Kicking Financial Ass
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Value 20 years later @ 9.7% growth $3,822 $3,822
Tax upon withdrawal (25%**) N/A $956
Net withdrawal $3,822 $2,866
*Assumes $400 tax refund is reinvested (40% of $1,000).
** Assumes a lower tax rate in retirement.
In the above examples, the RRSP beat out the TFSA when the tax refund was reinvested and the tax rate was lower in retirement. The TFSA beat out the RRSP if you did not reinvest the RRSP refund. Using this logic, invest in a TFSA first, and RRSP second if you feel you will not be able to reinvest the refund.
Note that contributing to an RRSP does not guarantee a refund, but contributions will reduce taxes owed, which is essentially the same idea. However, the downside to a TFSA is it is very flexible for withdrawals and may lead to temptations to raid it over the years. In that case, RRSPs are the better choice due to the severe early withdrawal penalties, for anything but withdrawing for a down payment or education purposes. Furthermore, TFSAs typically have lower contribution limits per year than RRSPs.
TFSA RRSP
Contribution limits You start collecting contribution room the year you turn 18, and the annual limits are set by the CRA. The limit for 2018 is $5,500. Your maximum contribution limit is 18% of your earned income up to a maximum amount set by the CRA. The maximum contribution limit for 2018 is $26,230.
Contributions are Post-tax Pre-tax
Withdrawals You can withdraw funds from your TFSA at any time without paying taxes. Withdrawals from an RRSP will be treated as taxable income for that year with a few exceptions.
Contribution room You can recontribute whatever amounts you have withdrawn starting in the following calendar year. Withdrawals cannot be added back to the contribution room.
Consequences of over-contributing You will pay a 1% penalty of the over-contributed amount for every month that your TFSA contains excess funds. You can make a cumulative over-contribution of $2,000 to your RRSP in your lifetime with no tax penalty. After that, you are charged 1% of the over-contribution per month.
Accounts Can be open as long as you live, and contributions can made indefinitely. You can only have an RRSP open until you turn 71. After that, you must convert your RRSP into a registered retirement income fund (RRIF), use the funds to buy an annuity, or withdraw all the funds.
THE MONEY ALLOCATION ORDER
The order to allocate your money is similar for both the U.S. and Canada. Typically, you want to establish an emergency fund. Then, max out the contributions your company matches with a 401(k) or company pension. Next, pay off your credit card debt first, followed by tax-free retirement savings accounts, and finally a direct-managed investment account if you have extra cash.
1.Establish an emergency fund.
2.Contribute to your 401(k) or company pension up to their match.
3.Pay off your credit card debt.
4.Max your Traditional or Roth IRA contributions if you are in the U.S. In Canada, max your TFSA contributions.
5.Max your 401(k) contributions in the U.S. In Canada, max your RRSPs.
6.Invest any remaining cash in a direct investing account.
If you live in the U.S., step 4 can be to max your health savings account (HSA). HSA funds are completely tax-free when used for medical expenses, making the HSA better than either traditional or Roth IRAs for that purpose.
If you expect your marginal tax rate to be higher in retirement, invest in your IRA before maximizing your 401(k) because withdrawals are tax-free. In Canada, max out your TFSA before your RRSP.
If you expect your marginal tax rate to be lower in retirement, invest in your 401(k) and RRSPs first.
Always invest any tax refunds from the government back into an investment account.
Why this order? You need an emergency fund to provide enough flexibility just in case the unexpected happens. The last thing you want to do is to dip into your investments when the market is down. You want to contribute up to your company match because this is the highest return you can get on your money, which can be 50% to 100% depending on their match policy.
Credit cards are next. You immediately receive a 15%+ gain on your investment through savings on interest payments.
Then, you want to invest in your IRAs or TFSAs because your investments will grow tax-free. Also, you will not be tempted to spend the cash refund from the government you would receive with an RRSP or equivalent.
Then, you want to max your 401(k) contributions or RRSPs. Finally, if you have any remaining cash, open a direct investing account and keep saving!
AVOID WITHDRAWING
If you can help it, never take money from a retirement account. The only exception is if you are taking out money for a down payment on a house or using it for education. In these cases, look up the limitations and calculate if it is worth the lost investment potential. Many people dip into their retirement savings at one point or another, which can be a fatal mistake for their retirement. Not only will they be paying taxes on it, in the U.S., they will also be charged another 10% withdrawal fee. This penalty is meant to keep your retirement funds where they belong, in your retirement account, so that you can save for retirement.
SUMMARY
Whether you live in the United States or Canada or anywhere else in the world, retirement accounts are essential to help you achieve your retirement goals. With the benefits that governments give, which include tax breaks allowing your money to grow tax-free and compound over time, using these accounts to your advantage is essential.
In the U.S., whether you choose a Traditional 401(k), a Roth 401(k), a Traditional IRA, or a Roth IRA, the concept of saving money remains the same. If you find it hard to choose, open a 401(k) and an IRA to maximize your saving potential
In Canada, open an RRSP and TFSA, and know the pros and cons of each. Below is a quick summary of the various accounts and why you should use them.
I also include the American and Canadian Money Allocation Order at the bottom. If you live outside of North America, adjust accordingly.
UNITED STATES
•If you expect your marginal tax rate to be higher in retirement, then invest in a Roth 401(k). Otherwise, invest in a Traditional 401(k). Some employers allow you to switch from a Traditional 401(k) to a Roth 401(k) but not vice versa.
•It is advisable to have both a 401(k) and IRA account.
•Know the annual contribution limits for each investment account.
•Never withdraw from your retirement accounts if you can help it. You are seriously harming the compound interest potential if you withdraw anything.
•If you face a financial emergency, an alternative to pursuing an early withdrawal from your 401(k) is to borrow from it. You can do this anytime and for any reason and pay back the money within five years without penalty.
•If you have a financial emergency and need to withdraw from your retirement accounts, know the criteria when you can withdraw without paying taxes and/or a penalty:
•Traditional 401(k): Any early withdrawals before the age of 59½ will be subject to income tax and a 10% early withdrawal penalty.
•Roth 401(k): You can withdraw your contributions tax-free, but your earnings are subject to income taxes and a 10% penalty.
•If you leave your employer, either keep the funds in the retirement account or have them rolled over into your new employer’s investment plan. Avoid cashing out.
•Traditional IRAs: Any early withdrawals before the age of 59½ are subject to income tax and a 10% early withdrawal penalty.
•Roth IRAs: You can withdraw your contributions anytime without penalty. Any earnings withdrawn before the age of 59½ are taxed except for the following qualified distributions if you have had your account open for at least five years:
•Higher education.
•Unreimbursed medical bills exceeding 10% of your adjusted gross income or health insurance premiums you pay while you are unemployed.
•Home-buying costs, which can include a down payme
nt or closings costs, up to $10,000.
•You become disabled.
CANADA
•Having both an RRSP and TFSA is recommended.
•Generally, if you reinvest the RRSP refund and expect to have a lower tax rate in retirement than you currently pay, the RRSP is preferred. Furthermore, it is less likely that you will withdraw from an RRSP early. So, using this logic, it is advisable to invest in an RRSP before a TFSA. However, if you think you will spend the RRSP refund or you think your tax rate will be higher in retirement, then the TFSA is the better option.
•Always reinvest the RRSP refund.
•If you have a financial emergency and need to withdraw from your retirement accounts, know the criteria when you can withdraw without paying taxes and/or a penalty:
•RRSPs: You can withdraw without penalty for the following reasons:
•First time home buyer’s plan (HBP): You can withdraw $25,000 tax-free for a down payment if you have not purchased a home in the past four years. You will have to pay it back over a maximum of 15 years.
•Lifelong Learning Plan (LLP): You can withdraw up to $10,000 per year, to a maximum of $20,000 total, from your RRSP for education purposes and pay it back over a maximum of 10 years.
•TFSAs: You can withdraw any amount without penalty.
The Money Allocation Order:
1.Establish an emergency fund.
2.Contribute to your 401(k) or company pension up to their maximum match.
3.Pay off your credit card debt.
4.Max out your Traditional or Roth IRA contributions if you are in the U.S. In Canada, max your TFSA contributions.
5.Max out your 401(k) contributions in the U.S. In Canada, max your RRSPs.
6.Invest any remaining cash in a direct investing account.
CHAPTER TWELVE
THE PERILS & BENEFITS OF REAL ESTATE
HOME OWNERSHIP
The United States and Canada have some of the highest levels of homeownership in the world. More interesting is that in many Western European countries homeownership does not have the same appeal. For example, about 50% of German households76 own a home compared to 65% of Americans77 and 68% of Canadians.78 More facts about homeownership:
•New York, Vancouver, Los Angeles, and Toronto have some of the most expensive real estate in the world.
•Canada and the United States have some of the highest levels of debt in the world.
•Interest rates are low (today), which has helped boost real estate prices.
You do not have to be a rocket scientist to figure out that the housing market in these cities could be in a financial bubble. I hear it all the time, especially regarding Vancouver and Toronto. When is the market going to crash? Is it going to crash? It is hard to say, but keep in mind that house prices do not always go up. Recall the 2008-2009 housing market crash. Rising interest rates will not help either.
For most Americans and Canadians, their home is or will be their largest financial asset. It is also a leveraged asset, meaning most people need a mortgage to buy their home. This means when real estate prices rise or drop, it can have a substantial impact on your net worth.
For example, if you own a $250,000 home and have $25,000 of equity in it, all it takes is a 10% drop in the housing market for you to lose all your equity. Also important to note: If you have problems making your mortgage payments, you risk losing the house plus everything you put into it.
RENTING VS. BUYING
Is owning real estate always a good idea? Yes, and no. On the one hand, it is a kind of forced savings. You are making mortgage payments instead of rent payments and are paying down the principal each month. On the other hand, it is an expensive savings plan. Not only is your mortgage payment likely higher than your rent, depending on the city you live in, but you have other hidden costs of homeownership. Think about repair and maintenance expenses than can often cost 1% or more annually. You also pay mostly interest for the first few years of the mortgage and property taxes each year. Do not assume home prices will increase every year, and if so, on average, they do not increase more than inflation. The word mortgage is derived from Old French and roughly translates to “an agreement till death.” That does not sound appealing to me, but to others, it may.
The alternative is to rent a place that is cheaper than a mortgage and invest the difference in index funds. You will build more wealth faster this way as you will receive a higher return on the money you would have used as a down payment and be able to retire sooner. The only problem with this approach is most people spend the difference between what they are saving on rent and what they would have paid on a mortgage. Another risk is that rents could rise. Many people spend more than the recommended 25% of income on housing. So, what should you do? Buying a house is a great thing when you are settling down in a place you want to live for the next 10 years, that is convenient, and where you are okay with several hours a month of maintenance work.
Saving Money on Rent
Keep in mind that you want housing to be less than 25%, ideally 10% to 20%, of your take-home pay. So, if you rent and want to save money, try the simple tactic of asking for lower rent. This approach is best done after living at your place for a year, proving you are a good tenant. The landlord may prefer to lower the rent to keep you rather than risk getting a bad tenant for $50 or $100 more a month. Again, this cannot be done in all cities, but it is certainly worth trying. If you have a spare bedroom or basement suite, look to sublet that space. Subletting is the practice of an existing tenant renting out their place or extra room to a subtenant. If you choose to pursue this option, first obtain your landlord’s permission, or else your rental agreement could be void. If your landlord agrees, do the appropriate background checks and ensure you have a signed, legally binding sublease contract with the subtenant.
REAL ESTATE CAN BE A POOR INVESTMENT
Real estate, if you are not careful, can be a poor investment. First, if your house is your biggest investment, how diversified is your portfolio? If you pay $1,500 a month in mortgage payments, are you offsetting that by investing $4,500 a month in other investments to balance your risk?
Second, real estate, on average, offers a poor rate of return for investors. Yale economist, Robert Shiller, found that “from 1890 to 1990, the average return on residential real estate was close to zero after inflation.”
Third, over the course of a 30-year mortgage, you pay nearly double the selling price because of the interest.
We constantly hear about people making money in real estate. It is not that easy, though. For one, it depends on which city you live in, and by the time you hear someone is making money, it is probably too late to invest.
As an example, say you bought your house for $200,000 in cash, and it doubled to $400,000 over 10 years. You made over $200,000. But let’s look at the fees associated with owning it and selling it:
•Realtor at 6% commission: $24,000
•Property taxes over the 10 years: $20,000, assuming $2,000 a year
Total cost= $44,000.79 You made at most $156,000 over 10 years, or a 5.8% annual return80 for a total return of 78%.
Another cost most people do not consider when investing in real estate is the opportunity cost of investing in real estate versus the stock market. Let’s say you took that $200,000 and put it into an S&P 500 index fund instead. At a 9.7% average annual return, your investment would be worth $504,773, for a total return of 152% or $304,773, meaning you missed out on $148,773.
You may argue that the benefit of real estate is using leverage to your advantage and borrowing with a mortgage versus paying cash. However, this assumes real estate will appreciate over time, which is not guaranteed. Remember, one of the reasons why property values have increased in some cities is because interest rates decreased to record lows after the 2008-2009 housing crisis and debt rose to record levels. This is not likely to continue forever.
The same could be said with the stock market, but if you buy an inde
x fund, you are more diversified than owning a single property and have fewer costs involved in case you need to sell your investment. Moreover, the above example implied real estate prices increased by 7.2% per year when they are more likely to rise at the inflation rate. If inflation is 2% per year, then the house would be worth $243,798 over 10 years with the realtor fees and taxes eating into all the gains if you were to sell.
But wait, what about saving money when you make your mortgage payments? You are paying down your principal as a form of saving, but you can do the same thing by renting a place that costs less than a mortgage payment plus principal pay down. Do not think of your home as an investment—it is a shelter. If your rent payment is equal to a mortgage payment, then owning is better. However, there is an alternative, an easier method to having exposure to real estate without going through the costs of having a mortgage.
INVESTMENT ALTERNATIVE TO OWNING A HOME
If you want real estate investment exposure without buying a property, owning a REIT, which stands for a Real Estate Investment Trust, is a low-cost way to get it without paying realtor fees, transaction fees, and everything else that comes with purchasing a property. Furthermore, they are highly liquid, meaning you can buy and sell freely, and they can be contained in your investment account as part of a diversification strategy.
What is a REIT? REITs are companies that own or finance income-producing real estate in a range of property sectors. Most REITs trade on major stock exchanges and offer several benefits. REITs are required to distribute at least 90% of their taxable income to shareholders as taxable dividends. I suggest putting REITs in a retirement savings account to avoid taxes.
Think of a REIT as a mutual fund focused on real estate. They allow anyone to invest in a portfolio of real estate assets that can include condominiums and commercial real estate, like shopping malls, offices, hotels, and much more. You buy shares in a REIT and are paid dividend distributions.