Monthly Archives: March 2015

RRSPs – The Taxman Giveth A Bone

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Deciding to invest your retirement money in something like the S&P 500 is an important step in setting up your personal finances. Being able to safely grow your money is important, but so is avoiding paying as much tax as possible when it’s time to retire and begin withdrawing from your savings.

Taxes are one of the three main agents of money corrosion (fees and inflation are the other two). If you follow the law, you will always pay some taxes. The trick is to figure out how to pay as little as possible.

Because the Canadian Pension Plan (CPP) pays out so little (currently $640 – $1060 per month), the government has given Canadians an incentive to take care of their own retirements by introducing Registered Retirement Savings Plan (RRSP).

RRSPs are a type of investment account that is registered with the government, they are designed to defer tax payments until you retire. They are not themselves accounts, but an account designation. That means that many types of bank accounts can be used as an RRSP: savings accounts, web broker accounts and mutual funds can all be designated as RRSPs.

The idea behind RRSPs is this:

When you are working, you are making much more money than when you retire. That means you are also paying more income tax too. By putting your money into an RRSP, you get a tax break next time you file your income taxes. If you make $100,000 per year, and you invest $18,000 into RRSPs, the tax break you get is the difference in tax you would pay if you made $82,000 instead of $100,000. The government lets you pay less income tax when you put money into your RRSP.

But later in life, when you retire and start tapping into your RRSPs, you pay regular income tax on whatever you withdraw. Because what you withdraw when you retire is likely to be less than what you made while you were working, you would be paying less income tax on that retirement income. Withdrawing $50,000 a year (for example) will still require you to pay income tax as though you had a regular income of $50,000. But a $50,000 income is in a significantly lower tax bracket than $100,000, you would end up paying far less tax overall.

Not only are you paying less tax when you invest in an RRSP, the money you get back allows you to immediately invest it so that you have even more money that can grow over the years.

Some RRSP facts:

  • The maximum amount you can contribute for 2015 is $24,930, or 18% of your income, whichever is lowest.
  • You can buy and sell equities (stocks) and take a profit in an RRSP without paying any taxes.
  • You cannot contribute if you are 71 or older.
  • You can withdraw up to $25,000 to help with the down payment on your first home, but you have to pay that amount back within 15 years.
  • If you can’t contribute the maximum amount, the difference will be carried over to the next year.
  • You will be charged 1% per month if you contributed more than your contribution limit.
  • When you are ready to retire, you need to convert your RRSP into a Registered Retirement Income Fund (RRIF). You can do that at any time.

Because the money you get back from the government when you contribute to your RRSPs is based on what income tax bracket you are in, the higher the tax bracket, the greater the tax break. But if you are in a lower income tax bracket, the benefits of contributing diminish. You can use an RRSP contribution calculator to see what you would get back from the government if you contributed to your RRSPs.

Using an RRSP calculator, you will notice that if you live in Ontario, make $40,000 per year and contribute $5,000 you will get a return of $1003. But if you make a salary of $100,000 and contribute $5,000 your return more than doubles to $2170.

RRSPs are a great way to help grow your money tax-free, but they are designed for average to above average income earners or households. If that’s not you, that’s OK, because Tax Free Savings Accounts (TFSAs) offer an even better way to save your money, and the benefits of TFSAs apply equally to everyone, as I will explain next week.

 

The S&P 500 – The Best Way To Save Your Money

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Last week, I talked about mutual funds and how they are able to grow your money much better than savings accounts. One of the problems with mutual funds is that there are so many to choose from. Personally, I just don’t have the time or desire to really hunker down and maul over financial details of funds, what they are invested in, and how much.

And that’s a real problem. When I didn’t know any better, simply being shown an impressive graph of a fund with a name like ‘Mackenzie Ivy Foreign Equity-A’ by a financial adviser with a reassuring smile was all I needed to invest.

It could well be that Mackenzie Ivy Foreign Equity-A is a great place to invest your money, but I personally don’t know. And I don’t really care either because I don’t have the time to research mutual funds, and quite frankly, I find it really boring.

As I mentioned in my first blog post, I have things I want to do with my one life. I have ambitions and passions to pursue, and the sooner I can stop having to work for the Man, the sooner I can really focus on doing the things I want to do. This means that my free time now is also valuable, too valuable to waste researching boring things.

Like many before me, I thought to myself, “Surely, someone has figured out the best place to put money, this must be a solved problem.”

After a short search, it was revealed to me that the Standard & Poor’s (S&P) 500 was such a place and that it was actually a well known solution amoungst investor types. Indeed, Even Warren Buffett, the most successful investor of the 20th century, where he amassed most of his staggering 72 billion dollar fortune, has very publicly endorsed the S&P 500 as the best place for the average person to put their money.

The S&P 500 itself isn’t a fund, it is an index: a list of 500 large companies publicly traded in America that basically make the world work. Companies are put on or taken off the list based on specific criteria by a committee.

In its current form, the S&P 500 has been around since 1957. The way the index is calculated is pretty simple: Add up the capitalization (number of company shares multiplied by the share price) of all 500 companies in the index, and divide by ‘the Divisor’. The Divisor is technically proprietary info owned by the people who manage the S&P 500, but it is approximately 8.9 billion.

The math behind the S&P 500 is basic: the sum of the capitalization of the companies in the S&P 500 index is something close to $18.8 trillion, divide that by 8.9 billion and you get 2108.10, the S&P 500 index as of March 20, 2015.

Because the index is based on the stock market share price of each of the 500 companies, the better individual companies do, the higher the S&P 500 index goes. Over the last 5 years, the S&P 500 index has gone up an average of nearly 16% per year. Over the last 20 years, 11% per year. Over the last 100 years, 12% per year. At 12%, you are doubling your money every 6 years, $100 with the S&P 500 could become $200 in 6 years.

Of course, it’s not quite that straight forward. The S&P 500 is not a fund, but and index. There are several funds, however, whose sole purpose is to emulate the index for as cheaply as possible. But there are still three largely unavoidable costs that will effect all investments: taxes, inflation, and fees. These costs will chip away at what you actually end up taking home on any investment.

But as far as investments that require the least amount of energy go, it’s hard to beat the S&P 500. There are all kinds of companies in that index that you use every day: Disney, Visa, Apple, Starbucks, Black & Decker. Other well known companies like Boeing, P&G, Gap, Staples, Ford, Whirlpool and Google are also included.

The S&P 500 is a very diverse investment. The individual companies that make up the index make your world go round: they mine natural resources, build all the stuff you use, move goods, grow food, make the internet useful, provide electricity, entertain you, cloth you, etc. It is a single investment in 500 companies that gives you a little part of every industry. And it is good to be diversified, because unseen things always happen. I sure wouldn’t want all my life savings tied up in only Starbucks if a mold that killed the worlds coffee crop broke out (god help us…).

Fees are another strength of the S&P 500. Because the index is easily calculated and publicly available, software can easily do the job of fund managers, significantly reducing fund fees. My preferred S&P 500 ETF (Exchange Traded Fund) is Vanguard’s, its management fee is only 0.08%.

So how does one put their money in the S&P 500? To answer that, we must first consider some new realities, namely, the incredible amounts of money one can make. Consider having $100k in the S&P 500, it is possible to double that in 6 years. That’s an average of more than $15k per year of investment income. Imagine having $10 million in the S&P 500?

The government is fully aware of the massive potential for income on investments, and has taxes in place to rain on a good investors parade.

Taxes are a problem well known by Canada’s wealthy, where solving the problem of having to amass a fortune becomes the problem of finding the best way to avoid taxes when withdrawing from said fortune. But for anyone who plans to someday live off interest from investments, knowing how to avoid taxes from the start is key.

 

Mutual Funds – A Better Way To Save

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Despite their name, savings accounts don’t really save your money. Because the rate of inflation is almost always higher than the rate your money grows in a savings account, you are effectively losing money in any savings account each year.

Mutual funds, however, can offer a much better Return On Investment (ROI) than a savings account. A top performing savings account will grow your money by around 1% a year, a typical mutual fund might grow your money by 5% a year.

To emphasize the importance of a mutual fund’s higher growth potential, consider the difference between 1% savings growth and 5%. Ignoring inflation, at 1% a year, you will double your savings every 70 years, thanks to compound interest.

At 5%, you double your savings every 14 years.

A mutual fund is basically a pool of money a group of investors use to purchase various stocks, currencies, bonds or a mixture thereof. They can be focused on investing in one geographical region, like Asia or Western Canada, and they can also target specific industries or sub-industries, like mining or small-scale banking.

Mutual funds buy and sell assets based on the discretion of the fund manager. Fund managers are typically going to be your Bay Street types who are constantly reviewing individual assets, like a particular company they may buy into and introduce to their fund, or perhaps shares of a company already in the fund that are underpreforming and needs to be cut.

One of the problems I found with my own experience with mutual funds is knowing what exactly your money is being invested in. There are two angles to this:

  • Simply knowing where your money is going. You wouldn’t buy a car without knowing as many details about it as possible. Why invest your life savings into a Canadian mid-cap fund without knowing what a mid-cap is, or what specific companies are included?
  • There are other reasons for wanting to know what specific companies your money is being invested in: Do you only want to invest in companies that are environmentally friendly? Do you want to invest in Asia, but not China? Maybe only small US-based tech stocks?

Every major financial institution has their own set of mutual funds, and naturally, every financial institution will say they have a mutual fund perfect for you. According to fundlibrary.com, there are around 36,000 mutual funds in Canada. With so many, how are you going to find the right one?

Here are a few things I learned to be aware of when shopping for mutual funds:

  • Fees. Those Bay Street-types aren’t cheap, and it’s you, the investor who pays their wages. The biggest complaint against mutual funds is the fees. Many funds have a Management Expense Ratio (MER) of 2%, where every year 2% of your investment will be taken by the fund to pay for itself. The fees include management fees, advertising/marketing fees, legal fees, transaction costs in acquiring assets, etc.
  • There are many re-sellers of mutual funds who are paid a commission. And some funds pay better commission to sales people than others. Remember to ask how the person encouraging you to invest in any mutual funds is being paid. Investing in something because a sales person gets a cut is a bad reason.
  • Because mutual funds are more risky than savings accounts, you want to avoid putting all your eggs in one basket. If your only mutual fund targets small tech stocks, that is a traditionally risky investment. Be just as prepared to lose a sizable chunk of your savings on bad years as you are to reap the rewards of a risky investment paying off in the good years. If you have mutual funds that invest in very specific things, I would strongly suggest diversifying and looking at a broader range of funds.
    • The agony of losing your life savings on a bad bet will always elicit a much stronger emotion than the joy that comes from doubling the value of your life savings.

In comparing mutual funds, you could use a comparison tool such as Van Guards fund comparison page. But I find it difficult making sense out of fund-to-fund comparisons. Instead, I prefer to compare my investments to the bellwether of benchmarks, the S&P 500.

The S&P 500 is an index of the 500 biggest companies in the US. This includes Disney, Apple, Verizon, Citibank, Walmart, Google, etc. The index is calculated by looking at every company’s balance sheets, and regularly ejecting poor preforming companies from the list in favor of up-and-coming companies with excellent balance sheets.

The S&P is also what almost every fund manager uses as their benchmark in determining how well their investment acumen is doing. At an average annual rate of return of 12.65% over the last 40 years, there are virtually no mutual fund managers who have been able to consistently beat the S&P over that period of time.

Which begs the question, can’t you just invest in the S&P 500 index yourself?

Savings Accounts – The Usual Suspects

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So, because of inflation, we know that we can’t just leave our money in a regular savings account. Your money does grow slightly in a typical savings account, usually by less than 1%, which is barely better than nothing, but still better than nothing.

Why do banks give you any interest on your saved money at all? It’s because they want you to put your money with them. Banks don’t just sit on your money and keep it safe, they invest it in their various business endeavors (typically mortgages and other types of loans) and take whatever return on investment (ROI) for themselves, which will be much higher than 1%. So it’s in their best interest to have people save money with them so that they can invest it into something that offers them a better return than 1%.

Banks are required to keep a certain amount of cash on-hand, but given that most people keep their savings with their banks and rarely make significant withdraws, they don’t need all your cash on-hand as only a very small percentage of deposits are withdrawn on a regular day. Of course, if times get tough and trust in banks or the economy plummets, people will want their money in their hands and withdraw their savings at the same time as everyone else. That creates a major problem, as Greece experienced with their recent election, where the banks simply didn’t have enough money to give to people. But don’t worry, in Canada, if such a thing were to happen, the Canadian Deposit Insurance Corporation (CDIC) will cover you up to $100k per account with tax payer’s money (though I’m not sure how that would work if the Canadian government was out of money too).

Some banks have a high interest savings account, which is usually under 1%. The various savings rates are usually dependent on how much money you have with a bank, here is a breakdown of some of the banks’ current savings rates:

  • TD
    • Savings interest rates: 0.1% – 0.8%
    • If you have less than $5000, your savings will grow by 0.1% per year
    • If you have more than $5000, your savings will grow by 0.15% per year
    • If you have more than $5000 in TD’s High Interest Savings Account, your savings will grow by 0.8% per year
    • If you’re a youth with less than $5000, your savings will grow by 0.05%
    • If you’re a youth with more than $5000, your savings will grow by 0.15%
  • CIBC
    • Savings interest rates: 0% – 0.85%
    • If you have less than $5000, your savings will not grow
    • If you have more than $5000, your savings will grow by 0.85% per year
  • RBC (Royal Bank of Canada)
    • Savings interest rates: 0.05% – 0.75%
    • If you have less than $5,500, your savings will grow by 0.05% per year
    • If you have less than $5,500 to $25,000, your savings will grow by 0.1% per year
    • If you have more than $25,000, your savings will grow by 0.2% per year
    • If you have a Tax Free Savings Account (TFSA), your savings will grow by 0.75% per year
  • Scotiabank
    • Savings interest rates: 0.1% – 1.3%
    • If you have less than $5000, your savings will grow by 0.1%
    • If you have $5000 – $25,000, your savings will grow by 1.15%
    • If you have more than $25,000, your savings will grow by 1.3%
  • Tangerine (formally ING Direct)
    • Savings interest rates: 1.05%
    • Tangerine has many kinds of accounts, but their savings account seems to offer 1.05% to everyone

As you can see, it’s pretty tough to get much more than 1% interest on your savings at any bank or financial institution. To make it more difficult, the range in savings rates depends on how much you invest, CIBC gives you no interest for any savings that total less than $5000. To get a savings growth rate of 0.2% at RBC, you need $25,000 deposited with them.

I have mentioned how inflation makes everything cost more every year. Over the last 15 years, the average annual inflation rate has been 1.97% per year, which is significantly higher than any of the interest rates any bank will give you to grow your money. This means that even if you had money in any of these bank’s savings accounts, your money would still lose about 1% to 2% of its value every year.

What this boils down to is that in Canada, you effectively lose money every year when it’s in any savings account. Banks still want you to invest with them though, they regularly offer incentives to lure your money into their accounts, usually with a limited time ‘high’ rate of return, currently between 2.5% and 3%. But buyer beware, those rates only last for a few weeks, then you are back on the regular low rates.

So what’s the solution? How does one protect the value of their money?

Let me answer with another question: How do rich people grow their savings?

Inflation – The Hidden Dark Horse

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You remember when you were a kid and a chocolate bar cost far less than it does today? This phenomenon happens because of inflation, and the same thing that happens to chocolate bars happens to your money too.

I don’t see inflation talked about as much as I think it should be, especially when it comes to personal finance. This blows my mind because every year all money, including yours, loses a bit of value to inflation. In fact, since 1993 the Bank of Canada has been openly committed to an inflation target of 1-3%, meaning a little inflation is good for the economy in general, just not your savings.

Inflation is a big, complicated, abstract concept which is why I think it is so often overlooked. But after looking at various ‘high interest rate’ savings accounts, I started to think that people not familiar with inflation are losing money when they think they’re gaining money.

To better illustrate inflation, let me offer a basic example:

You are king/queen of a small village of 100 people. To avoid everyone bartering, you decide to create a currency based on gold, you have one kilogram of gold and you decide to create coins for your 100 subjects. So you take your gold and make 200 royal coins. Your people are happy, they now have something that allows them to price their goods and services more accurately than if they were trading for other goods and services.

Your plan works well. The villagers find it easier to buy and sell goods, and thus easier to make money. But you only have 200 coins, and your inventive villagers start coming up with new ways to make money, new goods and services to sell and you soon notice a coin shortage in your economy. Your more successful inhabitants are saving coins from their successful business endeavors, taking fewer and fewer coins out of general circulation. You discover that of the 200 coins you made, only 100 seem to be exchanging hands regularly, making the coins more scarce, and thus more valuable to the point where one coin can buy a villager enough grain to feed a mule for a whole year.

So you decide to buy another kilogram of gold (perhaps by introducing taxes) and mint another 200 coins, doubling the amount of coins in your economy. Because so many more coins are now in general circulation, they are no longer scarce and one coin will now only buy a villager enough grain to feed a mule for only half a year. Those who saved coins before you introduced more coins would find that their savings have effectively been halved because they can now only buy half the goods for the money they had saved.

By doubling the amount of coins available, you’ve effectively halved the monetary value of all your coins. Inflation went up 100%!

The Canadian economy works on the same principle, except it isn’t based on gold and is more sophisticated. In addition to introducing new money into an economy, rising costs in manufacturing or a commodity scarcity are also big factors in inflation.

The Bank of Canada is the institution that manages the Canadian Dollar; it issues new money and sets the interest rates. It also has a target inflation rate of 1-3% that it uses to steer the economy.

The Bank of Canada measures inflation by measuring the change in the Consumer Price Index, which is a “basket” of thousands of consumer goods (for example: a kilogram of Royal Gala Apples, a new Toyota Camry, a pair of Levis 501s, etc.) and tracks the price changes. In fact, the Bank of Canada has a handy inflation calculator that lets you see exactly what inflation has been. Using this calculator, I can see that in 2014, inflation was at 0.97%. In 2013 inflation was 1.48%. Since 2000, inflation has gone up 32.94% with an average annual inflation rate of 1.92%.

Looking at the inflation calculator, I see that $100 in 2000 would get me the same amount of goods then as $132.94 in 2015. Put another way, a chocolate bar that cost $1 in 2000 would cost you $1.33 in 2015.

Inflation means each year $1 will buy you less, so if you have money just sitting in a bank account collecting little or no interest, you aren’t losing money, but as the cost of goods grows, the value of your money does not, and you will be able to afford less things as the years go on with the same amount of money.

To use another example, if $11,000 was a median annual salary in 1950, and I worked for a year and managed to bank my entire salary (somehow avoiding taxes and the cost of living), I would have $11,000 in the bank today. Which won’t get me nearly as much as if I had today’s median annual salary of $45,000 in the bank.

If you have $1000 in the bank today, what do you think you’ll be able to buy with it in another fifteen years?

Next week, I’m going to look at various savings accounts and see how those “high interest” rates stand when you apply inflation.