Category: Personal Finance

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Personal Finance

Benefits of Tax Free Savings Account (TFSA)

The Canadian government announced the creation a new savings account type (Tax-Free Savings Account) which allows Canadians to contribute after-tax money without any taxes on the earnings within the account (interest, dividends, capital gains) and there will be no withdrawal taxes whatsoever. For any Americans reading, this account will be very similar to your Roth IRA account except there aren’t any restrictions on withdrawals in the TFSA.

While this announcement has generated a lot of excitement in the Canadian blogosphere and for good reason, since it will be very useful financial planning tool, my opinion is that the benefits of this new savings account will be very limited for the average Canadian.

Here is an explanation of the new tax free savings accounts for Canadians.

First of all let’s look at some benefits and uses for this new account.

Saving for large purchases during your working years

In my mind, this is one of the greatest benefits of this new account. If you are saving up for a car, a house down payment, vacations or anything else, this account is the way to do it. Previously, if you wanted to save large amounts of cash then you had to pay your marginal rate on any interest earned which for most people is probably at least 30%. You could mitigate this problem with Canadian dividend stocks which are more lightly taxed, but they are still taxable and then you expose yourself to market risk since the money might not all be there when you need it.

Emergency fund

I wrote recently about how I think having a cash emergency fund is not a good idea for someone with a mortgage, a HELOC and a high marginal tax rate. With this new tax sheltered account, my main argument about paying high taxes on the interest is now a moot point so the remaining issue is the interest rate you can get on the savings account vs. the interest you are paying on the mortgage. Unless you have a huge emergency fund, this small interest rate difference might not be large enough to sway the argument one way or the other.

Retirement planning

A lot of Canadians don’t really understand the benefits of an RRSP account (American translation = 401k) which is unfortunate since it is the best tax planning and retirement tool available to Canadians by far.
TFSA are not as good as RRSPs for retirement planning because RRSPs allow you to defer all the tax payable on the contribution and to pay LESS tax upon withdrawal.

One of the common misconceptions of RRSPs is that you have to be in a lower marginal tax bracket in retirement than when you made the contribution. This is not the case because when you make a contribution, the tax deferral is the marginal tax on the entire contribution ie if you make $100k and contribute $10k of pre-tax income and your marginal rate is 43% then you are deferring $4300 of taxes.

When you withdraw this money in retirement then you are paying the AVERAGE tax rate on the withdrawal – not the marginal rate (assuming no other income). So if someone withdraws from their RRSP in retirement and is at the same marginal tax rate as they were when they made the contribution, they will still save a lot of tax. In reality they will probably be in a lower marginal tax bracket which means they save even more tax.
With the TFSA, you don’t get this benefit since you pay your marginal tax as soon as it is earned.

Non-registered investing

For investors who have money in non-registered accounts either because they have already maxed out their RRSPs or other reasons, this new account is a huge benefit since they can reduce the tax drag on earnings on their investments. Previously dividends and capital gains (if they occurred) had to be paid which affects the long term returns of those investments.

Why the general public won’t benefit

Saving for purchases – I don’t believe very many Canadians save for large purchases. You don’t need 20% to buy a house and things like cars and vacations are so easily bought on credit that most people won’t bother to save. Even if we are savers, most of us don’t appreciate the effects of tax drag so paying taxes on the interests may not bother everyone (like it bothers me!).

Emergency fund – Similar to my previous point, how many Canadians even have an emergency fund? While our high taxes made an emergency fund fairly inefficient, with the TFSA this is not an issue anymore. I doubt it will make any difference for the average Canadian since I don’t think they will consider having an emergency fund.

Retirement Savings – The reality is that there are a lot of Canadians who don’t save enough (or at all) for their retirement so introducing a new method (which isn’t even designed for retirement savings) isn’t going to help them. Since I believe that a lack of understanding of how RRSPs work might discourage some Canadians from using them, I am hopeful maybe some of those people will use a TFSA instead since it’s a lot better than nothing but I doubt that many of them will.

Who will benefit?

Simple – savers. People who save, people who complain because they don’t have enough RRSP room, people who invest outside their RRSP, people who are doing a Derek Foster plan (retire on dividends), geeky personal finance bloggers (I guess I could have omitted the word geeky) 🙂

More information on the TFSA

Tax Free Savings Account (TFSA) Basic information for Canadians

TFSA contribution limits

Comparison between Canadian TFSA and American Roth IRA

Tax Free Savings Account refresher for Canada

ING offers TFSA refresher for Canadians

Is the RRSP still worthwhile because of TFSA accounts?

Using the Tax Free Savings Account (TFSA) for Canadians as an emergency fund

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Personal Finance

Tax Free Savings Account (TFSA)

The Canadian government recently announced a new type of tax-free savings account (TFSA) available to Canadians which is similar to the Roth IRA account available to Americans. Here are some of the details:

What is the TFSA?

A type of account where you make contributions but don’t get any income tax refund. While the money is in the account there are no taxes applied to any kind of earnings such as interest, dividends, capitals gains. Any withdrawals from the account are not taxable and won’t count against any government programs ie GIS, OAS.

How does the TFSA work?

  • You can contribute $5000 per year to this account for the years 2009 to 2012 and $5,500 for year 2013 and beyond.
  • The contribution room is carried forward.
  • No taxes on any earnings.
  • No taxes on any withdrawals.
  • When you withdraw money from the account, the contribution room available gets increased by the amount of the withdrawal – please note that this new contribution room is not available until the following calendar year.

When can I open up a TFSA account?

January 2, 2009 was the first day you could deposit funds into a TFSA.  Most institutions allowed customers to set up accounts prior to this date however.

Why do I want to open a TFSA account?

Any money that you might be saving for emergencies or upcoming large purchases will have a constant tax drag in an non-registered account. With the TFSA, this tax drag no longer exists so you will end up with more money for your purchase or emergency.  Here are some more benefits of the Canadian tax free savings account.

More information on the TFSA

Tax Free Savings Account (TFSA) Basic information for Canadians

TFSA contribution limits

TFSA Over-Contribution Penalty Fix

Tax Free Savings Account refresher for Canada

ING offers TFSA refresher for Canadians

Using the Tax Free Savings Account (TFSA) for Canadians as an emergency fund

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Personal Finance

Reasons Why Your HELOC Can Be Your Emergency Fund

Debt Free Revolution published an interesting post today on why she likes to have a cash emergency fund and hates the idea of using your HELOC for your emergency fund. I thought I better write a post to address this idea since having a cash emergency fund is not always the best way to manage your money.

I use my home equity line of credit (HELOC) as my emergency fund because I believe that having too much cash on hand is not good money management.

Some problems with keeping a cash emergency fund:

  • tax inefficiency – the interest earned on the emergency fund is taxed at your marginal tax rate. If you earn 4% interest and have a marginal rate of 30% then your net interest is only 2.8%.
  • higher debt costs – using all your cash to pay down debts will keep interest on your debt lower than if you kept your money in an emergency fund.

Let’s look at an example:

Two homeowners – let’s call them Mike and Ana, both have mortgages of $200,000 at 5.19% and they have $10,000 each in cash. Ana likes the idea of keeping the $10,000 in cash as her emergency fund while Mike prefers to pay down the mortgage with the cash and will use a HELOC if an emergency comes up. Both mortgages have interest-only payments for simplicity.

So we have:

Mike – mortgage = $190,000, cash = $0.

Ana – mortgage = $200,000, cash = $10,000.

Scenario I

An emergency occurs after one year and both home owners have to cough up $10,000. Ana has the cash on hand and Mike borrows $10,000 from his HELOC.

How do the home owners compare in this scenario?

Mike – mortgage = $190,000, HELOC = $10,000, payments = $9861, total debt = $200,000.

Ana – mortgage = $200,000, cash = $280, payments = $10,380, total debt = $200,000.

Both home owners end up owing exactly the same amount however Ana has $280 (net of taxes -30%) of interest on the emergency fund but Mike has paid $519 less in interest which tips the scales to Mike and his HELOC emergency fund.

Scenario II

There is no emergency.

Mike – mortgage = $190,000, HELOC = $0, cash = $0, payments = $9861.

Ana – mortgage = $200,000, cash = $10,280, payments = $10,380.

In this scenario, after one year, Ana has netted $280 in interest but Mike has paid $519 less in interest on the mortgage so Mike comes out ahead.

What does it mean?

From the example above it should be pretty clear that using a HELOC is cheaper than using a cash emergency fund for some situations.

There are factors which should be considered which might make the cash emergency fund a better choice:

  • If the home owner doesn’t have a HELOC or other low interest credit then a cash emergency fund might be a better plan. Using a credit card as an emergency fund is not a good idea.
  • If the home owner doesn’t want to worry about exactly how much cash is in his/her account then having extra cash might be a good idea. Keeping a low cash balance can mean bounced cheques and late payments if the home owner is not organized.

Conclusion

There are some situations (like mine) where using your HELOC (or regular line of credit) as an emergency fund is the best way to manage your cash. On the hand there are other scenarios where a cash emergency fund makes more sense. It’s up to you to learn the various pros and cons of both methods and apply one method or a combination of both methods to your situation.

Some other posts on this topic:
Mr. Cheap is a fan of line of credits
The Financial Blogger says that cash emergency funds are wasteful.
The Money Gardener explains why he doesn’t like having cash.
Million Dollar Journey says he relies on a combination of cash and a line of credit in an emergency.
Never one to follow a crowd, Thicken My Wallet likes the cash method for emergencies – the more the better.

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Personal Finance

Role Playing Games and Personal Finance

“I didn’t spend all those years playing Dungeons and Dragons without learning anything about courage” – U.F.O. geek on X-Files

Growing up, I got pulled into “Dungeons and Dragons” (D&D) at a fairly early age, and played role playing games (RPGs) of one sort or another until I left for university. For those who haven’t encountered them, RPGs are games where a group of people sit around a table with dice and tons of rule books. One player is typically the Dungeon Master (DM) and the others are players. What proceeds is a form of collaborative storytelling where the DM creates an adventure for the players, who each control one of the main characters in the story. The story will be played over a number of nights, often stretching into years for dedicated groups.

The ultimate goal is for everyone to have a fun time, and it’s typically not competitive: the DM isn’t trying to “beat” the players. Instead, the players tend to work together to achieve goals (often called Quests). The dice and rules are there to provide a framework to resolve “risky” actions within the world. Say you get in a bar fight, the rulebooks provide guidelines on how to model the situation, then the dice help you figure out the resolution (who wins, and how badly each side is hurt). With a few rulebooks and a DM who can think quickly on their feet, anything can be ATTEMPTED within the game (although attempts can and will fail).

At the start of the game, the players are usually very wimpy. A wizard (called a “Magic User” in D&D) might be able to cast one spell a day, and a fighter may have trouble beating a couple of farmers in the above mentioned bar fight. As the game progresses, the players accumulate items (like a +3 Long Sword of Goblin Slaying) which make them progressively more powerful and more likely to successfully deal with challenges they encounter. They also gain “experience points” (XP) and gain levels, which make them inherently more powerful, allowing the magic user to cast more spells of greater power, and the fighter to kill entire villages of farmers (if that’s your bag baby). As you get further in the game, the players can fight and beat dragons, giants and even gods (often RPGs take place in a fantasy setting – think J. R. R. Tolkien and Lord of the Rings).

This has evolved into computer RPGs, and more recently into Massive Multi-player On-line Role-playing Games (MMORPGs) like World of Warcraft.

The compounding nature of finance and investing, as well as the risk element, always struck me as somewhat familiar to RPGs. As you get more “powerful” (wealthier), you have more options, and it becomes easier to deal with challenges (including the challenge of building more wealth).

The risk element is also present. As much as you may have a good understanding of the rules, as soon as you start rolling the dice, there’s no guarantee what will happen. Having the right equipment to deal with unforeseen emergencies (such as a potion of healing in case it looks like you’re going to lose) is vital. Monitoring the risk and status of your investments, and having contingency plans is also vital. Deciding whether to buy something to deal with a potential problem is similar to decisions about buying insurance.

The fact that you’re “playing” with other people is also important. If there’s a disagreement within your party, it might cause more problems then the “official” challenges of the game. The DM might interpret the rules differently then you expect, and this can throw a wrench into your plans (the DM is the ultimate authority in the game). No matter how well you understand an investment, other investors are playing with you. In situations like the tech bubble or the sub-prime meltdown, their perception of the situation can cause problems for you. Dealing with problems from personally misunderstanding an investment is probably a problem most of us don’t like to admit to.

I’m not necessarily advocating RPGs as a way to teach investing to children, but I think there are certainly elements that will lay the foundation for similar concepts that may appear in finances later.

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Personal Finance

The Danger Of Being Too Conservative

For out non-Canadian readers, GIC stands for Guaranteed Investment Certificate, and its pretty well the same as an American CD. You put the money in for a fixed length of time at a fixed interest rate, then at the end of the term, you get your money back plus the interest (or you can get the interest paid out over the term of the loan). They’re guaranteed by the government, so are a very safe, very conservative investment. They’re typically referred to a “fixed income”.

Most of my family and friends are VERY conservative investors. We’re talking GICs, Canada Savings Bonds and savings accounts conservative investors. My mom won’t touch mutual funds because they’re too volatile and she wouldn’t be able to weather the market fluctuations. While I’m certainly sympathetic to taking a conservative position with investments, there’s a price and a danger when this is how you invest.

The price you’ll pay is that your return is going to be about equal to inflation, so you’ll lose whatever you make.

If you were getting 5% on your GIC, it may seem pretty good until you take away 40% for taxes (this puts you down to 3%), then take 3% away for inflation (this puts you down to 0%). In real terms, you’re just preserving your capital. This isn’t unnecessarily a BAD idea (your capital is VERY safe), but the problem is that your money isn’t working for you. All your savings will simply be what you’ve earned and stashed away: it won’t grow.

“But Mr. Cheap” you protest, “what about times when there are high interest rates, like when it was 12% back in the 80’s?” Well, back in the 80’s when we had high interest rates inflation was very high as well. What fixed-income giveth, inflation taketh away.

Inflation isn’t too big of a worry, since with high inflation, interest rates will go up, so if you set up laddering (where different GICs come due at different times), you’ll get pretty close to the average interest rate. What inflation taketh away, fixed-income giveth.

The real danger with this is simply that you won’t be able to save enough money to live off of in retirement. Compounding won’t be working for you, so even if you’ve been saving since a young age, it will be hard to accumulate enough to be comfortable in retirement. Of course, if you put the money into a RRSP, you won’t be taking the tax hit mentioned above, but at 2% compounding it’s going to be quite meager. This can work if you live well below your means, and save aggressively, but I think there are better options.

When you allow a little more volatility in an investment (give up the absolute guarantee of GICs), the market rewards investors richly for taking on this risk. If you earn the average nominal return on equities, 10%, you’ll lose 4% to taxes (40%), and 3% to inflation, leaving you with 3% to compound (7% if its in your RRSP). Certainly better than treading water.

Something like the couch potato portfolio is an easy way to set up a very diversified equities portfolio. You don’t have to put all your savings into it (start small, maybe with 10 or 20% of your savings until you get your sea legs). If you can set it up, re-balance once a year and ignore it the rest of the time, you’ll do fine. The danger is if there’s a correction and you’re tempted to sell and flee back to GICs (don’t do this!). It may be a good idea to keep your investment small until you have gone through a real dip to make sure you have the stomach for it. Over time you’ll see that you’re getting a lot more growth from the equities compared to your fixed income (the GICs) and hopefully will become comfortable with the idea of exchanging a bit of volatility for dramatically higher returns.

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Personal Finance

BusinessWeek – End Of An Era

I used to love reading BusinessWeek – so much so that I’ve had a subscription to this magazine for about 15 years. Recently I got a renewal notice and for the first time I won’t be renewing.

I still like reading this magazine and because of the Canadian dollar it’s cheaper than it’s ever been but I just don’t get much value out of it anymore.

Back then

I started reading BW back in 1993 – at the time there was no world wide web and even though the www started two years later in 1995, it was a number of years before the web became a pretty good business resource. I liked almost all of its articles since I was very interested in investing and I even had dreams of being a stock analyst when I grew up.

Now

These days I found that I often read very little of each magazine for a few reasons:

  • Time – For some reason I just don’t have as much time as I used to have for reading.
  • Duplication – There are so many other great business resources on the web such as all the fine blogs I like to read.
  • BW online – The magazine is online now so I often read articles of interest before I get the print copy.
  • Relevancy – Now that I am a passive investor I don’t have as much interest in hearing about various companies around the world which I used to think of as investment possibilities.
  • Non-Canuck – You would be hard pressed to find one mention of Canada in ten issues. The fact that the magazine is not Canadian was one of the reasons I liked it since it provided different material from the Canadian newspapers. However even though Canada is small potatoes in the business world, we are the largest trading partner of the US and it’s hard to understand how little we get mentioned.

The future

I started a subscription last year to MoneySense which is an awesome Canadian financial magazine and I’m really enjoying it. I imagine there will come a time when I let that subscription expire but hopefully that day won’t come anytime soon.

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Personal Finance

Insurance Poor and Self-Insuring

I had a grandfather who would worry about the potential problems that might crop up in life, and bought extensive amounts of insurance to try to protect himself. He felt this was the prudent, safe way to navigate life. In part due to the extensive insurance coverage he purchased, he was never able to save very much money, had to work at an intensely physical job (he was the caretaker at a cemetery) well into his late 60’s (because he couldn’t afford to retire) and died from a heart-attack on the job.

Who says hard work never killed anyone? That’s why Mr. Cheap avoids work like the plague (and because of this has a pair of the softest hands around…).

An alternative approach to life may have been to purchase insurance to deal with catastrophes, save all of the other money that you may have spent to insure against minor emergencies, then dip into these savings if a minor emergency occurs. This is called self-insuring and it’s a very good idea.

A series of commercials out right now (in Toronto anyway) show an insurance agent going about their life when they’re approached by someone who enthusiastically starts asking them about all the things insurance protects them from, then starts brow-beating the reluctant agent to sell them some insurance. In real life (off the TV), insurance agents tend to be very hard-sell. People work hard to sell you things you don’t need. I rarely get the hard sell when I’m looking at bread and eggs in the grocery store.

Future Shop / Radio Shack / Best Buy type stores push their extended warranties hard. They do this because it’s a bad deal for consumers and is likely to be pure profit for the store.

Years ago a woman came to visit my parents and tried to convince them to buy life insurance on my father (who was the sole breadwinner at the time). My mom told the sales-woman that she’d completed teachers’ college and that her diploma was all the insurance she needed if something happened to my dad (she’d go back to work). The saleswoman didn’t have an answer to that and that was the end of that sales pitch.

Look over your insurance and see what you can live without. If your DVD player breaks, are you going to be in dire straits? No, then don’t get insurance. If your car breaks a headlight, can you afford to pay $75 to get it repaired? Yes, then raise your deductible. Are you a couple with two incomes, no kids and life insurance? Why would the surviving spouse need cash in case of death? Would the bulk of your wealth go up in flames if the family home burned down? Then maybe it’s a good idea to get insurance with a VERY high deductible to deal with that risk.

If your view of insurance is “wouldn’t it be nice to get a bit of cash if this happened?” then you aren’t purchasing insurance, you’re gambling. And much like casinos, the insurance company has a lot of very smart people working very hard to make sure they come out ahead of you. Sunlife and Manulife employ so many nice people (who will reluctantly sell to you if you beg them), maintain such large buildings and pay such a nice rising dividend because they take in more money then they pay out. An insurance company couldn’t operate if this wasn’t the case.

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Personal Finance

Reader Question On US Dollar Investment

I posted on a reader question regarding buying a stock in Canadian or US dollars some time ago.

This is another question from that reader.

Ian writes that he has a large $US money market mutual fund sitting in a non registered account that for tax efficiency should be registered but he just can’t swallow the forex conversion at below par (he obtained the US$ when it was worth much more than the Canadian dollar).
My answer

As far as keeping your US$ money market in a non-reg account in the hope that it will go up – I would say that is not a good strategy. I’m not saying sell it, but rather you should look at your total investment portfolio, figure out asset allocation which will include different currencies and go from there. If you can fit in the US$ into a non-reg account then great, otherwise forget about the past and just set up the best portfolio you can starting now.

You are doing a lot of investing in US dollar securities which I think is a good move since the Canadian dollar is very high. It may hurt to convert the US dollar cash into Canadian dollars but if that’s the better move then you have to do it.

I saw Peter Lynch speak a number of years ago and one of the points that I remember best was his example of someone who bought a stock at $100, the stock goes down and the investor gets all despondent and just wishes the stock would go back up to $100 so that they can sell it and not lose any money. They refuse to sell the stock or buy more – they just want to sell the stock at the price they paid (ie get a refund). Lynch said that this is not a logical way to invest. You have to evaluate that stock at the new price and figure out if you would buy it at that price (ie keep it) or if not, then you should sell it.

I don’t know much about your overall portfolio but I can’t imagine that having a lot of money in a money market fund in a non-reg account fits in very well. If you were to put that money into an rrsp and buy US$ investments then you are really not converting anything (ignore the double currency conversion) – it will still be US$.

Please note that I am not a financial advisor and you should consult with a professional financial advisor before implementing any financial changes.