on oil sales to drive our economy.

What about China and demand for oil? I’m sure you’ve heard dire warnings on TV that the Chinese economy is crashing and therefore oil demand is plummeting. As it turns out, if in fact the Chinese economy is slowing, it’s really not showing up in oil demand numbers and therefore not likely to be driving prices:


See that green line above? That’s how much oil the world is consuming per day. See that giant drop around the end of 2014? Neither do I, because it isn’t there. World oil demand is just fine, it’s the staggering size of increase in oil output in the US that is almost entirely to blame (or to thank for, depending on your point of view) for the oil price fall.

Compare the green line over the last 3 years versus the green line between 2007 and 2009. There is a definite drop in oil demand in the period leading up to the great recession signalling a severe drop in production and economic activity. The fact that this time around we are not seeing a similar drop in demand, but rather the drop appears to be entirely supply driven, is very good news for the world economy. It means we are unlikely to see a world wide recession and the fears of a repeat of 2008 are much overblown.

In summary

  1. Oil price is driven by supply and demand.
  2. Price declines can be either caused by increases in supply or decreases in demand.
  3. In general decreases in oil demand signal a slow down or problem in the world economy, while increases in supply can actually have many positive implications.
  4. Since we are looking at a supply driven oil price decline this time around, the decline is unlikely to be signalling an economic slow-down as many fear.

All well and good then, but how does that relate to the Canadian dollar and Canadian economy? Stay tuned for part #2 of the article coming soon. To make sure you don’t miss it subscribe to email alerts (on the top right of this page) or follow me on social media by clicking one of the buttons below. 


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Retire 5 years earlier by ditching your mutual funds

Just imagine, retiring 5 years earlier than planned, simply by switching from mutual funds to exchange traded funds. The difference between retiring in 30 years, instead of in 25 years, can be all just due to mutual fund management (MER) fees.  How is that possible? Aren’t mutual fund fees something tiny like 1 or 2%?

Mutual fund fees need to be compared against the benchmark expected return

Mutual fund fees are always quoted based on the amount of money you have invested in the fund, not on the amount of money you are making from owning the fund.

The way mutual fund fees are presented is a bit like dividing maintenance fees on an investment condo by the full price of the condo. It’s a great way to make those fees look small, but not a very accurate way of measuring their true cost. If we want to assess whether the condo is a good investment, we would instead check how those fees compare to the rent charged to tenants.

Similarly, we need to compare the fees mutual funds charge to the investment returns they are likely to provide.

How much does an average mutual fund tracking the S&P 500 really charge in fees?

Let’s say we invest $10,000 in a mutual fund tracking the S&P 500 and charging a 2.11% management fee. This type of fund, if it does it’s job well, should return approx. 10% per year over the long term with dividends reinvested (before fees).

Therefore, in an average year we will pay 2.11% out of the 10% annual return or 21.1% of our expected return in fees

In dollar terms, that’s a potential return of $1,000 on the year being reduced by $211 to earn us only $789. That’s a huge difference!

What about the lower fee bond funds?

The news does not get better with lower fee funds because they also generally offer lower expected returns. For example this bond fund charges only a 1.47% fee, which might seem like a bargain compared to the one above, however the fund is also only expected to return 5.2%.

This means the fund fee is actually 1.47% out of 5.2% yearly return, or 28% of our expected return in fees.

In dollar terms, that’s a potential return of $520 on the year being reduced by $147 to earn you only $373. Despite this fund charging a lower fee on your investment, it’s actually more expensive than the S&P 500 fund when compared to it’s expected return!

How about over the long term?

I hope you can see, from the two examples above, that mutual fund management fees are actually far bigger than they first appear. The problem just gets worse over time though because of compounding.

Assuming a 10% annual return on the S&P500, here is a 3 year comparison between the mutual fund charging 2.11%, and a comparable exchange traded fund charging a 0.17% fee.

Per $10,000 invested

End of End of Year Balance  0.17% fee End of Year Balance 2.11% fee Additional fees paid for 2.11% mutual fund over 0.17% ETF
Year 1 $10,983.00 $10,789.00 $194.00
Year 2 $12,062.63 $11,640.25 $422.38
Year 3 $13,248.39 $12,558.67 $689.72

We can see that the total of additional fees paid after 3 years, is greater than 3 times the 1 year additional fee ($689.72 > 3 * $194). Why? The fee reduced balance after each subsequent year is smaller, which in turn means the same 10% return generates less money. This effect is called compounding and it greatly amplifies small differences over long periods of time.

After 25 years, assuming a 10% annualized return, a $100,000 mutual fund investment (2.11% fee) will turn into $667,621. That’s not bad, but the same $100,000 will be worth $1,042,376 if invested into the 0.17% exchange traded fund.

That “little” 2.11% fee ends up costing us around $330,000, or 30% of our total potential retirement nest egg!

Incidentally, it takes an extra 5 years before the mutual fund balance comes close ($975,969) to that of the exchange traded fund.

feechart

What would you do with an extra 5 years of retirement? 

Note sure where to start? See my article on how to set up an exchange traded fund (ETF) based retirement portfolio in 3 easy steps.

If you’ve enjoyed this article and would like to see more please use the “subscribe” option on the right or follow me using one of the social media buttons below. Thank you!


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3 easy steps to a fully diversified retirement portfolio

I am always surprised how much confusion exists regarding various account types and investment options. The majority of people I talk to either do not have an investment account at all, or if they do, it contains some mutual funds that the guy or girl at their local branch recommended. I think what scares most people off is the financial industry’s love for acronyms and making simple things seems difficult.

I work in the financial industry and I can tell you it’s not coincidence that you’re finding it hard to understand. It is in the industry’s favor to make things seem difficult and confusing, so that you do not try to do anything yourself. This is what makes their revenue flow and profits grow, and it the end, it makes you that much poorer. While picking individual stocks and analyzing companies is in fact complicated, the approach I’m about to outline is not only easy, but is likely to work for you far better than paying for stock picking and analysis. (not convinced? See the most up-to-date analysis here)

In my previous posts I’ve already discussed why investing in the stock market over the long term is near risk free, but I’ve never really explained how to practically do it. Without further delay then, the 3 steps to a full diversified portfolio

Step #1 – Establish a self-directed investment account

There are plenty of brokers out there but the best option for simplicities sake is to go with whoever you already bank with. All the big 5 banks in Canada have what are called “discount brokerages” which offer self-directed accounts (RBC Direct, TD Waterhouse, BMO InvestorLine, CIBC Investor’s Edge and Scotia iTRADE) . The nice thing about going with your bank is that your account will be integrated with all your other internet banking and moving money between accounts will be very easy.

One thing to keep in mind is that an account is not an investment. Technically you do not invest into an RRSP or a TFSA but you contribute or deposit money into it. You then use that money to purchase investments. This is an important distinction because it underlines that you can choose the same investment regardless of which account you choose.

If you don’t already have a self-directed investing account you should set one up as soon as possible. There are 3 major account types for individual investors under the age of 65. I list them in the order of importance.

  1. RRSP (called an IRA in the US) – contributions to these accounts are deducted from your income for tax purposes. In other words the government gives you an interest free loan for somewhere between 30% and 50%  of what you contribute. Best of all this loan may never really have to be paid back, or at least not in full. It’s like getting an immediate return on investment between 30% to 50% and is the single most powerful way to build wealth for individual Canadians. In addition any investment returns you generate in this type of account are generated completely tax free.
  2. TFSA (called a Roth IRA in the US) – contributions are NOT tax deductible, however, you can withdraw the money tax free at any time. The investment returns in this type of account are mostly tax free. There are some exceptions but describing them goes beyond the scope of this article. These are best if you have either maxed out your RRSP contribution room or if know you will need the money before retirement.
  3. Regular/Margin – these are regular fully taxable investment accounts and should only be used if you have exhausted both your RRSP and TFSA room.

One note of caution on the RRSP. The amount you are allowed to contribute is cumulative, so if you have a Mutual Fund RRSP account or an RSP plan at work, you may have already used up some of your room. Talk to your HR department.

Step #2 – Figure out the allocation that is best for you

The 60/40 rule has been used for over 70 years as a default “balanced” stock/bond allocation. It means that 60% of your portfolio should be in stocks while 40% should be in bonds. Most financial advisers use this as a starting point but make various adjustments based on a number of factors. The most important adjustment is based on the age of the investor and how long they have until retirement.

The rule of thumb generally used is to take 100, 110 or 120 and minus your age to get at a stock allocation. This is an oversimplification because it fails to consider that one 30 year old is not necessarily in the same stage of life as another 30 year old. However it is generally a good starting point and will work well for the “average” investor.

The reason this simple rule works rather well is because, during the wealth accumulation phase of an individuals life, the exact allocation of their retirement savings is not all that important. This is because over a long enough period of time the stock market always ends up providing a solid return.  The purpose of the bond part of the portfolio is to reduce the volatility (ie. large swings up and/or down in the value) of the overall portfolio and help you stay on track. However, if you close your eyes, and wake up 25 years later, the best return is still achieved by going 100% stock.

The calculations are very different if you are either nearing or in retirement. In that case the primary purpose of an allocation is to provide you with a steady stream of income that can support your life style. Because life styles and incomes vary so much and because the consequences of not getting this calculation exactly right are far more serious I am going to stay away from suggesting allocations for anyone over 55. If you are near or in retirement I strongly advise you to hire a professional adviser to help you structure your portfolio.

Having said all that, assuming the following:

  • You are putting this money away for a minimum of 15 years and have no need for withdrawals
  • You are not already retired

Here are the approximate allocations based on a 120 – your age calculation:

Age 20-30 30-40 40-50 50-55
Stocks 100% 90% 80% 65%
Bonds 0% 10% 20% 35%

I chose 120 instead of 110 or 100 for the following two reasons

  1. Interest rates are near 0, therefore upside for bond investments is limited while downside is significant. A very minor move in interest rates can destroy decades of returns. Allocating a large percentage to bonds right now is the equivalent of picking up pennies in front of a steamroller.
  2. Volatility (up and down swings in value) of your portfolio is not an actual risk if you plan to keep your money invested for over 15 years. Why not get paid more to take this volatility on?

I am sure I will hear comments from various corners that the allocations I’m suggesting are too aggressive. The truth is there is no standard in the financial world and for every 10 people you ask you will get 20 answers. I think getting too hung up on whether someone should have 10%, 20% or 30% allocated to bonds makes people paralyzed with fear and prevents them from investing all together. Remember, in the grand scheme of things, the exact allocation matters far less than minimizing your fees and being in the market in the first place. Speaking of minimizing fees…

Step #3 – Use ultra-cheap ETFs to construct your balanced diversified portfolio

Exchange traded funds are similar to mutual funds except they are traded on stock exchanges. This gives them the following advantages:

  1. Since any financial institution can sell an ETF on the US or Canadian markets it means a much larger selection than your local bank offers in mutual funds.
  2. The huge number of investors and assets in ETFs means the management fees (MER) are kept ridiculously low. None of the funds I’m about to describe charge more than 0.2%. That’s not a typo, it’s less than one fifth of a percent.

The ETFs I suggest to build your quick fully diversified portfolio are all from Vanguard, a company that prides itself on having the lowest management fees in the world. The funds can be bought using your self-directed brokerage account, just like you would buy any other stock being traded on a US stock market exchange. The difference being that you’re not just buying a single stock but rather thousands of stocks and/or bonds that cover virtually the entire world of invest-able assets.

VT – Buying this ETF is equivalent to buying 7,137 different stocks/companies in 48 different countries across every sector of the world economy. This fund charges a 0.17% annual management fee. A similar mutual fund would charge around 2.3%. That’s a savings of $2,130 in fees over 10 years for every $10,000 invested.

BND – This ETF is the equivalent of investing in 6,512 different high grade bonds across the US bond market. 63.4% are classified as US government bonds and therefore can be considered default risk free. For this one you will pay a 0.07% annual management fee. A similar mutual fund would charge around 1.4%. That’s a savings of $1,330 in fees over 10 years for every $10,000 invested.

BNDX – This ETF is the equivalent of investing in 3,613 different high grade bonds across 98 different countries (outside of the US). This one charges a whopping 0.19% management fee. Once again a similar mutual fund would charge around 1.7%. That’s a savings of $1,510 in fees over 10 years for every $10,000 invested.

The following allocations would be excellent suggestions and cost you little to nothing in expenses.

Age 20-30 30-40 40-50 50-55
VT 100% 90% 80% 65%
BND 0% 5% 15% 25%
BNDX 0% 5% 5% 10%

Or if you hate percentages, the following per each $1,000 invested

Age 20-30 30-40 40-50 50-55
VT $1,000.00 $900.00 $800.00 $650.00
BND $0.00 $50.00 $150.00 $250.00
BNDX $0.00 $50.00 $50.00 $100.00

For example, if you have $10,000 to invest and you are between 30-40 you should buy the following amounts:

10 * $900 = $9,000 of VT
10 * $50 = $500 of BND
10 * $50 = $500 of BNDX

One note of caution is that all the above funds trade in US dollars. Therefore first convert your Canadian Dollars to US Dollars at whatever rate your bank is offering before calculating how many shares of each fund to buy (or you can use this handy little excel spreadsheet to calculate the # of shares to buy).

I bought the funds, now what?

Now you forget all about investing and NEVER check your account until you retire!

I’m actually only half joking as you’d be surprised how well this approach would work! The biggest risk to a long term investor is checking their portfolio too often.

Hyperbole aside, you should in fact re-align the allocation as you age and go into different age thresholds. Eventually you’ll move from your 30’s to your 40’s and as you do you should put more money into bonds. This is the only action I would strongly recommend for everyone.

If you want to do even better than this, you should check your portfolio no more than once a year, and re-balance it to the target allocations you chose when you first started. There are a couple of reasons why the portfolio will get misaligned over time without you changing anything:

  1. The prices of the funds fluctuate in different directions and by different amounts. This causes you to become over-allocated to the “winning” funds and under-allocated to the “losing” funds. Re-balancing forces you to buy a little of the “loser” fund while selling a bit of the “winner” fund to keep your allocation in-line.
  2. The funds pay you dividends which are cash payments that get accumulated in a cash balance in your account. This means your allocation to non-return bearing cash increases over time. This cash balance should be periodically invested using the same target allocations as the rest of the portfolio.

Once again if you choose not to re-balance regularly it does not mean you’ll do badly. You might do slightly worse than a regularly re-balanced portfolio, but still far better than letting your money sit in a savings account or pre-paying your mortgage. Therefore don’t let this stop you from putting your money to work.

In general there is really no need to check up on your investments or “watch the markets”. There are no tenants (real estate) here to check up on, no quarterly reports to read (individual stocks) to make sure management isn’t embezzling money, and no employees slacking off at work and alienating customers (small business). Since you are invested in literally the entire world economy you are protected against any particular part of it failing. If Tesla is a flop, then maybe GM and Honda will take over the market and make you rich, if Tesla ends up dominating the car industry that’s great for you too. If the car industry fails entirely and cars get replaced by Star Trek-like transporter machines, you will own the company that makes those transporter machines and benefit regardless.

The only risk you have is the entire the world economy imploding in on itself and everyone going berserk Mad Max style. Something tells me in that scenario your retirement portfolio would be the least of your worries!

Note: This article does not mean to imply hiring a financial adviser is a bad idea. There are plenty of wonderful girls and guys out there helping to keep people on track to reach their financial goals. The service a good adviser provides minimizes your costs, stops you from making emotional decisions, tweaks your allocation to better suit your risk profile and helps you with tax implications and planning. They are also very likely to use ETFs similar to the ones I’ve described in this article when constructing your portfolio. However, if your financial adviser thinks their primary job is to “pick the best stocks”, run as fast you can!


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Should I pay down my mortgage and borrow back the money to invest?

This question was raised to me in response to my first article on why pre-paying your mortgage is not a good idea. It is also known as ” The Smith Manoeuvre”. The key idea behind this strategy is to deduct the interest paid on an investment loan from your income.

What are the steps for this strategy?

Assuming you have $10,000 saved up at the end of the year you would do the following:

1) You put the $10,000 into your mortgage to save on the mortgage interest
2) You then borrow the same $10,000 to invest
3) You invest the $10,000 into a diversified portfolio
4) You deduct the interest paid on your investment loan from your income

Since the investment return is the same as investing the $10,000 directly instead of paying off the mortgage first the only difference is in the borrowing rates and tax treatment. The idea is that the interest deduction will more than compensate you for the higher borrowing rate you will have to pay on an investment loan vs. your mortgage.

Why makes it difficult to determine whether this works? 

What makes this particular strategy difficult to assess is the fact that it’s profitability relies on an individuals marginal tax rate after all other deductions have been counted. In non-accountant speak it means it depends on your personal income and spending situation.

Gettin’ down and dirty with the math

I know this is everyone’s favorite part and believe me I’m excited! Nothing like poring over tax brackets and figures to make me jump around in joy. Yeah I’m weird like that.

Apples to apples

We are going to compare a variable rate mortgage versus a HELOC loan.

Why?

This is because the cheapest investment loan you are likely to get is a HELOC (home equity) loan. It also takes off the table any perceived benefit of not pledging your home as collateral since both loans are backed by the house. Since all HELOC loans are variable rate loans they must be compared against a variable rate mortgage.

It’s easier to compare a variable rate mortgage because comparing a fixed rate mortgage versus a variable rate HELOC would require the stripping out the rate benefit you get due to taking on the interest rate risk (just like you do when you get a variable rate mortgage versus a fixed mortgage). It’s easier to just compare apples to apples. Picking a fixed rate mortgage versus a fixed rate loan would not change the conclusion but I do invite you to do the math yourself and perhaps post your results in the comment section.

After-Tax Interest Rates

The next step is to make the interest rate on the mortgage comparable to the interest rate on the loan through reducing the investment loan rate by the tax benefit.

This is actually very easy to do as all you need to do is multiply the HELOC rate by (1 – your marginal tax rate). Here is a table based on a 3.35% HELOC rate which is the best rate available on RateHub.

Gross income up to Tax Rate HELOC 3.35% after tax rate
$40,922 20.05% 2.68%
$44,701 24.15% 2.54%
$72,064 31.15% 2.31%
$81,847 32.98% 2.25%
$84,902 35.39% 2.16%
$89,401 39.41% 2.03%
$138,586 43.41% 1.90%
$150,000 46.41% 1.80%
$220,000 47.97% 1.74%
Above $220,000 49.53% 1.69%

Benefit versus a Mortgage

Once we have the table above it’s really easy to compare whether we could save any money by pre-paying our mortgage and borrowing to invest versus just investing the $10,000. Since the HELOC rate is already tax-benefit-adjusted we only need to compare it against the best variable rate mortgage on RateHub which today stands at 1.99%.

Therefore the benefits of the borrow-to-invest strategy per $10,000 for various individual income levels are as follows:

Gross income up to Tax Rate HELOC 3.35% after tax rate Savings vs. Variable Mortgage ( 1.99% – adjusted HELOC rate) Annual benefit per $10,000
$40,922 20.05% 2.68% -0.69% -$68.83
$44,701 24.15% 2.54% -0.55% -$55.10
$72,064 31.15% 2.31% -0.32% -$31.65
$81,847 32.98% 2.25% -0.26% -$25.52
$84,902 35.39% 2.16% -0.17% -$17.44
$89,401 39.41% 2.03% -0.04% -$3.98
$138,586 43.41% 1.90% 0.09% $9.42
$150,000 46.41% 1.80% 0.19% $19.47
$220,000 47.97% 1.74% 0.25% $24.70
Above $220,000 49.53% 1.69% 0.30% $29.93

Does this mean there is a benefit to the strategy?

It would seem from the numbers above that there is a minor benefit if you make 90K+ in gross income (the first tax bracket level where the benefit from the strategy is larger than 0) and the benefit increases a little bit as you get into higher income brackets.

However, we need to not only consider the gross income but also other deductions available to reduce this income.

Why?

Because the interest rate deduction does not apply to any loans where money was contributed to either an RRSP or a TFSA.

The tax benefits of contributing to your RRSP or TFSA will far outweigh the very minor tax benefits derived from deducting the interest. (Note: while the TFSA contribution is not tax deductible the returns are completely tax free. In the long run this tax free return benefit will be far bigger than the interest deduction.)

Adjusting the chart to account for RRSP contributions having been made

In order to determine whether it still makes sense to follow the borrow-and-invest strategy there are some adjustments that need to be made. You will need to add the RRSP contribution room available to you at each income level to the income ranges in the chart above above.

Alternatively, and maybe more intuitively, you can also subtract the RRSP contribution room from your income and compare against the chart above.

These two calculations are equivalent but I’ll do the first one to give you one easy final chart that will show you whether the borrow-to-invest strategy could work for you.

The calculation in each tax bracket is as based on 18% of your income being contributed to an RRSP up to the maximum of $24,930 allowed by the CRA.

Gross income up to Tax Rate Max RRSP contribution Gross income up to (adjusted)
$40,922 20.05% $7,365.96 $48,288
$44,701 24.15% $8,046.18 $52,747
$72,064 31.15% $12,971.52 $85,036
$81,847 32.98% $14,732.46 $96,579
$84,902 35.39% $15,282.36 $100,184
$89,401 39.41% $16,092.18 $105,493
$138,586 43.41% $24,945.48 $163,531
$150,000 46.41% $24,930.00 $174,930
$220,000 47.97% $24,930.00 $244,930
Above $220,000 49.53% $24,930.00 Above $243,087

Once we have the adjusted tax brackets we just map them back to our previous benefit table to arrive at the benefits for each RRSP contribution adjusted tax bracket.

Gross income up to (adjusted) Tax Rate HELOC 3.35% after tax rate Savings vs. Variable Mortgage (1.99%) Annual benefit per $10,000
$48,288 20.05% 2.68% -0.69% -$68.83
$52,747 24.15% 2.54% -0.55% -$55.10
$85,036 31.15% 2.31% -0.32% -$31.65
$96,579 32.98% 2.25% -0.26% -$25.52
$100,184 35.39% 2.16% -0.17% -$17.44
$105,493 39.41% 2.03% -0.04% -$3.98
$163,531 43.41% 1.90% 0.09% $9.42
$174,930 46.41% 1.80% 0.19% $19.47
$244,930 47.97% 1.74% 0.25% $24.70
Above $243,087 49.53% 1.69% 0.30% $29.93

The adjustment for RRSP contributions increases the required individual personal income to approx. $106,000 (the first adjusted tax bracket where the benefit from the strategy is larger than 0). This means that the minimum gross income level where a salaried employee should even consider this option is $106,000.

The TFSA factor

Let’s say you are lucky enough to earn $106,000 in annual income, have enough savings to contribute the full allowable $19,080 to your RRSP, and still have money left over that you need to put to work. In that case the first place you should look to put that money to work is in your TFSA. The TFSA allows for $10,000 in annual contributions but the RRSP contribution will return a nice big chunk of your taxes to you that you can use for that purpose. In the case of a $106,000 income contributing $19,080 will yield approx. $8,000 in tax return leaving you only $2,000 short of the maximum. If you contribute the full $8,000 tax return + $2,000 extra in after-tax money to your TFSA and still have money left over you might want to consider pursuing the HELOC borrow back and invest strategy.

What if you are stuck in a high fixed rate mortgage? 

This is probably the only case in which it would actually be worth the effort to go out of your way and follow this strategy. However, lets understand why that is. It is not due to the interest rate tax deduction. The reason it works is because you are in fact re-mortgaging a portion of your house at a lower variable interest rate.

If you take $10,000 out of a 3% fixed rate mortgage by paying it down, and then borrow back at a HELOC 3.35% after-tax rate of less than 3% (again depends on your marginal tax rate, see chart above) you will see a benefit. However, please keep in mind that majority of the benefit is due to the refinance of a fixed rate to a variable rate. The moment you are able to refinance your entire mortgage at a lower rate you should do that because the savings from doing that will be far larger than the benefits from the HELOC borrow back and invest strategy.

Instead of doing the HELOC borrow back strategy a more profitable approach would be to reach out to mortgage lenders and see if they would be willing to pay your penalty fee to earn your business a bit earlier.

So, should I pay down my mortgage and borrow back the money to invest?

If you earn more than $106,000, have fully contributed to your RRSP, and have maxed out your TFSA, any additional money can be used to pay down your mortgage and borrow back the money for a minor tax benefit.

Would I suggest doing it?

Let’s just say it wouldn’t be at the top of my priority list. For the vast majority of the population making less $165,000 per year in individual personal income you can save far more money expanding your energy into making sure you invest in only the lowest cost investments, limiting your trading commissions, or even bringing your lunch to work one more day a week. We all have limited time, energy and resources and the return on this strategy is so low that I wouldn’t pursue it until I’ve made sure all my other bases are covered. Given that only approx. 10% of Canadians actually exhaust their TFSA contribution limit and plan to do so in the future I think the HELOC borrow-back strategy is more of a distraction than a help for the majority of the population.

We all want to believe that there is some complex way to make extraordinary profits and if we could just figure it out and put all our energy into it we would reap amazing rewards. We chase intricate tax saving strategies and look through screens of hundreds of stocks based on obscure detailed metrics to find the perfect investment. The truth as to what is important when it comes to retirement investing, is very different, and conflicts with the way we’ve evolved to think. The important things are dead simple and really do not require much intricate knowledge (maybe some knowledge of yourself), while the complex things usually just lead to lots of time spent and very little benefit.

So save yourself some time and money and forget that expensive book or paid financial adviser pushing the next great investment or tax strategy. Instead focus on the little things that work and have always worked for generations. In return I’ll promise I’ll concentrate my posts on more useful things in the future 😉

Question, concerns, want to yell at me about how wrong I am? I invite you to click the “Leave a Reply” link below or use one of the social networks to leave a comment.


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How to get a guaranteed return on your stock market investments

In my last post I outlined why on average it’s better to invest your money than pay down your mortgage in an interest rate environment like the current one. However, since we only live once, we’re not so much concerned with average outcomes as we are with actual outcomes that affect our lives. This means we must consider worst case scenarios.

What if it happens to be a particularly bad year for the stock market?

There is no denying that stock markets have some very bad years. This means many people think of it a bit like a casino where you need luck in order to succeed and the odds are against you. The fact is that, unlike a casino, the odds are actually stacked towards you if you are a patient long term stock market investor. What you need to remember is that the goal of financial security and maybe independence is a long term one. This means year to year variations are not as important as building wealth over a longer period of time.

This may surprise you but the S&P500 has NEVER returned less than 5.9% per year compounded over any 25 year period. Not even if you were unlucky enough to start your investing in 1929 just prior to the great depression would you have made less than that. This means if you invested $10,000 in the worst case in the last 100 years you would have had $42,000 at the end of the 25 year investment period (1929 to 1954).

(See full list of returns here)

On average the S&P500 returns approx. 10% per year for any random 25 year period. This means that an investment of $10,000 is expected to be worth $108,347 after 25 years, which is significantly higher than the interest savings from paying down $10,000 of your mortgage.

Some of you at this point will be saying “I get it!” while others are probably saying “my head hurts from reading all these percentage! What does this mean??”. Let me give you a practical example of what happens to Jim and Amy over a time period of 17 years.

Jim pre-pays his mortgage instead of saving

Mortgage: $500,000
Term: 25 years
Mortgage Rate: 2.5%
Pre-payment: $10,000 per year

Jim will be completely mortgage free in 17 years but will have no savings. His net worth will be exactly the value of his house and not a penny more. For the sake of easy calculation lets say the value of his house went up 50% and his net worth is $750,000, thought changing that assumptions makes absolutely no difference to the analysis. This is because paying down your mortgage makes no difference to the value of your house.

Amy does not pre-pay her mortgage but invests $10,000 per year in the S&P500

Mortgage: $500,000
Term: 25 years
Mortgage Rate: 2.5%
Pre-payment: $0 per year

Amy will still owe $194,798.78 at the end of the same 17 years. However, she has invested $10,000 every year into the S&P500 and achieved the median 15 year annualized yearly return of 12.22%. (http://en.wikipedia.org/wiki/S%26P_500#Annual_returns).

Amy’s investing account after 17 years would be worth $560,085.80. This means she could now pay off her remaining mortgage of $194,798.78 and still be left with $365,287 worth of savings. Since the value of her house is exactly the same as Jims her net worth is $750,000 (house) + $365,287 (investments) = $1,115,287. This is 50% higher than Jims!

(You can verify all the mortgage calculations here)

What if Amy didn’t achieve the median return? Even in the worst case scenario of a 4.24% annualized return (the worst 15 year return in the last 40 years as per my previous post) she still comes out ahead of Jim (though by a smaller amount). Despite the complex calculations above the rule to determine whether to pre-pay a mortgage or to invest is very simple.

If your mortgage rate is higher than your expected investment return you should pre-pay

If your mortgage rate is lower than your expected investment return you should invest

Here is a chart of the results for your comparison:

Jim Amy – average case
12.22% return
Amy – worst case
4.24% return
Amy – best case
18.93% return
Starting Mortgage $500,000 $500,000 $500,000 $500,000
Yearly pre-payment $10,000 $0 $0 $0
Mortgage after 17 yrs
after its paid off from investments
$0 $0 $0 $0
Investment account after 17 yrs
after paying off the mortgage in full
$0 $365,287 $57,380 $939,377
House Value after 17 yrs $750,000 $750,000 $750,000 $750,000
Total Net Worth (House + Investments) $750,000 $1,115,287 $807,380 $1,689,377

Amy’s worst case scenario is still better than Jim’s while her best case scenario makes her more than twice as well off.

So how do you get a 100% guaranteed return on your stock market investments? The answer, like most important truths in life, is simple and boring. If you invest your money in a well diversified portfolio over a period of at least 15 years, then based on history, you are guaranteed a positive return.

If after reading this you still feel like you’d rather just pre-pay your mortgage then you should go ahead and do that.  In our society paying down your mortgage has evolved to be such a great and noble goal that many people feel a great sense of accomplishment and pride when they put down a large amount. I don’t want to play down the importance of that feeling, I just want to point out that it’s not a financially optimal decision. Also remember, if you invest your gratification may only be delayed, as one day you will have enough savings to put down that one gigantic payment and pay off the rest your mortgage in full.


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Why pre-paying your mortgage may not be a good idea

This is not a subject I wanted to tackle in my first post! I find people hold very strong almost religious-like beliefs when it comes to housing and mortgages. However, as I was relaxing on my train ride to work a couple of days ago noticed and read the following article in TheGlobeandMail.

“Why paying off a mortgage beats investing”

The way to dispel an illusion is to take the argument, deconstruct it, and then disprove it point-by-point. In that way both of the blog posts linked to in the article are great starting points because they reflect widely held views on mortgages and money.

Interest savings and investment returns are two sides of the same coin

The author writes

“The tax deduction essentially gives you about 25% of your interest payment back. There are people out there that keep their mortgage to pay the bank $400 in order to get $100 back from the government. According to my math, that’s a $300 loss.”

Then he continues with…

““By paying off my entire mortgage in just over three years, I was forced to pay only $6,000 in interest payments instead of the $70,000 that I would have incurred by carrying my mortgage the full 30 years.”

Never pay off your mortgage unless you have no other debt left

Assuming the author means $400 in interest per month and assuming a 2.5% fixed mortgage rate this means the hypothetical person would need to pre-pay $192,000 of their mortgage to save $400 x 12 = $4,800 a year in interest. Therefore right away you can see saving $400 a month in mortgage interest is not very realistic for most people.

However, let’s say you have an extra $5,000 sitting around at the end of the year and want to decide where to put it.

If you put it in into your mortgage you will save approx.. $5,000 * 2.5% = $125 per year or $10.42 per month.

Sounds good? What if you instead pay off your credit cards?

If you pay of an 18% credit card you will save approx. $5,000 * 18% = $900 per year or $75 per month. That’s much better!

How much of your mortgage would you have to pay off to generate $75 per month in savings? It turns out it would take $36,000!

Therefore paying off $5,000 of credit card debt saves you the exact same amount of money as paying off $36,000 of your mortgage!

The same calculation can be done for car loans (and leases!), credit lines and virtually any other type of debt you may have. Mortgage debt is by far the cheapest type of debt so unless you own everything else out right it you should not consider pre-paying it at all.

Here is a chart comparing the approx. interest savings from pre-paying various types of debt:

Interest Savings from paying off $5000
Credit Card (18%) Unsecured Credit Line (8%) Auto Loan (5%) Mortgage (2.5%)
Per Month $75.00 $33.33 $20.83 $10.42
Per Year $900.00 $400.00 $250.00 $125.00

If you have no other debt except a mortgage than what matters is the interest rate

The author of the article states

“ For example, the S&P 500 was worth $1,441.47 on January 7th, 2000. Fifteen years later, the S&P 500 has risen to $2,025.90. It sounds like a pretty impressive increase doesn’t it? But, when factoring in the 15 year time-span, we soon understand that the average growth during this period was only 2.3% per year. That’s pretty crappy. I think many of us would have rather paid off our home mortgage.”

There are two mistakes in the above statement that show either the author does not have a good grasp on how investing in stocks actually works or he’s ignoring facts to prove his own point.

  • He forgot to count the dividends!

Dividends are payments made to you when you hold a particular stock, or in the case of the S&P 500, it’s payments received from 500 different stocks. It’s a little like rent when you buy an investment property. The author considered only the price increase but not the rent you get from your tenants and concluded you haven’t done very well!

With dividends reinvested the annual per year return for that particular 15 year period was actually 4.24%.

  • He cherry picked the investing time period to suit his point

If we consider last 10 years the per year average total return (including dividends) is 7.67% and if we consider last 20 years it’s 9.85%.

If we look at the 15 year period ending in the year 2009, just after the worst stock market collapse in modern history, the per year average return was still 8.04%!

Why does the particular 15 year period the author chose look so bad? It just happens that 15 years ago there was gigantic internet stock bubble which drove stock prices far above where they would otherwise be. If you had bought at the exact peak of that bubble then your return would in fact be 4.24% per year, the worst 15 year return of the last 45 years, but still 70% higher than your current 2.5% mortgage rate.

The historical median total one year return on the S&P500 since 1970 has been 15.79%.

Assuming the $5,000 in the previous example was invested in the S&P 500 over the course of an average year it would be worth $5,789.50 at the end of the year. That’s an extra $789.50 and significantly higher than the $125 you would have saved by pre-paying your mortgage.

(You can check the S&P 500 returns here http://en.wikipedia.org/wiki/S%26P_500#Annual_returns)

Here is the same chart as above except this time including the median one year return for the S&P500:

Expected benefit from paying off or investing $5000
Credit Card (18%) S&P 500 Investment (15.79%) Unsecured Credit Line (8%) Auto Loan (5%) Mortgage (2.5%)
Per Month $75.00 $65.83 $33.33 $20.83 $10.42
Per Year $900.00 $789.50 $400.00 $250.00 $125.00

For most people I would recommend paying off the unsecured credit line and perhaps even the auto loan as the median S&P500 return is not guaranteed. However, the right action depends on more than I have time to explain in a single blog post. The bottom line though is I would never recommend them paying off their mortgage in the current rate environment.

In my next post: What if it happens to be a particularly bad year for the stock market? Isn’t it better to get a small guaranteed return from paying down my mortgage rather than risk money on investments?


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