Monthly Archives: May 2015

Financial Goals – What It’s All About

financial-goals

What am I saving money for?

For myself, this is the most important of all financial matters to get right. If I didn’t have a financial goal, I would simply lack the motivation to save. Having a goal constantly reminds me of what I’m working for, and gives me a light at the (far) end of the tunnel. To me, it is the most reassuring thing to think about after a rough day, knowing a plan is in place, and underway and that I’m not simply spinning my tires.

As I mentioned in my first post, my personal financial goal is to become financially independent as soon as possible. How will I be financially independent? I will be living off the the interest of my savings! The S&P 500 has a long term annual return of 12.65%. If you had $1,000,000, that would be $126,500 in interest a year! Of course, once you factor in inflation, fees and taxes, you would be looking at a more modest, but still ample, return.

My goal helps me in more ways than giving me a sense of purpose, it also helps me know where to put my money. The S&P 500 is a great long term (at least 5 years) investment, which is what I need for my personal financial goal.

But what if your reason to save money is more short term? What if you are saving up for a down payment on a house, or something that will require you to spend your money within 5 years?

The S&P 500 is pretty safe as far as stock investments go. But it still has its down years, like 2008, the year of the great recession. Had you invested at the end of 2007, it would have taken 5 years for the S&P 500 index to grow back to the price you bought it at.

If you are investing for the short term, that probably means you have something fairly specific in mind you want to buy (house, car, vacation, etc). If you say “I want to save up $100,000 for a down payment on a house in 5 years,” you may value the added certainty of knowing your money will be there in 5 years with a little bit of interest accrued, rather than be less sure your money will be there in 5 years, but with more interest accrued. The cost of safer investments is a lower return, and is a cost worth bearing if you are looking for a more short term place to invest your money.

For shorter term investments, I suggest looking at government bonds, GICs, or even a high interest savings account. There are also many safe mutual funds and Exchange Traded Funds (ETFs) that will also achieve the same effect. They will not grow your money much, but they are very safe. The small amount they grow is better than nothing. Having anything offset the constant encroachment of inflation is important. And if you need a place to stash your cash short term, these are great savings options.

 

 

Taxes – The Unavoidable Cost of Civilization

taxes

It is said that only 2 things are absolute in life: death and taxes. Taxes have been around for thousands of years. The purpose of taxes is to pay for the government, and various government expenditures, like police, fire, hospital, garbage collection, clean drinking water, education, food inspectors, military, and wars.

All these things cost money and various levels of government have been able to find ways to get more tax revenue every time someone discovers a new way to make money. Because taxes have been around for so long, everywhere, they are ingrained in the very fabric of society. You simply cannot avoid paying taxes in some way, which is why, along with inflation and fees, taxes are the 3rd and possibly most costly of the Unavoidable Trifecta of Investment Costs (UTIC)

Kinds of taxes include:

Consumer Taxes

In Canada, consumer taxes are:

  • Goods and Services Tax (GST), which is a federal tax (ie. national, run from Ottawa) and is spent across the country.
  • Provincial Sales Tax (PST), which is run at a provincial level, so the money is directly collected by Quebec City, Regina or Halifax and is not shared with other provinces. Only Alberta has no PST.
  • Or Harmonized Sales Tax (HST), which is a combination of PST and GST in one tax. Currently, only 5 provinces have HST instead of PST and GST:
    • Ontario
    • Nova Scotica
    • Prince Edward Island
    • Newfoundland
    • New Brunswick

As its name suggests, you will pay a lot more in consumer tax if you buy a lot of stuff, ie. consume.

Income Taxes

In Canada, both the federal government, ie. the Canada Revenue Agency (CRA), and provinces, eg. Fredericton, Regina will take a significant chunk of your paycheque before it even reaches you. Every year, you have until the end of April to complete your income tax return. Your income tax return is basically you telling the government how much money you made in a given year (including money from investments, foreign properties, and pretty much anything else you can make money on), and the government making sure you’ve paid your fair share of taxes on the income you claimed.

The CRA, ie. federal government, takes 15% of your income if you made less than $44,701, up to 29% on anything more than $138,586.

The provinces each take a different amount of your income. In Alberta, the provincial government in Edmonton simply takes 10% of your taxable income, no matter how much you made. In other provinces, your income tax will be determined by your income: the provincial government will take as little as 5% in BC and Ontario for low income earners, up to 21% in Nova Scotia for high income earners.

Property Taxes

Canadian cities and towns are all run by local governments and mayors, but the only taxes they are legally allowed to collect are property taxes. Because there are so many municipalities in Canada, there is a wide range of property taxes. Typically, your land will be assessed by the municipality you live in to determine the value of your property, taking into account renovations, the local housing market, amenities, proximity to good things like schools and transit. You will then pay an annual tax on the estimated value of your property that goes straight to city hall.

Capital Gains Taxes

This one is just for investors. If you make an investment, and sell it to collect a profit, you have to pay taxes on that. It doesn’t matter if it’s a house (as long as it’s not your only house) or stocks in your favorite company, the government wants you to give a share of the proceeds back to public coffers.

In Canada, you pay a capital gains tax on 50% of your investment profits. That means if you invest $10,000 in an unprotected fund (ie. outside of a TFSA or RRSP), and make a 40% profit, and then withdraw your $14,000, you would need to pay your current income tax rate on half your profit of $4000.

50% of $4000 (the income from your investment) is $2000. If your income tax rate is 37%, 37% of $2000 is $740 in capital gains taxes. The CRA has another example of calculating your capital gains here.

 

There are many other kinds of taxes and fees governments charge, like corporate taxes, inheritance taxes, carbon taxes, custom taxes, tariffs, etc. But there are also many kinds of tax deductions / breaks you can apply for to avoid paying a significant portion of your regular taxes.

It is controversial to say if tax payers get good value for the taxes they pay or not, but certainly, it is hard to argue that society would be better off without the kinds of services governments offer.

Compound Interest – The Double Edged Sword

compound_interest

In my first post, I mentioned that I make decisions to buy certain things by weighing having something vs the value of that item in 20 years, with interest, for when I retire. I mentioned buying an Xbox One, let’s say that costs $500. If I spend $500 now, I have an Xbox One, but what if I instead put that money into my S&P 500 TFSA?

Well, it just so happens that I have a Google spreadsheet that tells you exactly what happens right here. The document assumes we invested $500 into the S&P 500, in our tax protected Tax Free Savings Account (TFSA), so we don’t have to pay taxes at all on this. It assumes the particular S&P 500 fund we want to invest in keeps its current fund fee of 0.08%, and inflation runs at 1.5% annually. You’ll see that our $500 investment grows to about $3900.

For me, $3900 can easily be enough to let me live comfortably for a month or two when I decide to retire. So Xbox One now, or 1-2 months of extra retirement in 20 years? As a PC gamer, the choice was easy.

I remember first hearing about compound interest, it sounded like you could turn on the ‘compound interest’ switch and start making serious money. Albert Einstein described compound interest as “The eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it”

Compound interest is the growth of your principle investment, and collecting interest on that growth in the next year (or compound period).

To illustrate with another example, let’s assume you have $1000 invested and your investment grows by 10% a year. Here is how that would work over 5 years:

  1. At the end of year one, your $1000 will grow by $100 (10% of $1000) to $1100.
  2. At the end of year two, your $1100 will grow by $110 (10% of $1100) to $1210
  3. At the end of year three, your $1210 will grow by $121 (10% of $1210) to $1331
  4. At the end of year four, your $1331 will grow by $133 (10% of $1331) to $1464
  5. At the end of year five, your $1464 will grow by $146 (10% of $1464) to $1610

Compound interest is the interest that grows off interest you’ve already accumulated. Notice that after 5 years, your investment has grown to $1610, that is the base amount of your assets for year 6. Because of compound interest, it will take just over 7 years for your investment to double at a 10% annual rate of growth.

But compound interest can also work against you. Mortgages and credit card debt are good examples of that. If you have a credit card with an annual interest rate of 30% (the high end of interest rates in Canada currently), that 30% will be applied monthly or even daily by your credit card company. If it is monthly, you will be charged 2.5% (30% divided by 12 months) per month. As credit cards usually have a higher interest rate on overdue balances than most investments can return, this means that you can double your credit card debt in only a few years. This is one of the reasons why many financial advisers suggest paying off all your expensive debt before saving or investing your money.

If you are in the position of wanting to buy a house in Toronto or Vancouver, and happen to have an amazing down payment where you’d ‘only’ need a $500,000 mortgage, what would the (compound) interest be in 25 years? Using online mortgage calculators, at a historically average 7% interest rate the banks will charge you, you’re looking at $550,623 in interest charges alone over 25 years. That is more than double the amount you borrowed.

Compound interest is the only way you can grow your savings and investments, it truly is the engine that drives the value of your savings up. But if you have a tough time controlling your spending, it also has the potential to cripple you in debt and force you to waste your time working only to pay off interest.

Fees – The Unavoidable Cost of Service

fund fees

Fees are one of the Unavoidable Trifecta of Investment Costs (UTIC), taxes and inflation being the other 2. Fees are unavoidable because you really can’t even save your money, let alone grow it, without the services fees yield. Without banks, for example, you would have to store your paper money in a physical location in your house, which suddenly becomes vulnerable to fire, theft, and other bad things.

Types of fees to expect:

Bank fees / credit card fees – It is really hard to function in our economy without a bank account. In addition to the physical protection and government insurance that blanket your money, banks provide loans to people who would otherwise not be able to launch their business idea, or buy their first house. Banks have many annoying fees (ATM fees, having a savings account with little money in it), but provide a lot of services that make buying things easier and safer. Certainly a necessary cost.

Stock trade fees – As reviewed in my post about actually buying stocks, you will need a web broker that will execute your order. These typically cost from limited-time-free to $10 per trade. That means if you want to invest a bit of your money every month into the S&P 500, you might have to pay as much as $120 a year in web broker fees buying new shares.

Fund management fees – Every fund has a management fee that is charged to investors like us to pay for the management of the fund. This fee can include everything, include marketing and legal costs for the company that runs the fund. Generally, if the fund is human managed, you can expect fees of up to 1% – 2%.

1% – 2% may not sound like a lot, but it adds up to a lot over time. To illustrate, I’ve put together a spreadsheet in Google Docs that has a table with a breakdown in money invested, investment growth, and fees. You can’t edit it from your web browser, but if you go to the top right and click File -> Download as, you can download the spreadsheet as your own .xlsx to play around with.

The spreadsheet can be found here, in it you’ll clearly see how investing $200,000 over 20 years will result in a total take-home (before taxes) of $409,000 after $53,000 in a typical fund’s management fees are applied. If you play around with the spreadsheet, you’ll find that the more money you have invested, the more scary your fees will be.

Index funds, like Vanguards S&P 500, also have fees, but because index funds are run by a fairly straight forward computer program, humans generally aren’t involved. That makes index funds comparatively inexpensive, Vanguards S&P 500 has a Management Expense Ratio of 0.13%.

Financial adviser

Not everyone has a financial adviser, most don’t. But those who do will need to pay for them. Lots of large financial institutions will typically pay their financial advisers commission. Your financial adviser will probably take a fraction of that 1-2% fund management fee, or they might take a cut of any mortgage or other financial service they are providing you.

I personally don’t like this payment model, it is one of the reasons why I decided to manage my finances myself. The problem is that obfuscating how your financial adviser is paid will hide the fact that they are paid (and thus, motivated) more for selling you more profitable services, like insurance. And obviously, a financial adviser working and ABC Bank will only be able to help you with funds and services that ABC Bank provides, meaning you’re only getting the best products and services from ABC Bank, not the best products and services available.