Insurance is the type of subject that should be dealt with solely on logic, and yet people make snap decisions on whether to buy it, or how much of it to buy. In reality, what most young investors do when faced with any insurance products (not only health or life insurance, but also product warranties, house/fire, etc.), is weigh the chances of it happening against the potential loss if the ‘bad thing’ were to actually occur. In other words, they do an expected value calculation.
For example, if you were at Future Shop, and you just bought a brand new 52” plasma TV for $1000, (with HD technology and a March Madness channel pack) and then the store offered you an extended 3 year warranty for an extra $200 – would you purchase the extended warranty? Well, if you’re like most people, you’d try to guess the chances of the TV breaking down – maybe you’d ask the store clerk about it. Let’s say, you estimated that a quarter of TV’s (1/4) break down within three years. You would then apply the formula: (1/4) times $1000, which equals $250. Aha! – that’s more than the $200 price of the warranty, which means I should definitely purchase the extended warranty. Correct?
You’d apply this concept to most scenarios, even if you aren’t so mathematical. Should I buy house insurance against theft/fire? Well, you might reason, I live in a safe neighbourhood, therefore the chances of my house being robbed or burnt is very low, so I don’t think I need to buy the house insurance, especially since it costs over $500/year. In plainer terms, you’re looking at the price of the insurance, and then comparing it to the potential loss and probability of the accident occurring.
What’s wrong with this type of thinking? Seems logical, eh?
To understand why it’s wrong, think of it from the Insurer’s perspective. How does an insurance company make money? Well, they calculate the average amount of money they’d have to pay out, and then charge slightly higher to make their profits. For example, if a particular college student crashes his car on average X times a year which costs on average $5000/year in total, the company would charge maybe $6000/year in insurance. The insurance company would NEVER charge less (or even equal to) the amount they’re expecting to pay out for accidents. In the aforementioned TV example, there is no way the company would offer a warranty for the price of $200, if they expected to payout $250 on average. In fact, most insurance companies charge WAY more than the expected payout, as much as 200% of the expected payout! That means, if the warranty costs $200, the company is only expecting to pay $100, meaning that only 1 out of 10 TV’s break down within the first 3 years (not 1/4 as you predicted). Ouch! Maybe you shouldn’t have bought that warranty...
This concept should be pretty obvious to you. Yet, you still try to use expected value calculation to figure out whether to buy that insurance product, or how much to buy. We clearly need a new method here!
The method that most experts suggest is that you should really only focus on the size of the potential loss, and whether you can afford to take on the risk of the loss occurring. What I mean by that is, you should have a floor value of what type of loss you can take. For example, let's say that in your financial situation, you cannot afford losses greater than $1,500. If your house were to burn down, you'd be in big trouble. If your car were to crash, there’s no way you could afford to replace the car, or pay huge health bills associated with the crash. Conversely, while it would be really annoying if your $500 TV broke down tomorrow, it wouldn’t be the biggest deal. You could live with the $500 loss. What I’m saying here is, you shouldn’t insure ANYTHING that is worth less than $1,500, which is the floor used in our example. However, you can’t take chances on bigger things. Even if the chances of your house burning down are really, really small, what happens if it does? You cannot afford that situation. The RISKS involved are too great.
Case in Point: If I told you not to insure the next printer you buy, and then it actually did break down and you lost your money, you’d be a bit upset with me. However, you would probably still continue to read this blog. But if I told you not to get car insurance, and then your Porsche was stolen, you’d probably hunt me down. Why? Because, that's a loss you cannot live with. There is actually a mathematical formula that represents this concept –it’s called logarithmic utility. Ask me to explain it if you like..it’s pretty simple.
So, my advice is to never buy insurance/warranties on small potential losses. For me, computer purchases are at the tipping point – sometimes I buy the extra insurance, and sometimes not. But if you’re a millionaire, you probably shouldnt buy extra computer warranties – you’re guaranteed to lose value on your money, and you’re better off putting that extra money in the bank, and I guarantee you that you will, on average, end up with more money than before, at the end of the warranty term. How can I guarantee that? Simple – I’m 100% sure that Apple Computers is ripping you off with their insurance product – that the price of their warranty is higher than what they expect to pay you out. And believe me, Apple knows best when it comes to how many of its computer break down and are needing of warranty repairs.
Finally, to even further illustrate this point, I can pretty much guarantee you that Bill Gates does not purchase warranties or insurance on anything (regarding his household life; I’m not talking about his company/overall net worth). Think about it.
How can we apply this concept to car or health insurance? Well, what many experts advise is that you should look into buying an insurance product with a high deductible. This means that the insurance company only pays you out when the insurance claim is higher than the deductible amount. For example, I can buy car insurance that has an $800 deductible, which means that any damage worth less than $800, I have to pay for. Only if the damage tops $800, will the insurance company chip in. Insurance companies will almost always give you cheaper premiums as your deductible increases, since their expected payout is less. Why should you do something so crazy as too get high deductibles on your insurance? Well, for the same reason mentioned above – the losses worth less than $800 are losses that you can live with, so there’s no point in paying insurance premiums that, are on average, going to be higher than the expected pay out. Only the losses that you cannot afford to take a chance on, should you be insuring against.
So in conclusion – when deciding about whether to buy insurance/warranties, focus on the risks of that accident happening. Can you afford to risk not buying insurance against the relevant loss? What happens if the accident occurs – can you live with that situation? This method should give you an approximation of your floor insurance price. For some people, its $500. For others, it could be $500,000. Either way, it’s important to keep this in mind when faced with any insurance product.
Note: Life insurance is slightly more complicated and involves a different set of rules – ask me about it if you’re unsure and I’ll tell you what the consensus opinions are on that.
Tuesday, September 14, 2010
Tuesday, August 3, 2010
Credit Cards - good or bad?
We’re going to continue our discussion on credit cards. Credit cards represent the most dangerous form of debt, for a number of reasons, the most important being the enormously high interest rates that are associated with them. Yet credit cards do provide some benefits, and if utilized properly, can be an asset to your personal financial situation (pun intended!). Let’s discuss the benefits of credit cards.
1)Credit cards are convenient. No one can deny that! It’s no doubt easier to carry around a piece of plastic in your wallet instead of a wad of cash.
2)If used properly, credit cards can increase your credit score, which can go a long way in helping you to qualify for a mortgage in the future with more advantageous rates, should you need one. I will be speaking more about credit scores in a future post, but in short, every individual who has a social insurance number also carries a credit score, which is a summary of your credit history. If your credit history shows that you were a responsible credit card holder who always made your payments on time, your credit score will increase.
3)Credit cards can offer rewards and benefits in the form of cash-back returns, travel points, travel insurance, etc. Everyone loves free vacations, right?
These three benefits to carrying credits are the reason why there are an estimated 75million credit cards in circulation in Canada, an average of over 2 per person. Canadians spent about $265 billion on their credit cards in 2009. The reason why I’m telling you all this is because credit cards can be very good financial tools, if used responsibly. Let’s talk about the other side of credit cards – the things to be aware of if you do want to be a responsible credit card user.
As I explained in last week’s post, the reason for a credit card’s incredibly high interest rate is reflective of the borrower, not the lender. Credit cards are not collateralized by any hard assets, and therefore, banks are forced to charge high rates on their cards. Banks choose a rate that will ensure that even with a relatively higher number of unprotected (uncollateralized) credit defaults, their money lent out will still provide a profitable rate of return. As was also explained previously, debt works in the same manner as savings, and therefore, grow exponentially just like savings. Why does debt grow exponentially? Suppose you owe $10,000 on your credit cards, which incurs a 30% interest rate. After a year, supposing you do not make any payments on your card, your $10,000 will incur 30% interest, or another $3,000, so that your total outstanding balance owed to the credit card lender will be $13,000. However, in the second year, you won’t only incur $3,000 in interest – you will now incur 30% interest on your new $13,000 balance (instead of on your original $10,000 balance) which equals $3,900 in interest, which brings your total balance owing to $16,900 after year 2. Interest begets more interest, in the same way that savings compounded begets more savings. I’m sure that you can easily see now that over time, outstanding balances can grow very quickly. And remember how last post we saw the unbelievable difference in interest costs that result from taking a 7% mortgage instead of a 5% mortgage? Now imagine the difference between a 5% mortgage and a 30% mortgage.
To give you an idea of just how astronomical a 30% interest rate is, imagine a scenario where an individual owes $100,000 in credit card balances (unfortunately, hardly a rare circumstance in today’s world). At 30% interest, that individual can pay $30,000 back to the lender every year, and yet not a single dollar of that amount will go to paying down the principle of the debt owing. In the world of corporate finance (as opposed to personal or residential finance), there would never be a company that would even think to borrow at 30%. How anyone else would do that is beyond me!
Credit card companies know that obtaining a 30% return on their money (by charging a 30% rate) is a very rare opportunity to gain a return on investment that simply cannot be matched by any other investment in the world. In fact, the residential credit card industry is so popular amongst large corporations, that almost every large retail store in North America now offers them. Shoppers Drug Mart, Costco, Sears, Canadian Tire, even Walt Disney diversified from their primary business models to offer credit cards to their consumers. One company that got heavily involved and suffered for its forays into the credit markets during the recent economic recession was General Electric. One of the most respected and successful companies in the history of the global business world, GE’s stock price fell an incredible 83% in just over one year (2008/2009) as a result of huge losses suffered because of over-zealousness in the residential credit industry. Even during the stock market recovery of 2009/2010, GE stock has only recovered 26% of its value lost, and many analysts predict that it will never fully recover from the losses sustained due to credit write-downs. Notice however, that the list of companies that forayed into the credit card industry mentioned above is made up of only retailers (companies that service the general public directly, as opposed to wholesalers). Why is this so? Because (and I don’t mean to offend any of us residential consumers) no corporate financial controller in their right mind would ever borrow funds at 30%. Only residential consumers are foolish enough to do that.
What’s my point here? Credit card companies appreciate consumers who don’t fully pay back their borrowings on a timely month by month basis, because it gives the credit companies the chance to earn a 30% return on their investments. This is the exact reason why most credit cards will highlight a ‘minimum payment’ on their monthly credit card bills. The only point of mentioning a ‘minimum payment’ is to try to psychologically soothe a consumer into thinking that it’s okay to only pay back the minimum payment. It’s nothing more than a trap, plain and simple. In fact, non-profit consumer credit organizations have in the past tried to sue credit card companies for writing ‘minimum payments’ on their bills, because they believe the tactic is essentially an attempt to mislead the consumer.
I cannot stress this point more: do not ever borrow on your credit card if you cannot pay the full balance on time at the end of each month. And if you already have an outstanding balance, get rid of it in any way possible. If you cannot trust yourself to not spend beyond your means on a credit card, just don’t use one. The benefits of credit cards mentioned at the beginning of this post do not come anywhere close to justifying paying 30% interest on your borrowings.
Finally, one last point about credit cards and debt in general. I keep mentioning over and over that debt is nothing more than negative savings. In the posts about savings, I often talked about the essential importance of diversification – which means to diversify your investments in different asset classes (such as stocks, bonds, real estate, treasuries, etc.). What about debt?
Debt is the flip side of savings. And therefore, diversification is a very bad thing in debt. However, for some reason, people feel psychologically better about themselves when their debt is diversified. For instance, imagine a scenario where a couple is holding a $250,000 mortgage debt at 2.5%, a $35,000 car loan at 6%, student debt of $40,000 at 5%, and credit card debt of $25,000 at 30%. Now, supposing the house is worth $500,000 – so the couple technically has (gross) equity in their house of 500,000 – 250,000 = $250,000. If you add up all the interest payments on the couple’s debt – it will equal $17,850/year in interest payments.
Now here’s an interesting idea. Supposing the couple goes to the mortgage company and asks them to borrow an additional $100,000 against the equity in their house, at their regular mortgage interest rate of 2.5%. The couple then takes the $100,000 and pays off all the other debts that are currently outstanding. So now, the couple has only 500,000 – 350,000 = $150,000 in equity in their house. How much in interest does the couple pay every year in this situation on their mortgage? $8,750. Incredible! By combining all their debts into one (this process is called debt consolidation), the couple has managed to save 17,850 – 8,750 = $9,100 in interest payments each year.
Yet, many Canadians dislike the concept of debt consolidation. I can think of two reasons why - let me know if you think of any others:
1)Splitting up the total debt in different categories seems to psychologically diminish the value of the total debt being carried.
2)People are more protective of the equity in their house than their cash. In other words, psychologically, people put too much emphasis on having $250,000 of equity in their house instead of $150,000, when in reality, what really matters is your overall financial position, not just your stake in your house!
These reasons are entirely illogical, and are big personal finance mistakes for obvious reasons. Diversification is bad because interest rates are fixed, as opposed to rates on return on savings. If I put my savings in stocks, the rate of return I will receive is unknown and there exists a considerable risk for low returns or even losses. Therefore, as explained in previous posts, diversification of savings reduces risk and smoothes out rates of return. But debt is entirely predictable. When you borrow funds, you sign a contract with the lender, agreeing to a known interest rate. Therefore, you might as well consolidate all your savings into one debt at the lowest rate possible. This is analogous to a situation where rates of returns on your savings are guaranteed and there was no risk involved. If that was the case, of course you would put all your money into the investment that guarantees the highest rate of return! There is no difference with debt – it’s just the flipside of savings.
Point in hand: If you incur credit card debt – why not ask your mortgage lender to increase your mortgage, and pay off your credit card instead? This could save you many thousands of dollars in interest every year.
Next post, we will move on to other forms of debt, such as line of credits, credit union borrowings, student debt, etc., and then we will start talking about mortgage and house purchases.
To end, I want to propose a question, and see what you guys think. If I had $100,000 in credit card debt at 30% interest, and $100,000 in savings invested in stocks that earn, on average, a 30% rate of return, what should I do with my money? Should I pay down the debt or watch my savings grow?
1)Credit cards are convenient. No one can deny that! It’s no doubt easier to carry around a piece of plastic in your wallet instead of a wad of cash.
2)If used properly, credit cards can increase your credit score, which can go a long way in helping you to qualify for a mortgage in the future with more advantageous rates, should you need one. I will be speaking more about credit scores in a future post, but in short, every individual who has a social insurance number also carries a credit score, which is a summary of your credit history. If your credit history shows that you were a responsible credit card holder who always made your payments on time, your credit score will increase.
3)Credit cards can offer rewards and benefits in the form of cash-back returns, travel points, travel insurance, etc. Everyone loves free vacations, right?
These three benefits to carrying credits are the reason why there are an estimated 75million credit cards in circulation in Canada, an average of over 2 per person. Canadians spent about $265 billion on their credit cards in 2009. The reason why I’m telling you all this is because credit cards can be very good financial tools, if used responsibly. Let’s talk about the other side of credit cards – the things to be aware of if you do want to be a responsible credit card user.
As I explained in last week’s post, the reason for a credit card’s incredibly high interest rate is reflective of the borrower, not the lender. Credit cards are not collateralized by any hard assets, and therefore, banks are forced to charge high rates on their cards. Banks choose a rate that will ensure that even with a relatively higher number of unprotected (uncollateralized) credit defaults, their money lent out will still provide a profitable rate of return. As was also explained previously, debt works in the same manner as savings, and therefore, grow exponentially just like savings. Why does debt grow exponentially? Suppose you owe $10,000 on your credit cards, which incurs a 30% interest rate. After a year, supposing you do not make any payments on your card, your $10,000 will incur 30% interest, or another $3,000, so that your total outstanding balance owed to the credit card lender will be $13,000. However, in the second year, you won’t only incur $3,000 in interest – you will now incur 30% interest on your new $13,000 balance (instead of on your original $10,000 balance) which equals $3,900 in interest, which brings your total balance owing to $16,900 after year 2. Interest begets more interest, in the same way that savings compounded begets more savings. I’m sure that you can easily see now that over time, outstanding balances can grow very quickly. And remember how last post we saw the unbelievable difference in interest costs that result from taking a 7% mortgage instead of a 5% mortgage? Now imagine the difference between a 5% mortgage and a 30% mortgage.
To give you an idea of just how astronomical a 30% interest rate is, imagine a scenario where an individual owes $100,000 in credit card balances (unfortunately, hardly a rare circumstance in today’s world). At 30% interest, that individual can pay $30,000 back to the lender every year, and yet not a single dollar of that amount will go to paying down the principle of the debt owing. In the world of corporate finance (as opposed to personal or residential finance), there would never be a company that would even think to borrow at 30%. How anyone else would do that is beyond me!
Credit card companies know that obtaining a 30% return on their money (by charging a 30% rate) is a very rare opportunity to gain a return on investment that simply cannot be matched by any other investment in the world. In fact, the residential credit card industry is so popular amongst large corporations, that almost every large retail store in North America now offers them. Shoppers Drug Mart, Costco, Sears, Canadian Tire, even Walt Disney diversified from their primary business models to offer credit cards to their consumers. One company that got heavily involved and suffered for its forays into the credit markets during the recent economic recession was General Electric. One of the most respected and successful companies in the history of the global business world, GE’s stock price fell an incredible 83% in just over one year (2008/2009) as a result of huge losses suffered because of over-zealousness in the residential credit industry. Even during the stock market recovery of 2009/2010, GE stock has only recovered 26% of its value lost, and many analysts predict that it will never fully recover from the losses sustained due to credit write-downs. Notice however, that the list of companies that forayed into the credit card industry mentioned above is made up of only retailers (companies that service the general public directly, as opposed to wholesalers). Why is this so? Because (and I don’t mean to offend any of us residential consumers) no corporate financial controller in their right mind would ever borrow funds at 30%. Only residential consumers are foolish enough to do that.
What’s my point here? Credit card companies appreciate consumers who don’t fully pay back their borrowings on a timely month by month basis, because it gives the credit companies the chance to earn a 30% return on their investments. This is the exact reason why most credit cards will highlight a ‘minimum payment’ on their monthly credit card bills. The only point of mentioning a ‘minimum payment’ is to try to psychologically soothe a consumer into thinking that it’s okay to only pay back the minimum payment. It’s nothing more than a trap, plain and simple. In fact, non-profit consumer credit organizations have in the past tried to sue credit card companies for writing ‘minimum payments’ on their bills, because they believe the tactic is essentially an attempt to mislead the consumer.
I cannot stress this point more: do not ever borrow on your credit card if you cannot pay the full balance on time at the end of each month. And if you already have an outstanding balance, get rid of it in any way possible. If you cannot trust yourself to not spend beyond your means on a credit card, just don’t use one. The benefits of credit cards mentioned at the beginning of this post do not come anywhere close to justifying paying 30% interest on your borrowings.
Finally, one last point about credit cards and debt in general. I keep mentioning over and over that debt is nothing more than negative savings. In the posts about savings, I often talked about the essential importance of diversification – which means to diversify your investments in different asset classes (such as stocks, bonds, real estate, treasuries, etc.). What about debt?
Debt is the flip side of savings. And therefore, diversification is a very bad thing in debt. However, for some reason, people feel psychologically better about themselves when their debt is diversified. For instance, imagine a scenario where a couple is holding a $250,000 mortgage debt at 2.5%, a $35,000 car loan at 6%, student debt of $40,000 at 5%, and credit card debt of $25,000 at 30%. Now, supposing the house is worth $500,000 – so the couple technically has (gross) equity in their house of 500,000 – 250,000 = $250,000. If you add up all the interest payments on the couple’s debt – it will equal $17,850/year in interest payments.
Now here’s an interesting idea. Supposing the couple goes to the mortgage company and asks them to borrow an additional $100,000 against the equity in their house, at their regular mortgage interest rate of 2.5%. The couple then takes the $100,000 and pays off all the other debts that are currently outstanding. So now, the couple has only 500,000 – 350,000 = $150,000 in equity in their house. How much in interest does the couple pay every year in this situation on their mortgage? $8,750. Incredible! By combining all their debts into one (this process is called debt consolidation), the couple has managed to save 17,850 – 8,750 = $9,100 in interest payments each year.
Yet, many Canadians dislike the concept of debt consolidation. I can think of two reasons why - let me know if you think of any others:
1)Splitting up the total debt in different categories seems to psychologically diminish the value of the total debt being carried.
2)People are more protective of the equity in their house than their cash. In other words, psychologically, people put too much emphasis on having $250,000 of equity in their house instead of $150,000, when in reality, what really matters is your overall financial position, not just your stake in your house!
These reasons are entirely illogical, and are big personal finance mistakes for obvious reasons. Diversification is bad because interest rates are fixed, as opposed to rates on return on savings. If I put my savings in stocks, the rate of return I will receive is unknown and there exists a considerable risk for low returns or even losses. Therefore, as explained in previous posts, diversification of savings reduces risk and smoothes out rates of return. But debt is entirely predictable. When you borrow funds, you sign a contract with the lender, agreeing to a known interest rate. Therefore, you might as well consolidate all your savings into one debt at the lowest rate possible. This is analogous to a situation where rates of returns on your savings are guaranteed and there was no risk involved. If that was the case, of course you would put all your money into the investment that guarantees the highest rate of return! There is no difference with debt – it’s just the flipside of savings.
Point in hand: If you incur credit card debt – why not ask your mortgage lender to increase your mortgage, and pay off your credit card instead? This could save you many thousands of dollars in interest every year.
Next post, we will move on to other forms of debt, such as line of credits, credit union borrowings, student debt, etc., and then we will start talking about mortgage and house purchases.
To end, I want to propose a question, and see what you guys think. If I had $100,000 in credit card debt at 30% interest, and $100,000 in savings invested in stocks that earn, on average, a 30% rate of return, what should I do with my money? Should I pay down the debt or watch my savings grow?
Wednesday, July 21, 2010
Introduction to Debt
Debt. The word seems to conjure negative connotations, the ultimate evil when building a stable and promising personal financial future. In fact, nothing can be further from the case. Sort of. What do I mean?
Well, debt can be a valuable tool in personal finance, and often a vital one. Studies have shown that property ownership, which is most often financed by debt (specifically known as mortgages), has a wonderfully positive correlation with above-average wealth accumulation. Notwithstanding the recent economic events of the past few years, married couples who have committed to house ownership with the help of a mortgage, has on average, accumulated about 10 times the wealth as single, non-property owning individuals (upon retirement)! Experts have disagreed over the reason for this anomaly – but I believe the reason to be something about increased responsibility. Having a family, combined with a mortgage, will force families to save money by contributing a very significant part of their income into building equity into their house. Individuals with no house/mortgage, simply end up spending their extra income on perishable items, and find that, upon retirement, they wonder where all the money earned over their lifetime went!
On the other hand, debt can be a very dangerous investment (including mortgages!), and is often the undoing of many individuals and their personal financial situations. The key here is to exactly understand how debt works, and how to identify the good debt from bad debt. In this post, I’m going to give an overall introduction to exactly how debt works, and in subsequent posts, I will be discussing the various kinds of debt that is offered to the residential community, and how to approach them. So here goes.
What is debt? This may seem obvious – debt refers to money borrowed. Why would anyone want to lend out his/her money? Because money lent out produces a return on investment (ROI) – specifically interest payments. If I lend you $1,000, and receive $100 from you in interest every year, I am receiving a 10% return, or, said differently, charging a 10% interest rate on my money that you borrowed. Why would anyone want to borrow money? To produce a return on investment that otherwise would not have been attainable without the borrowed money. These investments can produce returns that do not necessarily have to be monetary; for instance, I may borrow money to finance a convertible, which brings me a return composed of pleasure, ego-pumping, etc. (point is, it's not a monetary return!).
What differentiates different types of debt? There are many factors, but by far the most important one is the interest rate, which refers to size of the annual interest payments relative to the size of the overall debt. Mortgages usually have low interest rates, while credit card balances usually have very high interest rates. Why would that be? It’s all about the risk of defaulting on the debt. If you had $1,000 to lend out to someone, and the first person who asks you for the money was a beggar off the street with no assets whatsoever, you’d probably ask for an extremely high interest rate on your $1,000, because the risk of a beggar blowing your money and then not being able to pay you back is really high. Conversely, if you lent your $1,000 to the US government, you’d expect a much lower interest rate, because the chances of the US government defaulting on its loans are essentially nil.
In reality, this is exactly how the real credit markets work. Mortgages, or secured lines of credit, often carry relatively low interest rates, because there’s a property/asset backing up the loan. The banks knows that if you default on your mortgage, it can (and will!) re-possess your house, sell it, and get back its money. Therefore, the risk of lending money to you is much lower (even for mortgages though, banks charge variously higher and lower interest rates based on the borrower's credit history, wealth, income etc., but these rates usually don't exceed 10%, because of the property collateralized against the money borrowed). On the other hand, credit cards carry high interest rates because they are unsecured borrowings. To become a credit card holder, all you have to do is fill in an application, and sometimes the bank will run a credit check on you. But the fact is, the bank has no guarantee on your loan, so it has to charge you higher interest rates. This is one of the biggest misconceptions about banks. Most people believe that banks are evil for charging incredibly high interest rates on their credit cards to unsuspecting borrowers. But the funny thing is, those rates are a reflection of the borrower, not the bank. The bank will be happy to lend you money at a cheaper interest rate, if you are able to prove that you are a credit-worthy borrower, or back your borrowed funds with some assets. If all you do is fill out a credit-card application, the bank has no choice but to charge you a high interest rate; otherwise, it will lose money in the long run. (Note – I never said banks aren’t evil – I just said they’re not evil for charging high rates on credit cards!).
So what should be the strategy for someone who needs to borrow money from a lending institution? You guessed it – try to obtain the lowest interest rate possible. The difference between a few interest rate points on a loan is absolutely humongous. For example, let’s say you want to take out a 25 year, $300,000 mortgage, compounded monthly. There are two companies offering to give you the mortgage. Bank A will lend it to you at a fixed interest rate of 5%, and Bank B at 7% (assuming that rate is fixed for all 25 years of the mortgage). Over the entire lifetime of the mortgage, how much more in interest payments will you pay if you took the mortgage from Bank B, rather than Bank A? Care to guess? The answer is (drum roll please): $109,735. Incredible! A 2% difference in the mortgage interest rate (5% vs. 7%) will result in over $100,000 in increased interest costs over the lifetime of the mortgage.
How can such a small interest rate difference equal such a huge overall interest payment difference?
The answer is surprisingly simple and very much related to some of the previous posts on this blog – regarding saving. Debt is essentially negative saving. For example, if you had $100,000 in savings and $100,000 in debt, overall, you have net $0 in savings. Savings minus debt equals wealth. Our goal is to increase wealth, and therefore there are 2 ways to do that: a) increase savings or b) decrease debt. So debt is nothing more than negative savings. When we talked about savings, the incredible power of compounding interest was described. Over time, interest on savings (let’s say, interest earned on investments in the bank) compound and grow exponentially. (See the 'intro to investments' post to fully understand this concept). Since debt is nothing more than negative savings, it works the exact opposite way. Interest on debt is exponentially increased as the debt interest rate grows higher. So while the goal on our savings accounts it to gain the maximum possible rate of return on our investments, the goal of our debt is to lower the debt interest rate, because it works in the exact opposite way of savings.
Said differently - if you had $10,000 in debt which charges you a 10% interest rate, and $10,000 in savings that grow at 10% each year - you essentially have $0 in savings, and you will always have $0 in savings for years to come. Both debt and savings grow at the exact same pace, so they will always cancel each other out. My point is - savings and debt are the same thing, just 2 sides of the same coin. The reason why this concept is important will become clear to you in future posts.
Sounds logical, eh? Problem is, most Canadians fail to understand this concept. For some reason, we get all excited when our savings grow by a higher amount than we had anticipated. But we fail to understand the consequences of debt growing at the same rate. There is, in fact, no difference!
There are a number of lessons we can learn from the above-noted concepts, many of which I will describe in upcoming posts. The remainder of this post will describe the first lesson of debt.
Lesson #1 – Credit Card balances are bad. Very, very bad. Check the interest rate in the upper corner of your next VISA bill. It very well might read 29%. That number is astronomically high in finance circles. To illustrate a very practical lesson here – suppose you had a balance of $10,000 on your VISA bill that you’re having trouble paying off. Suppose also that your total savings in the bank equal $10,000, which are invested in GIC’s, paying you 2% annually. What should you do? Should you pay off the VISA balance by cashing your GIC’s, or keep your only savings in the bank?
I hope this post taught you the right thing. In case it didn’t, let me explain. Debt is really negative savings, nothing more and nothing less. So if you want to increase your overall wealth, obviously you should pay down the credit card balance, because the interest rate is so much higher on it than the rate of return on your savings. In fact, I’d probably advise a couple to liquidate every last penny of their savings (there are exceptions of course!) to pay off their credit card debt, because there is little chance your savings will ever produce a rate of return that will match a credit card interest rate.
So lesson number one is: Never, ever borrow on a credit card (if you know you can’t pay it back), unless you are super-desperate and have tried every last means under the sun to borrow money at a cheaper rate. And if you already have a credit card balance, pay it off immediately. Even borrow money to pay it off. Beg for the money – whatever it takes. Because you will never earn a rate of return on your borrowed funds that will out-perform your credit card interest rate.
This first lesson may seem obvious, but incredibly, I have seen a study showing that only 15% of recent college graduates in the US do not have a credit card balance owing. Do not fall into the trap. Do not incur unpaid credit card balances!
Next week, I will further our discussion on credit cards (believe it or not, there are some positives for having credit cards!), before moving on to discussing mortgages.
Well, debt can be a valuable tool in personal finance, and often a vital one. Studies have shown that property ownership, which is most often financed by debt (specifically known as mortgages), has a wonderfully positive correlation with above-average wealth accumulation. Notwithstanding the recent economic events of the past few years, married couples who have committed to house ownership with the help of a mortgage, has on average, accumulated about 10 times the wealth as single, non-property owning individuals (upon retirement)! Experts have disagreed over the reason for this anomaly – but I believe the reason to be something about increased responsibility. Having a family, combined with a mortgage, will force families to save money by contributing a very significant part of their income into building equity into their house. Individuals with no house/mortgage, simply end up spending their extra income on perishable items, and find that, upon retirement, they wonder where all the money earned over their lifetime went!
On the other hand, debt can be a very dangerous investment (including mortgages!), and is often the undoing of many individuals and their personal financial situations. The key here is to exactly understand how debt works, and how to identify the good debt from bad debt. In this post, I’m going to give an overall introduction to exactly how debt works, and in subsequent posts, I will be discussing the various kinds of debt that is offered to the residential community, and how to approach them. So here goes.
What is debt? This may seem obvious – debt refers to money borrowed. Why would anyone want to lend out his/her money? Because money lent out produces a return on investment (ROI) – specifically interest payments. If I lend you $1,000, and receive $100 from you in interest every year, I am receiving a 10% return, or, said differently, charging a 10% interest rate on my money that you borrowed. Why would anyone want to borrow money? To produce a return on investment that otherwise would not have been attainable without the borrowed money. These investments can produce returns that do not necessarily have to be monetary; for instance, I may borrow money to finance a convertible, which brings me a return composed of pleasure, ego-pumping, etc. (point is, it's not a monetary return!).
What differentiates different types of debt? There are many factors, but by far the most important one is the interest rate, which refers to size of the annual interest payments relative to the size of the overall debt. Mortgages usually have low interest rates, while credit card balances usually have very high interest rates. Why would that be? It’s all about the risk of defaulting on the debt. If you had $1,000 to lend out to someone, and the first person who asks you for the money was a beggar off the street with no assets whatsoever, you’d probably ask for an extremely high interest rate on your $1,000, because the risk of a beggar blowing your money and then not being able to pay you back is really high. Conversely, if you lent your $1,000 to the US government, you’d expect a much lower interest rate, because the chances of the US government defaulting on its loans are essentially nil.
In reality, this is exactly how the real credit markets work. Mortgages, or secured lines of credit, often carry relatively low interest rates, because there’s a property/asset backing up the loan. The banks knows that if you default on your mortgage, it can (and will!) re-possess your house, sell it, and get back its money. Therefore, the risk of lending money to you is much lower (even for mortgages though, banks charge variously higher and lower interest rates based on the borrower's credit history, wealth, income etc., but these rates usually don't exceed 10%, because of the property collateralized against the money borrowed). On the other hand, credit cards carry high interest rates because they are unsecured borrowings. To become a credit card holder, all you have to do is fill in an application, and sometimes the bank will run a credit check on you. But the fact is, the bank has no guarantee on your loan, so it has to charge you higher interest rates. This is one of the biggest misconceptions about banks. Most people believe that banks are evil for charging incredibly high interest rates on their credit cards to unsuspecting borrowers. But the funny thing is, those rates are a reflection of the borrower, not the bank. The bank will be happy to lend you money at a cheaper interest rate, if you are able to prove that you are a credit-worthy borrower, or back your borrowed funds with some assets. If all you do is fill out a credit-card application, the bank has no choice but to charge you a high interest rate; otherwise, it will lose money in the long run. (Note – I never said banks aren’t evil – I just said they’re not evil for charging high rates on credit cards!).
So what should be the strategy for someone who needs to borrow money from a lending institution? You guessed it – try to obtain the lowest interest rate possible. The difference between a few interest rate points on a loan is absolutely humongous. For example, let’s say you want to take out a 25 year, $300,000 mortgage, compounded monthly. There are two companies offering to give you the mortgage. Bank A will lend it to you at a fixed interest rate of 5%, and Bank B at 7% (assuming that rate is fixed for all 25 years of the mortgage). Over the entire lifetime of the mortgage, how much more in interest payments will you pay if you took the mortgage from Bank B, rather than Bank A? Care to guess? The answer is (drum roll please): $109,735. Incredible! A 2% difference in the mortgage interest rate (5% vs. 7%) will result in over $100,000 in increased interest costs over the lifetime of the mortgage.
How can such a small interest rate difference equal such a huge overall interest payment difference?
The answer is surprisingly simple and very much related to some of the previous posts on this blog – regarding saving. Debt is essentially negative saving. For example, if you had $100,000 in savings and $100,000 in debt, overall, you have net $0 in savings. Savings minus debt equals wealth. Our goal is to increase wealth, and therefore there are 2 ways to do that: a) increase savings or b) decrease debt. So debt is nothing more than negative savings. When we talked about savings, the incredible power of compounding interest was described. Over time, interest on savings (let’s say, interest earned on investments in the bank) compound and grow exponentially. (See the 'intro to investments' post to fully understand this concept). Since debt is nothing more than negative savings, it works the exact opposite way. Interest on debt is exponentially increased as the debt interest rate grows higher. So while the goal on our savings accounts it to gain the maximum possible rate of return on our investments, the goal of our debt is to lower the debt interest rate, because it works in the exact opposite way of savings.
Said differently - if you had $10,000 in debt which charges you a 10% interest rate, and $10,000 in savings that grow at 10% each year - you essentially have $0 in savings, and you will always have $0 in savings for years to come. Both debt and savings grow at the exact same pace, so they will always cancel each other out. My point is - savings and debt are the same thing, just 2 sides of the same coin. The reason why this concept is important will become clear to you in future posts.
Sounds logical, eh? Problem is, most Canadians fail to understand this concept. For some reason, we get all excited when our savings grow by a higher amount than we had anticipated. But we fail to understand the consequences of debt growing at the same rate. There is, in fact, no difference!
There are a number of lessons we can learn from the above-noted concepts, many of which I will describe in upcoming posts. The remainder of this post will describe the first lesson of debt.
Lesson #1 – Credit Card balances are bad. Very, very bad. Check the interest rate in the upper corner of your next VISA bill. It very well might read 29%. That number is astronomically high in finance circles. To illustrate a very practical lesson here – suppose you had a balance of $10,000 on your VISA bill that you’re having trouble paying off. Suppose also that your total savings in the bank equal $10,000, which are invested in GIC’s, paying you 2% annually. What should you do? Should you pay off the VISA balance by cashing your GIC’s, or keep your only savings in the bank?
I hope this post taught you the right thing. In case it didn’t, let me explain. Debt is really negative savings, nothing more and nothing less. So if you want to increase your overall wealth, obviously you should pay down the credit card balance, because the interest rate is so much higher on it than the rate of return on your savings. In fact, I’d probably advise a couple to liquidate every last penny of their savings (there are exceptions of course!) to pay off their credit card debt, because there is little chance your savings will ever produce a rate of return that will match a credit card interest rate.
So lesson number one is: Never, ever borrow on a credit card (if you know you can’t pay it back), unless you are super-desperate and have tried every last means under the sun to borrow money at a cheaper rate. And if you already have a credit card balance, pay it off immediately. Even borrow money to pay it off. Beg for the money – whatever it takes. Because you will never earn a rate of return on your borrowed funds that will out-perform your credit card interest rate.
This first lesson may seem obvious, but incredibly, I have seen a study showing that only 15% of recent college graduates in the US do not have a credit card balance owing. Do not fall into the trap. Do not incur unpaid credit card balances!
Next week, I will further our discussion on credit cards (believe it or not, there are some positives for having credit cards!), before moving on to discussing mortgages.
Monday, July 5, 2010
Canadian Child Care Supplements
So, you’re looking forward to the birth of a new child. Did you know that the Canadian government has various programs to financially help with the cost burden of raising children in Canada?
The Universal Child Care Benefit is a program that pays $100/month per child under the age of 6 to Canadian families. These payments can start from the month after the child is born, to the month the child turns 6 years old. Interestingly, there are NO financial eligibility conditions for the UCCB – everyone can receive it, no matter what the family’s income is. Assuming you are a legal resident of Canada and live with child, as well provide the primary care for the child, you can be eligible. See http://www.cra-arc.gc.ca/bnfts/uccb-puge/pplctn-eng.html for a complete list of eligibility criteria.
It is important to note that these payments are taxable. In other words, when you do file your annual tax return, the UCCB payments you received in the taxable year will be reported in your line 150. There is no option to deduct income tax at source for the UCCB payments, so make sure you will be able to pay the taxes on the UCCB when they become payable!
Applying for the UCCB program is relatively simple. You can (and should!) apply as soon as possible after the birth of the child, although it may be possible to retroactively collect various child care benefits for past months (up to 11 months I believe) where payments were missed because an application wasn’t sent in. The UCCB application is included in the Canada Child Tax Benefit application. What’s that?!
The Canada Child Tax Benefit is another program that can help a family with the cost of raising a child. The CCTB program differs from the UCCB in that CCTB payments are non-taxable, and are based on net income of the parent(s)/guardian(s) applying. The CCTB is actually made up of 3 separate benefits:
1)Basic Benefit – The basic benefit pays $112.33/month for each child (up to a maximum of 2 children) under the age of 18, and $7.83/month for your third and each additional child. These amounts are reduced for recipients with a family adjusted net income of over $40,970. For a family with one child, the amounts are reduced by 2% of net income that is over $40,970, and for a family with 2 or more children, the amounts are reduced by 4% of net income that is over $40,970.
2)National Child Benefit Supplement – The NCBS payments are: $174/month for the first child, $154/month for the second child, and $146.50/month for each additional child. NCBS payments will be reduced as follows:
a)For a family with one child, the reduction is 12.2% of the amount of the adjusted family net income that is more than $23,855.
b)For a family with two children, the reduction is 23% of the amount of the adjusted family net income that is more than $23,855.
c)For families with three or more children, the reduction is 33.3% of the amount of the adjusted family net income that is more than $23,855.
Another benefit of the NCBS is that if you do receive NCBS payments, your child may qualify for the Canada Learning Bond which contributes funds to your child’s RESP(s)– see last post for more information on the Canada Learning Bond.
3)Child Disability Benefit – the CDB provides financial assistance for families with children who have severe and prolonged impairment in physical and/or mental functions. The benefits pay a maximum of $205.83/month, and starts being reduced when the adjusted family net income is over $40,970.
Wait, there’s more!
Most Canadian provinces have their own programs that help parents cope with the financial burden of raising a child. The Ontario Child Benefit pays up to a maximum of $92.61/month per child, and begins to be reduced for adjusted family net incomes over $20,000.
Not bad, eh? The key here is to take advantage of these government benefits! Later in life, you will likely be paying high amounts of taxes on your income in order to support these very same programs for younger, lower income earning parents. Your own parents, relatives, and friends are probably paying a good amount of taxes which help support these programs. Now is your time to benefit from these programs, so don’t miss out!
Having trouble figuring out what your family’s total CCTB payments will be? You can check out the CRA’s on-line calculator to determine the approximate amount of the benefit at http://www.cra-arc.gc.ca/benefits-calculator. Just to give you an idea of the monthly benefits you may be eligible to receive, I tested the calculator for a married couple with an adjusted family net income of $30,000, with one child who does not qualify for the disabled benefits supplements. The results are:
Basic monthly amount = $112.33
National Child Benefit Supplement monthly amount = $123.72
Ontario Child Benefit Monthly Amount = $33.00
Total monthly amount = $269.05
On top of this amount is the $100/month UCCB payment.
There are no restrictions for where these funds can go – you can turn around and invest them in an RESP or gamble them away in Las Vegas, for all the government cares (I am not necessarily suggesting either!).
Information regarding applying for the CCTB program, as well as the UCCB and OCS, can be found here: http://www.cra-arc.gc.ca/E/pub/tg/t4114/t4114-e.html#P142_7327.
Essentially, you will need to fill out the Canada Child Benefits Application – Form RC66 (http://www.cra-arc.gc.ca/E/pbg/tf/rc66/README.html) or apply on-line if you have an e-account with the CRA.
There are various other programs that the federal and provincial governments run to help with the cost of raising children, especially tax credits/deductions from income. You should definitely talk to your accountant regarding those potential tax benefits.
The Universal Child Care Benefit is a program that pays $100/month per child under the age of 6 to Canadian families. These payments can start from the month after the child is born, to the month the child turns 6 years old. Interestingly, there are NO financial eligibility conditions for the UCCB – everyone can receive it, no matter what the family’s income is. Assuming you are a legal resident of Canada and live with child, as well provide the primary care for the child, you can be eligible. See http://www.cra-arc.gc.ca/bnfts/uccb-puge/pplctn-eng.html for a complete list of eligibility criteria.
It is important to note that these payments are taxable. In other words, when you do file your annual tax return, the UCCB payments you received in the taxable year will be reported in your line 150. There is no option to deduct income tax at source for the UCCB payments, so make sure you will be able to pay the taxes on the UCCB when they become payable!
Applying for the UCCB program is relatively simple. You can (and should!) apply as soon as possible after the birth of the child, although it may be possible to retroactively collect various child care benefits for past months (up to 11 months I believe) where payments were missed because an application wasn’t sent in. The UCCB application is included in the Canada Child Tax Benefit application. What’s that?!
The Canada Child Tax Benefit is another program that can help a family with the cost of raising a child. The CCTB program differs from the UCCB in that CCTB payments are non-taxable, and are based on net income of the parent(s)/guardian(s) applying. The CCTB is actually made up of 3 separate benefits:
1)Basic Benefit – The basic benefit pays $112.33/month for each child (up to a maximum of 2 children) under the age of 18, and $7.83/month for your third and each additional child. These amounts are reduced for recipients with a family adjusted net income of over $40,970. For a family with one child, the amounts are reduced by 2% of net income that is over $40,970, and for a family with 2 or more children, the amounts are reduced by 4% of net income that is over $40,970.
2)National Child Benefit Supplement – The NCBS payments are: $174/month for the first child, $154/month for the second child, and $146.50/month for each additional child. NCBS payments will be reduced as follows:
a)For a family with one child, the reduction is 12.2% of the amount of the adjusted family net income that is more than $23,855.
b)For a family with two children, the reduction is 23% of the amount of the adjusted family net income that is more than $23,855.
c)For families with three or more children, the reduction is 33.3% of the amount of the adjusted family net income that is more than $23,855.
Another benefit of the NCBS is that if you do receive NCBS payments, your child may qualify for the Canada Learning Bond which contributes funds to your child’s RESP(s)– see last post for more information on the Canada Learning Bond.
3)Child Disability Benefit – the CDB provides financial assistance for families with children who have severe and prolonged impairment in physical and/or mental functions. The benefits pay a maximum of $205.83/month, and starts being reduced when the adjusted family net income is over $40,970.
Wait, there’s more!
Most Canadian provinces have their own programs that help parents cope with the financial burden of raising a child. The Ontario Child Benefit pays up to a maximum of $92.61/month per child, and begins to be reduced for adjusted family net incomes over $20,000.
Not bad, eh? The key here is to take advantage of these government benefits! Later in life, you will likely be paying high amounts of taxes on your income in order to support these very same programs for younger, lower income earning parents. Your own parents, relatives, and friends are probably paying a good amount of taxes which help support these programs. Now is your time to benefit from these programs, so don’t miss out!
Having trouble figuring out what your family’s total CCTB payments will be? You can check out the CRA’s on-line calculator to determine the approximate amount of the benefit at http://www.cra-arc.gc.ca/benefits-calculator. Just to give you an idea of the monthly benefits you may be eligible to receive, I tested the calculator for a married couple with an adjusted family net income of $30,000, with one child who does not qualify for the disabled benefits supplements. The results are:
Basic monthly amount = $112.33
National Child Benefit Supplement monthly amount = $123.72
Ontario Child Benefit Monthly Amount = $33.00
Total monthly amount = $269.05
On top of this amount is the $100/month UCCB payment.
There are no restrictions for where these funds can go – you can turn around and invest them in an RESP or gamble them away in Las Vegas, for all the government cares (I am not necessarily suggesting either!).
Information regarding applying for the CCTB program, as well as the UCCB and OCS, can be found here: http://www.cra-arc.gc.ca/E/pub/tg/t4114/t4114-e.html#P142_7327.
Essentially, you will need to fill out the Canada Child Benefits Application – Form RC66 (http://www.cra-arc.gc.ca/E/pbg/tf/rc66/README.html) or apply on-line if you have an e-account with the CRA.
There are various other programs that the federal and provincial governments run to help with the cost of raising children, especially tax credits/deductions from income. You should definitely talk to your accountant regarding those potential tax benefits.
Wednesday, June 23, 2010
Registered Education Saving Plans
One of the least understood registered savings accounts is the registered education savings plan, or the RESP for short. Perhaps you are expecting your first child, or already have one or more children, and haven’t really considered the benefits of an RESP yet. Hopefully after this post, you will have a better understanding of how you can use an RESP and whether it’s worth it for you to utilize.
Firstly, I just want to clarify what an RESP is. An RESP is a savings account that is allowed to grow tax-free and can be used to fund a university/college education for the stated beneficiaries of the plan. It’s important to note that when the money is contributed to an RESP, you do not receive an immediate tax deduction (as with an RRSP contribution). When the money is eventually withdrawn for the beneficiary’s education costs, tax is paid on the earnings generated in the RESP; however, the beneficiary usually pays the taxes. This is advantageous because students are usually very low income earners, and end up paying minimal (if any) taxes on the RESP funds used for education.
Why else would you want to open an RESP? The most important reason by far is that the government actually contributes money to the RESP annually, through 2 programs:
1)Canada Education Savings Grant – Essentially, the government will match a portion of your savings, depending on your family net income and annual savings. Here is the exact amounts:
a)If your family net income is under $37,885 – the government will contribute 40% of your contributions to the RESP for the first $500 you contribute and 20% for next $2,000 you contribute, up to a maximum of $600 per year.
b)If your family net income is between $37,885 and $75,769 – the government will contribute 30% of your contributions for the first $500 you contribute, and 20% for the next $2,000 you save, up to a maximum of $550 per year.
c)If your family net income is over $75,769 – the government will contribute 20% for all contributions up to $2,500, for a maximum government contribution of $500 per year.
The maximum money that can be earned in an RESP from the Canada Education Savings Grant is $7,200. But obviously, those government contributions can earn interest – and there’s no maximum on that. And as well, don’t forget that the above noted numbers are per child.
2)Canada Learning Bond – This program is targeted for lower income families. To qualify for it, your child must have been born after December 31, 2003, and you receive what’s called the National Child Benefit Supplement (monthly payments from the government to help lower-income parents with raising children). The CLB works differently than the CESG – here’s a summary:
a)The CLB will pay $25 to help cover the cost of opening an account
b)The CLB will make a start-up payment of $500 to the RESP
c)The CLB will contribute $100/year until your child is 15 (as long as you still receive the National Child Benefit Supplement
The CLB can contribute up to a maximum of $2,000 for your child’s education. One important note about the CLB – you don’t have to be contributing any annual amount to receive the above-noted government contributions – just by simply opening an account, you can receive CLB benefits.
So is it worth it for you to open an RESP? The question is, when else do you receive free money from the government? And remember, the earlier you collect the government’s funds, the more time it has to earn interest and grow.
What happens if you need to withdraw RESP funds early? You will have to pay normal tax rates (the withdrawals are considered as income) plus an additional 20% penalty (yikes!). As well, you must return any government grants earned over the years of the plan (including the above-mentioned CLB and CESG), although not the interest earned on any grant. However it’s important to note that you only pay taxes on the interest earnings – the principle contributions you made throughout the life of the plans are after-tax dollars (they were already taxed before being contributed anyways). Therefore, the tax hit is not as bad as it seems. There are other ways to mitigate the strict penalties, including transferring the RESP contributions to an RRSP, donate the RESP balance, transfer the balance to another RESP, etc. Talk to your financial advisor.
What constitutes an educational program that an RESP can fund? Well – the list might be a little longer than you think. Besides the obvious Canadian post-secondary institutions, many part-time and even foreign institutions qualify.
The last issue that needs to be dealt with regards the actual plan itself. Should it be self-directed (i.e. you choose the investments) or should it done via mutual funds? Well, it is completely up to you. What I definitely would advise is to invest the majority of it in equities (risky assets), since the time frame is pretty long until you need the funds, and therefore, it’s ok to go for the higher returns. Many banks and different scholarship funds (like “Heritage”) offer RESP plans that may be a better fit for many investors. Why? Because often, RESPs are funded in small amounts over many years. If you self-direct your RESP, than the transaction costs for purchasing equities every time you contribute a little more money can be over-bearing. Scholarship funds will automatically add your money to the fund so you don’t have to incur the transaction costs constantly. When choosing a particular fund, make sure to ask questions like, “Is there an annual service fee?” “Is there a penalty for withdrawing funds?”
For a complete list of relevant questions, and for more information on RESPs, visit http://www.hrsdc.gc.ca/eng/learning/education_savings/public/resp.shtml
I hope you now have a better understanding of RESPs, and I definitely would recommend putting aside some money into an RESP, and watching it grow, along with receiving government payments. This is especially true in a case where parents are young, since a) you often qualify for higher government contributions and b) there’s more time for your RESPs to grow, so that the cost of your child(ren)’s education may become less of a burden in the long run.
Firstly, I just want to clarify what an RESP is. An RESP is a savings account that is allowed to grow tax-free and can be used to fund a university/college education for the stated beneficiaries of the plan. It’s important to note that when the money is contributed to an RESP, you do not receive an immediate tax deduction (as with an RRSP contribution). When the money is eventually withdrawn for the beneficiary’s education costs, tax is paid on the earnings generated in the RESP; however, the beneficiary usually pays the taxes. This is advantageous because students are usually very low income earners, and end up paying minimal (if any) taxes on the RESP funds used for education.
Why else would you want to open an RESP? The most important reason by far is that the government actually contributes money to the RESP annually, through 2 programs:
1)Canada Education Savings Grant – Essentially, the government will match a portion of your savings, depending on your family net income and annual savings. Here is the exact amounts:
a)If your family net income is under $37,885 – the government will contribute 40% of your contributions to the RESP for the first $500 you contribute and 20% for next $2,000 you contribute, up to a maximum of $600 per year.
b)If your family net income is between $37,885 and $75,769 – the government will contribute 30% of your contributions for the first $500 you contribute, and 20% for the next $2,000 you save, up to a maximum of $550 per year.
c)If your family net income is over $75,769 – the government will contribute 20% for all contributions up to $2,500, for a maximum government contribution of $500 per year.
The maximum money that can be earned in an RESP from the Canada Education Savings Grant is $7,200. But obviously, those government contributions can earn interest – and there’s no maximum on that. And as well, don’t forget that the above noted numbers are per child.
2)Canada Learning Bond – This program is targeted for lower income families. To qualify for it, your child must have been born after December 31, 2003, and you receive what’s called the National Child Benefit Supplement (monthly payments from the government to help lower-income parents with raising children). The CLB works differently than the CESG – here’s a summary:
a)The CLB will pay $25 to help cover the cost of opening an account
b)The CLB will make a start-up payment of $500 to the RESP
c)The CLB will contribute $100/year until your child is 15 (as long as you still receive the National Child Benefit Supplement
The CLB can contribute up to a maximum of $2,000 for your child’s education. One important note about the CLB – you don’t have to be contributing any annual amount to receive the above-noted government contributions – just by simply opening an account, you can receive CLB benefits.
So is it worth it for you to open an RESP? The question is, when else do you receive free money from the government? And remember, the earlier you collect the government’s funds, the more time it has to earn interest and grow.
What happens if you need to withdraw RESP funds early? You will have to pay normal tax rates (the withdrawals are considered as income) plus an additional 20% penalty (yikes!). As well, you must return any government grants earned over the years of the plan (including the above-mentioned CLB and CESG), although not the interest earned on any grant. However it’s important to note that you only pay taxes on the interest earnings – the principle contributions you made throughout the life of the plans are after-tax dollars (they were already taxed before being contributed anyways). Therefore, the tax hit is not as bad as it seems. There are other ways to mitigate the strict penalties, including transferring the RESP contributions to an RRSP, donate the RESP balance, transfer the balance to another RESP, etc. Talk to your financial advisor.
What constitutes an educational program that an RESP can fund? Well – the list might be a little longer than you think. Besides the obvious Canadian post-secondary institutions, many part-time and even foreign institutions qualify.
The last issue that needs to be dealt with regards the actual plan itself. Should it be self-directed (i.e. you choose the investments) or should it done via mutual funds? Well, it is completely up to you. What I definitely would advise is to invest the majority of it in equities (risky assets), since the time frame is pretty long until you need the funds, and therefore, it’s ok to go for the higher returns. Many banks and different scholarship funds (like “Heritage”) offer RESP plans that may be a better fit for many investors. Why? Because often, RESPs are funded in small amounts over many years. If you self-direct your RESP, than the transaction costs for purchasing equities every time you contribute a little more money can be over-bearing. Scholarship funds will automatically add your money to the fund so you don’t have to incur the transaction costs constantly. When choosing a particular fund, make sure to ask questions like, “Is there an annual service fee?” “Is there a penalty for withdrawing funds?”
For a complete list of relevant questions, and for more information on RESPs, visit http://www.hrsdc.gc.ca/eng/learning/education_savings/public/resp.shtml
I hope you now have a better understanding of RESPs, and I definitely would recommend putting aside some money into an RESP, and watching it grow, along with receiving government payments. This is especially true in a case where parents are young, since a) you often qualify for higher government contributions and b) there’s more time for your RESPs to grow, so that the cost of your child(ren)’s education may become less of a burden in the long run.
Tuesday, June 8, 2010
RRSPs or TFSAs?
So you’ve set aside some money to save for a registered savings account. Question is, what should you use, an RRSP or TFSA? What’s the real difference between the two anyways?
The key difference between a TFSA and an RRSP is that a TFSA uses what’s referred to as after-tax dollars, while an RRSP uses before-tax dollars. When you contribute funds to an RRSP, you get to deduct that contribution amount from your next year`s net taxable income on your tax return. In other words, you (temporarily) avoid paying taxes on that contribution amount, until you cash the RRSP upon retirement. Which means that a good portion of the benefit of an RRSP is used at the time of the contribution. An RRSP contribution is therefore a tax break.
On the other hand, a TFSA contribution doesn’t receive any special tax treatment. It’s considered after-tax because whatever contribution you make is made using funds that have already been taxed as ordinary income. The tax-free part of a TFSA involves the interest – all interest, dividends, capital gains, etc. earned in a TFSA is completely tax free, forever, as long as the money stays inside the TFSA.
There are some other differences that were discussed in the previous post. But the aforementioned difference drives most of the strategy involved with RRSP vs TFSA contributions. A big part of the benefit of an RRSP is immediate; that is, the current tax deduction on your next income tax return. This tells us a lot about whether to contribute immediately to an RRSP. If you are young, and you expect your income to increase substantially within the next few years, it may be smarter to wait for a few years to make your RRSP contribution, because the tax break you will receive is greater if your marginal tax rate is higher. As was discussed in the previous post, your contribution room grows over the years if you haven`t used it up previously. Furthermore, if your income is low right now, and your tax bill is very small to begin with, making contributions to your RRSP can be detrimental to your financial position. You’ll get a income tax deduction, but if you’re barely paying any taxes now, what use is that to you? Better to just invest your savings in an unregistered account and save your RRSP contribution for future, higher earning years.
Does the same concept apply for TFSAs? Absolutely not. As long as you’re paying even a dollar of tax, a TFSA will lower your taxes immediately. Furthermore, since there’s no immediate income tax deduction for the principle amount invested in a TFSA, it makes no difference whether you save your TFSA contribution room for now or later. In fact, in my opinion, every person should have maxed out their TFSA contribution already. That’s $5,000/person for 2 years running now. The only reason why your TFSA shouldn’t be used up is because all your savings are already being kept in another registered account, such as an RRSP or RESP.
If you are already earning a high income and your marginal tax rate is relatively high, then it perhaps makes more sense to use up your RRSP room before your TFSA room. If all your RRSP room is used up and you still have savings left over to invest, then start on your TFSA.
Anyways, point is, if you haven’t set up a TFSA yet and have some money in the bank in a savings account, go to the bank immediately and set one up.
The next question is, how should you invest your TFSA or RRSP money? Should your riskier, potentially higher-earning investments be put in a registered or unregistered account? The experts are pretty much divided on the issue. For investments that are safer and steadier, some experts believe that it’s better to put them in a registered account, since 1)it’s guaranteed to produce taxable gains, interest, dividends, etc. (as opposed to riskier investments, which can lose money in any given year) and 2)because the fact that it’s steadier means that taxes affect it more in the long run. Other experts believe that simply higher earning investments have the obvious potential for higher taxes (since the gains can be much greater), and therefore it’s better to put your riskiest investments in a registered account.
Personally, I think it’s completely your choice. The most important thing is that you are saving money and putting it away. That’s 90% of the battle. Obviously you should ask your financial advisor for his opinion in any case.
One obvious point is: Remember when I told you that every family should have an emergency fund (at least) equal to 3-6 months of living expenses saved away in risk-free investments? Those funds should not be prioritized ahead of riskier investments in terms of placement in a registered account, because taxes will be minimal on those investments. Remember, RRSPs and TFSAs help you grow your savings in a more efficient manner, without taxes impeding them. If your investments are not focused on growth, than they should not be in your TFSA. Nonetheless, obviously if you have no other savings, you might as well put the emergency money in your TFSA, to gain whatever tax break is possible.
Next post, I will discuss Registered Education Saving Plans - stay tuned!
The key difference between a TFSA and an RRSP is that a TFSA uses what’s referred to as after-tax dollars, while an RRSP uses before-tax dollars. When you contribute funds to an RRSP, you get to deduct that contribution amount from your next year`s net taxable income on your tax return. In other words, you (temporarily) avoid paying taxes on that contribution amount, until you cash the RRSP upon retirement. Which means that a good portion of the benefit of an RRSP is used at the time of the contribution. An RRSP contribution is therefore a tax break.
On the other hand, a TFSA contribution doesn’t receive any special tax treatment. It’s considered after-tax because whatever contribution you make is made using funds that have already been taxed as ordinary income. The tax-free part of a TFSA involves the interest – all interest, dividends, capital gains, etc. earned in a TFSA is completely tax free, forever, as long as the money stays inside the TFSA.
There are some other differences that were discussed in the previous post. But the aforementioned difference drives most of the strategy involved with RRSP vs TFSA contributions. A big part of the benefit of an RRSP is immediate; that is, the current tax deduction on your next income tax return. This tells us a lot about whether to contribute immediately to an RRSP. If you are young, and you expect your income to increase substantially within the next few years, it may be smarter to wait for a few years to make your RRSP contribution, because the tax break you will receive is greater if your marginal tax rate is higher. As was discussed in the previous post, your contribution room grows over the years if you haven`t used it up previously. Furthermore, if your income is low right now, and your tax bill is very small to begin with, making contributions to your RRSP can be detrimental to your financial position. You’ll get a income tax deduction, but if you’re barely paying any taxes now, what use is that to you? Better to just invest your savings in an unregistered account and save your RRSP contribution for future, higher earning years.
Does the same concept apply for TFSAs? Absolutely not. As long as you’re paying even a dollar of tax, a TFSA will lower your taxes immediately. Furthermore, since there’s no immediate income tax deduction for the principle amount invested in a TFSA, it makes no difference whether you save your TFSA contribution room for now or later. In fact, in my opinion, every person should have maxed out their TFSA contribution already. That’s $5,000/person for 2 years running now. The only reason why your TFSA shouldn’t be used up is because all your savings are already being kept in another registered account, such as an RRSP or RESP.
If you are already earning a high income and your marginal tax rate is relatively high, then it perhaps makes more sense to use up your RRSP room before your TFSA room. If all your RRSP room is used up and you still have savings left over to invest, then start on your TFSA.
Anyways, point is, if you haven’t set up a TFSA yet and have some money in the bank in a savings account, go to the bank immediately and set one up.
The next question is, how should you invest your TFSA or RRSP money? Should your riskier, potentially higher-earning investments be put in a registered or unregistered account? The experts are pretty much divided on the issue. For investments that are safer and steadier, some experts believe that it’s better to put them in a registered account, since 1)it’s guaranteed to produce taxable gains, interest, dividends, etc. (as opposed to riskier investments, which can lose money in any given year) and 2)because the fact that it’s steadier means that taxes affect it more in the long run. Other experts believe that simply higher earning investments have the obvious potential for higher taxes (since the gains can be much greater), and therefore it’s better to put your riskiest investments in a registered account.
Personally, I think it’s completely your choice. The most important thing is that you are saving money and putting it away. That’s 90% of the battle. Obviously you should ask your financial advisor for his opinion in any case.
One obvious point is: Remember when I told you that every family should have an emergency fund (at least) equal to 3-6 months of living expenses saved away in risk-free investments? Those funds should not be prioritized ahead of riskier investments in terms of placement in a registered account, because taxes will be minimal on those investments. Remember, RRSPs and TFSAs help you grow your savings in a more efficient manner, without taxes impeding them. If your investments are not focused on growth, than they should not be in your TFSA. Nonetheless, obviously if you have no other savings, you might as well put the emergency money in your TFSA, to gain whatever tax break is possible.
Next post, I will discuss Registered Education Saving Plans - stay tuned!
Wednesday, May 12, 2010
Registered Savings Accounts
Before I start talking about registered savings accounts, I want to re-iterate a previous point I made in one of the first posts. Saving for retirement (and saving in general) is not a luxury, an option, for boring people, etc. Saving is absolutely essential and mandatory. I cannot understate its importance. If there is anything you can learn from this post, and any of my posts on this blog, it's that developing, maintaining and continually evaluating a savings plan is perhaps the best and most important personal financial decision you can ever make.
There’s an old adage that says there are only two things in life that are certain: death and taxes. Taxes are not only certain, but momentous difference-makers regarding personal finance. Nothing affects your portfolio more than taxes, which makes tax strategising that much more crucial for the health of your investments. RRSPs, TFSAs, and RESPs are investment vehicles set up by the Canadian government to benefit taxpayers in accumulating wealth. Used the right way, they can be remarkably beneficial to accumulating your wealth. Understanding how they work are therefore essential.
What are RRSPS, TFSAs, and RESPs?
RRSP stands for registered retired savings plan. Basically, the Canadian government allows you to take a percentage of your earned income each year and store it in a specialized bank account, where it is allowed to grow tax free. In other words, over the years that it is earning interest, investment, or dividend income, it is not taxed at all; hence, it grows at a faster rate. The idea behind RRSPs is that after the age of retirement, you can convert your RRSP to an RRIF, which is the inverse of an RRSP – you have to withdraw a certain percentage of the account every year, presumably for retirement income. The RRIF is a retirement income fund – it funds your retirement.
The maximum amount you can contribute to your RRSP account on a yearly basis is 18% of your earned income (from the previous year), up to a maximum of $22,000 annually (for year 2010). Whatever amount you do contribute can be used as an income tax deduction for that year (to be explained later). As well, if you don’t contribute in any one year, that amount is carry-forwarded to the following year. For instance, if in 2008, your earned income was $50,000, your RRSP contribution limit is about $9,000 (50,000*18%). If you did not contribute anything in 2008, and then your income was $50,000 again in 2009, you can contribute up to $18,000 in 2010 ($9,000 for the carry-forwarded amount from 2008, and another $9000 for 2009).
How do you know how much you can contribute in any given year? Look at your notice of assessment. Every year, after you file your tax return, the government sends back a document confirming your net income and taxes payable. This document often includes your tax refund (if you qualified for it). That document states the allowable RRSP contribution limit for the following year. The document also automatically adds up previous years’ unused contribution amounts, so you are up to date with today’s contribution limit. So don’t throw it out!
It is important to note that an RRSP is not a tax-free account; it is a tax-deferred account. When you withdraw money out of your RRSP, you will be taxed at your regular income tax rate, even if you are passed the age of retirement. Why then would invest in RRSPs in the first place – in other words, what difference does it make? There are at least 4 reasons (that I can think of) for utilizing an RRSP account:
a) Over time, investments that grow tax free will become sufficiently larger than a comparable taxed account, so that even after you pay your taxes upon withdrawal, you will still end up with more money.
b) Presumably, your tax rate will be higher when you are earning a salary than when you are retired. If you are now earning $200,000/year, your marginal tax rate will be approximately 45%. But when you are retired, you probably will be earning between $50,000 - 100,000 (obviously every situation is different) which is a much lower tax bracket. So it can make sense to defer taxes until a later time, when you are in a lower tax bracket.
c) For any undisciplined savers: Once you put your money into an RRSP, you will incur heavy penalties for withdrawing it early. Therefore, RRSPs can be a deterrent for spending away your savings on the newest fashions, cars, gadgets, etc.!
d) There are ways to manipulate your RRSPs in later years to avoid certain taxes, such as buying an annuity. Speak to your financial advisor.
This makes RRSP strategising crucial. For instance, if you are only earning $30,000/year now, but you expect your income to jump to $100,000 within the next five years, it may be better to defer your RRSP contribution room to when you are paying a higher tax rate. More on these concepts next post.
What happens if you need to withdraw funds from your RRSP early?
If you withdraw early, you will incur withholding taxes on the amount of the withdrawal. The 2010 withholding tax rates are as follows:
Up to $5000: 10%
$5000 – $15,000: 20%
Over $15,000: 30%
However, you will end up paying the difference between your marginal tax rates (in the year of withdrawal) and the withholding tax rate. So, if your marginal rate is higher than 30%, you will pay the difference anyways. Furthermore, if you do withdraw early, that contribution room is lost forever. You cannot replace the RRSP withdrawal the following year – you have to wait until you’ve earned new contribution room.
Yikes! In other words, the government really, really doesn’t want you to withdraw your RRSP investments early. However, there is one major exception to this rule, which especially applies to younger couples. The Home Buyers Plan allows you to withdraw up to $25,000 from your RRSP to purchase a (first-time) home (for each spouse if applicable). This amount is essentially borrowed from your RRSP – you owe the $20,000 back to your RRSP over the next 15 years, or that amount will become taxable in the year that the 15 year-term expires. There are many rules regarding the HBP – check them out at http://www.rrsp.org/hbpguide.pdf. You can also withdraw funds from your RRSP to pay for your education, or your spouse’s education (not for your children!). To see the rules regarding that, see http://www.tninsurance.ca/lifelong.htm.
RRSPs are often complicated, and you should do your research before investing in them. However, RRSPs are extremely valuable tools that at least should be considered by everyone, so do your research!
What about TFSA’s?
A TFSA is a tax free saving account. The TFSA was first introduced in 2009 by the Canadian government, in response to the remarkably low savings rates that Canadians were employing. A TFSA allows you to contribute up to $5,000/year to a specialized bank account, in which savings grow tax-free. Just like with RRSPs, unused contribution room is carry-forwarded to following years. However, unlike RRSP’s, TFSA withdrawals can be made up – in other words, if you withdraw from a TFSA in 2010, you can re-contribute the withdrawal amount in 2011. You can withdraw money from your TFSA at any time, and avoid taxes completely upon withdrawal.
TFSAs are the only true tax-free savings account (as opposed to a tax-deferral account). In my opinion, TFSAs are a nicely wrapped gift from the Canadian government and should be utilized by practically everyone.
What’s the major, crucial difference between an RRSP and a TFSA? RRSPs are pre-tax contributions – you get to deduct the amount of the contribution from your net income in the year of the contribution. TFSAs are after-tax contributions – your contributions have already been taxed as regular income. In other words, it’s not the contribution that is tax free; it’s the growth on contributions that is tax-free.
Recent reports have shown that only 20-30% of Canadians have been utilizing TFSA’s, which really astounds me. In my opinion, practically every tax-filer should utilize their TFSA contribution room. There are reasons when it’s appropriate not to, but it’s more because you don’t have the money to contribute to them (after contributing your savings to other accounts). If you have a pile of cash/investments sitting in the bank that are not registered, nor have the ability to be registered, why wouldn’t you put them in a TFSA?
I will defer a discussion on RESPs for a later time.
So now you understand what TFSAs and RRSPs are. Should you contribute? How much to contribute? Which account to contribute to? What should I invest in?
These questions and others will all be discussed in next week’s post!
There’s an old adage that says there are only two things in life that are certain: death and taxes. Taxes are not only certain, but momentous difference-makers regarding personal finance. Nothing affects your portfolio more than taxes, which makes tax strategising that much more crucial for the health of your investments. RRSPs, TFSAs, and RESPs are investment vehicles set up by the Canadian government to benefit taxpayers in accumulating wealth. Used the right way, they can be remarkably beneficial to accumulating your wealth. Understanding how they work are therefore essential.
What are RRSPS, TFSAs, and RESPs?
RRSP stands for registered retired savings plan. Basically, the Canadian government allows you to take a percentage of your earned income each year and store it in a specialized bank account, where it is allowed to grow tax free. In other words, over the years that it is earning interest, investment, or dividend income, it is not taxed at all; hence, it grows at a faster rate. The idea behind RRSPs is that after the age of retirement, you can convert your RRSP to an RRIF, which is the inverse of an RRSP – you have to withdraw a certain percentage of the account every year, presumably for retirement income. The RRIF is a retirement income fund – it funds your retirement.
The maximum amount you can contribute to your RRSP account on a yearly basis is 18% of your earned income (from the previous year), up to a maximum of $22,000 annually (for year 2010). Whatever amount you do contribute can be used as an income tax deduction for that year (to be explained later). As well, if you don’t contribute in any one year, that amount is carry-forwarded to the following year. For instance, if in 2008, your earned income was $50,000, your RRSP contribution limit is about $9,000 (50,000*18%). If you did not contribute anything in 2008, and then your income was $50,000 again in 2009, you can contribute up to $18,000 in 2010 ($9,000 for the carry-forwarded amount from 2008, and another $9000 for 2009).
How do you know how much you can contribute in any given year? Look at your notice of assessment. Every year, after you file your tax return, the government sends back a document confirming your net income and taxes payable. This document often includes your tax refund (if you qualified for it). That document states the allowable RRSP contribution limit for the following year. The document also automatically adds up previous years’ unused contribution amounts, so you are up to date with today’s contribution limit. So don’t throw it out!
It is important to note that an RRSP is not a tax-free account; it is a tax-deferred account. When you withdraw money out of your RRSP, you will be taxed at your regular income tax rate, even if you are passed the age of retirement. Why then would invest in RRSPs in the first place – in other words, what difference does it make? There are at least 4 reasons (that I can think of) for utilizing an RRSP account:
a) Over time, investments that grow tax free will become sufficiently larger than a comparable taxed account, so that even after you pay your taxes upon withdrawal, you will still end up with more money.
b) Presumably, your tax rate will be higher when you are earning a salary than when you are retired. If you are now earning $200,000/year, your marginal tax rate will be approximately 45%. But when you are retired, you probably will be earning between $50,000 - 100,000 (obviously every situation is different) which is a much lower tax bracket. So it can make sense to defer taxes until a later time, when you are in a lower tax bracket.
c) For any undisciplined savers: Once you put your money into an RRSP, you will incur heavy penalties for withdrawing it early. Therefore, RRSPs can be a deterrent for spending away your savings on the newest fashions, cars, gadgets, etc.!
d) There are ways to manipulate your RRSPs in later years to avoid certain taxes, such as buying an annuity. Speak to your financial advisor.
This makes RRSP strategising crucial. For instance, if you are only earning $30,000/year now, but you expect your income to jump to $100,000 within the next five years, it may be better to defer your RRSP contribution room to when you are paying a higher tax rate. More on these concepts next post.
What happens if you need to withdraw funds from your RRSP early?
If you withdraw early, you will incur withholding taxes on the amount of the withdrawal. The 2010 withholding tax rates are as follows:
Up to $5000: 10%
$5000 – $15,000: 20%
Over $15,000: 30%
However, you will end up paying the difference between your marginal tax rates (in the year of withdrawal) and the withholding tax rate. So, if your marginal rate is higher than 30%, you will pay the difference anyways. Furthermore, if you do withdraw early, that contribution room is lost forever. You cannot replace the RRSP withdrawal the following year – you have to wait until you’ve earned new contribution room.
Yikes! In other words, the government really, really doesn’t want you to withdraw your RRSP investments early. However, there is one major exception to this rule, which especially applies to younger couples. The Home Buyers Plan allows you to withdraw up to $25,000 from your RRSP to purchase a (first-time) home (for each spouse if applicable). This amount is essentially borrowed from your RRSP – you owe the $20,000 back to your RRSP over the next 15 years, or that amount will become taxable in the year that the 15 year-term expires. There are many rules regarding the HBP – check them out at http://www.rrsp.org/hbpguide.pdf. You can also withdraw funds from your RRSP to pay for your education, or your spouse’s education (not for your children!). To see the rules regarding that, see http://www.tninsurance.ca/lifelong.htm.
RRSPs are often complicated, and you should do your research before investing in them. However, RRSPs are extremely valuable tools that at least should be considered by everyone, so do your research!
What about TFSA’s?
A TFSA is a tax free saving account. The TFSA was first introduced in 2009 by the Canadian government, in response to the remarkably low savings rates that Canadians were employing. A TFSA allows you to contribute up to $5,000/year to a specialized bank account, in which savings grow tax-free. Just like with RRSPs, unused contribution room is carry-forwarded to following years. However, unlike RRSP’s, TFSA withdrawals can be made up – in other words, if you withdraw from a TFSA in 2010, you can re-contribute the withdrawal amount in 2011. You can withdraw money from your TFSA at any time, and avoid taxes completely upon withdrawal.
TFSAs are the only true tax-free savings account (as opposed to a tax-deferral account). In my opinion, TFSAs are a nicely wrapped gift from the Canadian government and should be utilized by practically everyone.
What’s the major, crucial difference between an RRSP and a TFSA? RRSPs are pre-tax contributions – you get to deduct the amount of the contribution from your net income in the year of the contribution. TFSAs are after-tax contributions – your contributions have already been taxed as regular income. In other words, it’s not the contribution that is tax free; it’s the growth on contributions that is tax-free.
Recent reports have shown that only 20-30% of Canadians have been utilizing TFSA’s, which really astounds me. In my opinion, practically every tax-filer should utilize their TFSA contribution room. There are reasons when it’s appropriate not to, but it’s more because you don’t have the money to contribute to them (after contributing your savings to other accounts). If you have a pile of cash/investments sitting in the bank that are not registered, nor have the ability to be registered, why wouldn’t you put them in a TFSA?
I will defer a discussion on RESPs for a later time.
So now you understand what TFSAs and RRSPs are. Should you contribute? How much to contribute? Which account to contribute to? What should I invest in?
These questions and others will all be discussed in next week’s post!
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