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We were finishing up the Cajun hot dogs when David had the gall to complain that his were a bit more Cajun than usual. I told him that if he didn’t keep quiet, he might wind up with a good ol’ Louisiana-style blackened steak for dinner that night. That did the trick.
Fortunately, after lunch, Jan wanted to take a boat ride down to the harbour and offered to take our kids along. That meant Sandra and I were off the hook for a little while longer and could attend the afternoon session of the “strategy club,” as we had begun to call ourselves.
Uncle Wayne started off by saying this wouldn’t take any more than forty-five minutes because he really had to get back to Aunt Jen. Then he told us to pull out our binders or go online to our secure cloud service and look at a tax-related form called a Notice of Assessment. Everyone who files a tax return gets one of these from the Canada Revenue Agency (CRA) every year, but surprise, surprise … Sally couldn’t find hers!
Anyway, the point of checking out this form was to determine our limits for RRSP contributions for the current year and to determine whether we were able to take advantage of any unused contribution limits from the past.
“Well, Sally, if you can’t find the form, there’s always Plan B. On Monday, you can call the automated TIPS line at the CRA. Just follow the instructions, and enter your Social Insurance number, date of birth, plus the figure for your income, which is listed on line 150 of your tax return. They’ll tell you what your RRSP limit is. You can also register with the CRA for their My Account service, which allows you to access your information online.”
“It’s not as if I really cared,” she said softly.
“Well, you should,” Uncle Wayne said, chiding her gently. “This is where you’re going to start. I want everyone to put the maximum allowed this year into their RRSP. And since you’ve got the cash on hand, do it sooner rather than later. For example, if Sally were to contribute $10,000 a year to her RRSP at the beginning of each year, as opposed to the end of each year, by age sixty-five at a 6.6% annual return, she would have saved $937,312 versus $879,280!”
“I guess RRSPs are a good place to start an investment program because our money gets tax-sheltered growth,” remarked Alice. “But what if we have a large RRSP room? Should we use the tax deduction in our tax return in one year?”
“It depends on your marginal tax rate. Your accountant should be able to review how much you should deduct each year on your tax return to maximize your tax savings,” added Uncle Wayne.
“I understand I have to pay taxes, but what is a marginal tax rate?” I asked.
Sandra interjected. “From my understanding, Canada operates under a marginal tax rate system, which means that the more money you make, the more income tax you pay on each additional dollar of income. Simply, as your income rises, the tax rate percentage increases as well, and that is called your marginal tax rate.”
“Ok, smarty pants, what about TFSAs? How do they fit in?” I added.
Sandra glared at me and continued. “TFSA stands for Tax-Free Savings Account. You don’t get any tax deduction for the money you invested into a TFSA; however, you don’t pay any tax on the growth of the money in the TFSA, whether it is interest, dividend, and/or capital gains income. And you can take it out tax-free. With a TFSA, you can invest in basically the same type of investments as your RRSP. And to make it clear, honey, you never pay tax on the money you earn or take out of a TFSA. How’s that, Jack? Are you able to follow that?”
Mark started to laugh, and Uncle Wayne said to save me, “What I would add is that the amount of money you can invest into a TFSA increases each year; however, you have to be eighteen to invest in a TFSA. Here, all of you look at my iPad. TFSAs were introduced in 2009, and you can see how much you can invest per year since then:
- 2010—$ 5,000
“Since all of you were eighteen as of 2009, each of you could have invested up to $69,500 into a TFSA this year. If you take money out of a TFSA, you can re-contribute that amount the following year.”
Mark interrupted. “I just want to clarify. Since my oldest turned eighteen in 2014, does that mean he can invest up to $44,000 into a TFSA this year?”
“Wow, and I thought you couldn’t do the math!” Sally laughed out loud.
“Well, when I was a kid, we didn’t have a cell phone with a calculator on it, like you Millennials.”
Uncle Wayne continued. “Ok, you two! You’re correct on both counts, Mark. I always thought TFSAs were misnamed; they should have been called tax free investment accounts, because with the word ‘savings’ in there, many people assume you can only invest in saving types of accounts that pay a low interest rate, which is wrong, as you can have growth investments in there as well.”
“So how should we allocate our money amongst RRSPs, TFSAs, and non-registered investments?” David asked.
“Whoa! What are non-registered accounts?” Sandra questioned.
“Both are great questions,” Uncle Wayne continued. “First of all, RRSPs and TFSAs are considered registered accounts, as they are registered with the government, they have rules and regulations on how much you can invest, and they carry tax consequences, as we have talked about. So an investment that is not placed in an RRSP or TFSA is considered a non-registered investment. It’s simply an investment in your name as owner, and each year you pay tax on the income that it earns.”
Sandra commented, “I see why it’s called a non-registered account.”
“To get back to David’s question, I would first top up your RRSPs, then maximize your TFSAs, and lastly invest in a non-registered account. That way, you can get the tax deduction from your RRSP contribution, and, going forward, both your RRSPs and TFSAs can grow tax-free.”
“So how do we invest within each type of investment? Do we choose investments that are geared toward growth or toward income?” David asked.
“That’s a very good question, and there’s no clear-cut answer. Some experts suggest putting all your income type of investments inside your RRSP and TFSA and investments that bear dividends and capital gains, such as stocks, outside your RRSP/TFSA in a non-registered investment account. Their reasoning is that interest income is taxed at a higher rate than dividends and capital gains, and by being inside your RRSP and TFSA, the interest income is tax-sheltered while it grows. However, with today’s low-interest rates, it can make sense to have some equity/growth type of investments within your RRSP and TFSA. A common approach is to have the same allocation within your RRSP and TFSA and non-registered account. Again, you must do the math, and this is where your CFP® can help and model the various options.
“You’ve all told me that you hope to retire somewhere around the age of sixty, but ideally, you won’t want to activate your RRSP or turn it into a Registered Retirement Income Fund (RRIF) until you’re seventy-one, which is the age that an RRSP must be either collapsed or converted to a RRIF or an annuity. It makes sense to have some potential for growth inside your RRSP so that it has a maximum value when you’re seventy-one, especially when you consider that you could live until you’re well past ninety and will need money for a long time.”
“What about spousal RRSPs?” David asked. “I was wondering if I should get one for Alice since she doesn’t work yet.”
Alice’s lower jaw dropped about a foot. “What do you mean I don’t work yet?” she sputtered. “Just who do you think raised your children and looked after the house? Honestly, David, sometimes …”
Uncle Wayne tried to smooth her ruffled feathers. “Of course, you work, Alice, and with beautiful results, if the way Scott and Jan behave is any indication. And yes, spousal RRSPs are very important, David, whether the spouse works inside or outside the home. You see, both you and Alice will want to have approximately the same dollar value in your individual RRSPs when you decide to use them. This is called income splitting, and the goal is to pay the least possible amount of tax as you withdraw funds from your RRIFs.”
“Let me see if I’ve got this straight,” Alice said. “If David contributes to a spousal RRSP, he gets the tax deduction, and I become the owner. If we don’t start a spousal RRSP, he’ll have a large RRSP when we retire, but I won’t have one at all because I didn’t work outside the home. The total amount in our retirement fund will be the same either way, but as sole owner, David will wind up in a high tax bracket when it’s time to withdraw the funds. By using a spousal RRSP, the total taxable income is split between two people at retirement and—voila! – we save on taxes.”
“You’re getting very good at this,” Uncle Wayne said. “Once you’re both age sixty-five, you’re able to income split income from your RRIFs, and at any age prior, you can split pension income as Sandra has. However, to give you more flexibility, it’s still a good idea to try to split assets using spousal RRSPs, as you may need income prior to age sixty-five.”
“What about Jack and me?” Sandra asked. “Should Jack contribute to a spousal RRSP for me, even though I have my pension plan as a teacher, and we can income split?”
“That depends on the math,” Uncle Wayne answered. “You’ll want to split income at retirement, so you should project Jack’s RRSP to retirement age and figure out how much income it will provide. If that figure is greater than your projected pension income, he should contribute to a spousal RRSP for you. However, if the projections show that your pension income will be greater, you should contribute to an RRSP for Jack and then a spousal RRSP for him.”
“Now that’s what I call true equality between the sexes!” I said.
“You would!” Sandra countered. “The rest of the world just calls it good financial planning.”
“Before we leave the subject of RRSPs and TFSA, I want everyone to look in their binders and tell me how much money you were paying monthly on your debts before you took my excellent advice and paid off all loans that weren’t tax deductible. Jack, what were you and Sandra paying every month for your mortgage?”
Sandra had our binder and told everyone our payments had been $1,546 a month. When Uncle Wayne asked if we’d been comfortable with that level of payment, she nodded.
“I’m glad to hear it,” Uncle Wayne said, “because you’re going to continue making those payments, except now that you’re mortgage-free, you’ll be making monthly contributions to an RRSP, and please make sure that you set it up in a way that allows you to split income in the future.
“If and when the monthly RRSP contributions meet your allowable limit for the year, you should invest the excess in your TFSAs, followed by your non-registered account in the name of the lower income earner, but keep in mind there are certain attribution rules that you’ll have to watch for. You may want to ask your lawyer or accountant about this.”
“Why the lower one, and what are attribution rules?” asked Sandra.
“Attribution rules can be tricky, but basically, they prevent taxpayers from reducing their taxable income by shifting investment income to a lower-taxed person, such as their spouse, kids, or grandkids. If this happens, the income is ‘attributed’ back to the person who gave them the money, which means they have to pay the tax on that income. Your accountant and CFP® should be able to help you with this. So, in the case of a non-registered account, the income it earns each year is taxable, so you want them taxed in the hands of the person in the lower tax bracket,” he answered.
“Of course,” she reasoned. “By the way, what are the RRSP limits these days?”
“For 2020,” replied Uncle Wayne, “the maximum contribution is 18% of your earned income or $ 27,230, whichever is less. But remember, Sandra, you have a pension plan at work, so your maximum RRSP contribution every year will be reduced by something called the pension adjustment (P.A.). You’ll find that figure on the Notice of Assessment you were looking at earlier.”
“Uncle Wayne, I don’t know if I have the discipline to put the kind of money you’re talking about into an RRSP,” Sally admitted. “Although, if Jack and Sandra are accustomed to making the payments anyway, I guess your plan could build a solid portfolio for them. How much would their $1,546 a month be worth at the end of twenty years?”
“Hang on. I’ll use my phone calculator,” he replied. “Okay. If we assume a payment of $1,546 a month for twenty years into a balanced portfolio with a return of 6.6%, the last twenty-year average return … the answer is … hmm. Who wants to guess?”
“I say about $450,000,” ventured Sandra.
“Nope, you’re low. The grand total is $753,918. That’s the power and magic of compounding,” Uncle Wayne told us with a smile.
“So, to build a portfolio worth close to $800,000, all Jack and Sandra have to do is continue to make the same dollar payments as they did with their mortgage, but instead put the money into their RRSP and/or TFSA,” Sally said in amazement. “That’s incredible.”
“It sure sounds like the way to go,” Sandra added. “But you know something, Uncle Wayne, I still feel a knot in my stomach about investing in the stock market, even if the money is in a diversified portfolio. You say that stocks outperform bonds and GICs in the long term, but I still don’t understand why.”
“Neither do I,” Sally said.
“Well, we’ve looked at the long-term trends, and I’ve shown you in black and white that over time the stock market, like the economy, has always gone up,” Uncle Wayne explained. “If you really can’t cope with the temporary ups and downs of the stock market, then perhaps it isn’t for you. I’ve always felt that people must decide where they fit in the scheme of things when it comes to participating in the economy.
“For example, if you’re looking to invest $1,000, you’ve got several options. You could lend the money to a bank in the form of a GIC, and the bank agrees to pay you interest of 3%. The bank will then lend the money to a company, and the company will pay the bank a higher rate, say 5%. The company has to make a profit greater than 5% on the money it borrowed in order to pay back the bank so that the bank can pay you the interest it promised. So for you to get the guaranteed return from the bank, the bank must invest the money someplace else. So why let the banks make all the money?
“Over the long term, the success of any free-market economy depends on companies being productive. If all companies over the long term are not productive and don’t make money, the guarantees of GICs and bonds don’t mean a thing.”
“That makes sense, Uncle Wayne,” Sandra commented. “The economy is based on individual companies making money and people buying stuff. So, over the long term, some companies will always be successful!”
I told Uncle Wayne I had one further question. “You’ve helped us review the proper percentages for income and equity investments in each of our portfolios. But since the different types of investments will grow at different rates, won’t the percentages go out of whack?”
“I’m glad you asked that, Jack,” Uncle Wayne answered, “because that’s the last subject I want to tackle in this session: how to rebalance your portfolio.
“I’m sure you’ve all heard the old saying that the way to make money is to ‘buy low and sell high.’ The problem is most Canadians do the exact opposite; they buy high and sell low! The crash of 2008–2009 is a good example. A lot of Canadians had jumped on the bandwagon and invested up to 2007. When the market crashed in 2008, some panicked and sold their funds at a loss. In other words, they bought high and sold low.
“Here’s another way of looking at it. If the real estate market has been soft for a period of time, and the value of your house has gone down, would that be a good reason to sell your house?”
“That would be crazy,” David answered. “Why would we do that? Real estate has always appreciated over the long term.”
“Exactly,” Uncle Wayne agreed. “But people will bail out of their investments when they see a decline in value, and then they’ll buy when prices start going back up. They’re doing exactly the opposite of what they should. It’s obvious that these people don’t have a long-term plan or a wise old uncle!”
“How do we buy low and sell high?” I asked. “Isn’t that what the experts call market timing?”
“I’ve got an answer for you that will be easier in the long run. We’ve already reviewed the various asset allocations based on risk level and goals. Of course, the balance between the equity and income assets you’ve chosen will shift over time because the assets grow at a different rate.
“Keeping in mind the allocation of the portfolio assets between cash, bonds, and stocks can determine up to 85% of the difference in returns on your investments, so you’ll want to make adjustments in your portfolio now and then to keep your ideal balance intact.
That’s what we call rebalancing your portfolio, and you should do it once a year or whenever your portfolio shifts out of balance by more than 5% to 10%. This will help you to buy low and sell high.”
“I understand the rebalancing concept,” Mark said, “but I don’t see how it helps us buy low and sell high.”
“Ok, I’ll give you an example. Let’s say you’ve got $100,000 to invest at the beginning of the year, and your ideal asset allocation is 50/50 between equity/growth and income investments. When the end of the year rolls around, the equity portion might have grown by 10%, so it’s worth $55,000. The fixed income may have grown by a different rate, let’s say 3%, so their value would be $51,500. Your total portfolio would now be worth $106,500, but the asset allocation would no longer be 50/50, so you’re out of balance. To rebalance your portfolio, you’d have to sell off the appropriate amount of growth investments and use the money to purchase income investments. In this case, you want $53,250 invested in each category, so you’d subtract that amount from the value of the equity funds to tell you how much capital you need to move to guaranteed investments in order to rebalance your portfolio. By the way, the answer is $1,750. By doing this, you would have sold some growth investments at a high dollar value; in other words, you have ‘bought low, and sold high,’ and you’ve protected some of your profits.”
“So,” I reasoned, “if stocks were going through a temporary lull, and the income portion had increased in value more than the equity portion, then we’d have to rebalance by buying equity investments with a portion of the proceeds with the fixed income investments.”
“Of course,” Sandra added. “That makes perfect sense. If you’re going to buy stocks, buy low when they haven’t gone through a spurt in growth.”
Uncle Wayne looked at us with pride. “I’m glad you get it. By rebalancing your portfolio yearly, or whenever it’s out of balance, by 5% to 10%, you automatically buy low and sell high. People who did this in 2008 really benefited during the upturn starting in 2009.”
“Uncle Wayne,” Alice interjected, “I’m surprised that you haven’t recommended that we spread the purchase of our initial investment over a period of twelve to eighteen months. The books I’ve been reading say we should ease into the market slowly. Prices could vary quite a bit over that year and a half, and by investing all at once, we might be buying high!”
“Well done, Alice,” he replied. “With all the extra research you’ve been doing, you may want to lead the session next week.”
“Before you go,” Sandra said, “I have one last question. Whose name should our investments be in, mine or Jack’s?”
“From a strictly legal point of view, an inheritance is not considered part of the family or matrimonial property, which we will look at later. But the lines get fuzzy once you start paying off mortgages or purchasing spousal RRSPs. It gets hard to tell just whose money was used for what, and once you start mingling the funds, they may be considered matrimonial property in the event of divorce. Not that you two will ever come to that!
“We’re going to delve a bit deeper into the topic of who owns what in one of our future sessions when we talk about estate planning. In the meantime, just go by what we talked about earlier. For the lump sum inheritance, from a legal standpoint, it should only be invested in the name of the person who inherited, but for the monthly investments going forward, use RRSPs for your monthly investments until you reach your contribution limits, and then invest in each of your TFSAs, followed by a non-registered account in the name of the lower income-earner so that you’ll be splitting income.
“And now, I’m going home to see my wife.”
“What’s the plan for the golf tournament next weekend?” Mark asked.
“Well, the tournament starts at 10:00 a.m., so why don’t you come by to get me at about 8:00 a.m. That’ll give us all time to get warmed up, so you won’t have any excuses when I beat you!”
In the car, as we made our way home from the cottage that weekend, we got stuck in traffic around Barrie again. Paige and Connor had both fallen asleep, so Sandra and I reviewed the key issues from Saturday afternoon’s session:
- We should review taking advantage of our RRSP limit,
- TFSAs are the next location for investments.
- Use spousal RRSPs in order to split income at retirement.
- Invest the money we used to pay into our mortgage into a monthly RRSP investment plan.
- When we have reached our RRSP limits, put the monthly investment into each of our TFSAs, followed then into a non-registered account in the name of the lower income earner.
- Model and review what is the best long-term solution to allocate our investment types within our RRSPs, TFSAs, and non-registered accounts.
- Buy low and sell high by rebalancing our portfolio on a yearly basis or whenever it shifts more than 5% to 10% away from the recommended balance between income and stock/equity investments.
- Consider spreading the initial investment in the growth portion of your portfolio over a period of twelve to eighteen months.
For more information, you can refer to Preserving Wealth: The Next Generation – The definitive guide to protecting, investing, and transferring wealth by Jack Lumsden, MBA, CFP®.
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