Charitable giving in religion

The first piece of this puzzle came to me on a financial independence facebook group. A muslim member of the group was asking about how the concept of zakat fit in with reaching financial independence.

Zakat is a religious duty for all Muslims who meet the necessary criteria of wealth to help the needy. It is a mandatory charitable contribution, often considered to be a tax. Zakat on wealth is based on the value of all of one’s possessions. It is customarily 2.5% of a Muslim’s total savings and wealth above a minimum amount known as nisab.

The member of the group was trying to figure out how financial independence is possible while still following zakat. Their interpretation was that they would need 2.7 million in investments to cover their family’s living expenses of 40,000€/year as well as to pay the 2.5% to zakat if they were to use the 4% safe rate of withdrawal. For them, this means they will never reach FI in their lifetime.

A very interesting discussion followed.

Some compared this to tithing in Christianity which says to give 10% of your income to the church/charity.

One reader said that they personally try to look at the spirit of the law and the intention/culture at the time it was written. The spirit of the law was to look outside yourself and help those in need. When that law was written, the culture likely didn’t have taxes to the extent we have now. Today, part of our taxes go towards the poor through social assistance, welfare and disability programs as well as to education and recreation programs. If the government is collecting from you to give to the poor, could zakat be reduced to 1% for example. They also asked that if someone is volunteering and giving in time in lieu of money how does that play out?

There were many more ideas shared on how to interpret the spirit of this law if you want to read the full thread here but this concept sat with me and then I was presented with another piece of the puzzle.

Why don’t we donate more to charity

I know someone who is a nurse in the COVID ICU ward and I heard morale was very low just after Christmas when they were inundated with very sad cases. I wanted to do something to make them feel more hopeful so I ordered them a food hamper as a small token of appreciation. They were so touched and reciprocated by sending us some books for our son as I had mentioned we were sorely missing the library for having to re-read the same books at bedtime over and over and over. They also included a book for me. I never would have read or bought this book on my own but when offered it, it seemed interesting and ended up being really good.

It’s a book by an Irish professor called “Never mind the bollox, here’s the science – A scientist’s guide to the biggest challenges facing our species today”. It covers topics like free will, the anti-vax movement, the cost of medicine, dieting, depression, drug legalisation, gender differences, racism, climate change and so on. It includes a bit of history as well as a scientific viewpoint on each topic based on fact and scientific studies. Not one bit of fake news, so refreshing.

One chapter asked “why we don’t donate more to charity?”. It talked of various motivators for people to donate to charity. One study found that 85% of donations were made “because they were asked”. Another study found motivators to include:

• trust in the charity
• the need to help others
• to contribute to a cause important to them or someone they know
• to get a tax break
• to look good to other people

It also gave some very stark stats demonstrating how badly divided the world is (and perhaps always has been) when it comes to wealth:

• As it stands half of the world’s net worth belongs to 1% of the world’s population
• The collective net worth of the world’s poorest half (3.6 billion people) is equivalent to that of just eight of the world’s wealthiest men
• The top 10% of adults hold 85% of all the wealth, with the other 90% holding the remaining 15%

It covered how most of the super-wealthy actually do a lot of good with their excess cash through donations and philanthropy but that the decision on what cause to donate to is left up to individuals and what might be important to them personally. This spreads the wealth ineffectively.

More than half of billionaries are involved in philanthropic giving either through organisations that they themselves established or by other means. 35% of them have their own charitable foundations.

66% of billionaires give towards education (scholarships, educational support, outreach programs and teacher training) with

• 29% of all billionaire donations going to education
• 14% goes to healthcare
• 10% goes to arts, culture and sports
• 8% goes to environmental issues and
• 5% goes to religious organisations

Enter taxation

While it’s easy to complain about our governments wasting taxpayer money where money is seen not to have been spent effectively, it’s also important to look at the bigger picture and see what our taxes actually pay for.

First let’s see how much of our government’s revenue comes from which taxes.

In 2016 (I was too lazy to dig out a more recent report), 31% of the annual government revenue came from income taxes including USC, 21% came from VAT, 14% came from PRSI, 11% came from corporation tax and 9% came from excise duties. Only 1.4% combined came from dividends and CGT.

Looking at the 2020 Ireland Expenditure Report the country had 70 billion to spread across various departments. Below is the breakdown by department for all expenses of 2% or above.

• 32% went towards employment affairs and social protection
• 28% went to health (twice as much as the billionaire donation trend)
• 17% went to education and skills (12% less than the billionaire donation trend)
• 7% went to justice

Below is the detailed monetary breakdown per department including core and capital expenses.

Core expenses is money spent by the government on a regular or ongoing basis. The majority of government core expenditure involves the day-to-day provision of essential public services. Operating costs and wages for public sector workers account for a large portion of government core expenditure.

Capital expenses are ‘once-off’ projects or on infrastructure that will have long-term benefits for the country. Infrastructure refers to basic facilities, structures and services needed for the country to function including water, power lines, transport, communications systems, schools and hospitals.

This might start to sound familiar for anyone that’s ever played anything like Sim City or Tropico.

If you’re interested in the detailed split for each department you can check out the related sections in the full report. To give an idea of what each department pays towards:

Employment and Social Protection

• old-age pensions
• working-age income support
• working-age employment support
• illness, disability and carers
• child benefits
• jobseekers’ benefits
• supplementary payments

Health

Core expenses include:

• public healthcare hospitals and services (day to day running costs of hospitals and healthcare facilities eg: staff wages, buying medicines, light and heat
• primary and community services
• mental health services
• disability services
• services for older people
• palliative care
• health and wellbeing initiatives
• ehealth
  • electronic health records
  • infrastructure upgrades for national systems such as national medical lab information system, medical oncology clinical management system, national integrated medical imagining system

Capital expenses include:

• building new hospitals
• buying new equipment and ambulances

Education and skills

Core expenses include:

• expenditure to enable schools and colleges to operate eg: teachers salaries, light, heat and maintenance of school buildings
• national training fund
• higher education
• skills development

Capital expenses include:

• building or extending schools
• buying furniture and ICT equipment for schools

Justice

Expenditure to ensure our legal and judicial systems operate, e.g. judges’ wages, garda wages and operating costs of prisons.

Agriculture

Expenditure to help farmers and ensure the sector is maintained, e.g. income supports to farmers and funding for a wide variety of rural development schemes.

Defence

Expenditure to maintain defence of our country, eg: wages to members of the defence forces and civilians working for the sector, maintenance of facilities, training costs, etc

Transport and tourism

Money spent on maintaining our existing transport systems as well as providing funding for tourism promotion agencies such as Fáilte Ireland.

How to feel better about taxes

The book ended the chapter talking of the role of taxation.

Instead of the approach taken by most of the super-rich, which is to avoid taxes as much as possible to grow their wealth well beyond what they could ever spend in a lifetime, then to turn around and give most of it disproportionately to charities of their choosing, why not pay taxes to a government who democratically decide how best to distribute that money in the best interests of the country that you are living in?

Imagine how much better off we’d all be if corporations did not have ways of avoiding taxes? If the government had more money from taxes, could we live in a community with universal basic living income for all? Which has a whole range of benefits from better work conditions, fewer working hours, more time with family and friends, less money stress allowing people to be more creative and innovative to solve big world problems like climate change, gender inequality and racism for example.

While I’ve always had it in the back of my head, that taxes pay for our infrastructure and services, it never really made me feel better about handing my money over to the taxman but when I think about the bigger picture and of the path to financial independence I feel like I’ve had an aha moment.

What is the path to financial independence?

1. Keep your expenses (and taxes) as low as possible without compromising happiness
2. Invest 50%-80% of your income for 10-15 years
3. Have 25 times your annual expenses invested to cover an annual withdrawal of 4%
4. Reach financial independence and spend your time as you wish which could include earning even more income if you chose to continue working on projects that interest you
5. If you continue earning once you’ve reached FI like I intend to do, it means I will have more than enough money to remain financially secure and continue to build wealth beyond what I need to sustain my family until death.

What will I do with that extra money that I will possibly never fully spend? Will I donate to a charity of my choosing? Will I leave it all to my kid?

Personally, I’m not looking to build a legacy. I want just enough to be financially free to spend my time as I wish without worry of money and eventually to be able to make a contribution to the world and my community by advocating for financial literacy and security for all. I hope to impart financial literacy to my son so that he can build towards his own financial freedom. I do not want to hand it all to him as I think it’s important to instil a good work ethic and self-sufficiency.

So if my end goal in financial independence is to have more time to contribute more value to society (remember maslow’s hierarchy of needs?), why not contribute to society along the way in the way of taxes?

Instead of trying to avoid or optimise paying taxes as much as possible on the way to financial independence, pay as I go knowing that a good portion of those taxes is going to those less fortunate than me. Paying more taxes along the way may take me a bit longer to get to full financial independence but I’m not going to feel angry or annoyed when paying my investment-related taxes going forward and instead look at it as a way to give back to the community I’m living in. It’s actually been a really liberating change in viewpoint.

What do you think?

This is of no importance to me at the moment as I’m not earning Canadian income but it got me thinking. Is this a worth while approach?

In short, not if you could max it out without borrowing.

For non-Canadian readers: an RRSP is a tax deferral tool similar to a pension where you offset taxes in your higher earning years and pay your marginal tax rate in retirement once your income is (typically) lower.

Although this post looks at RRSPs in particular, the concept applies to any tax deferral investment tool.

The case against borrowing to max out your RRSP

Similar to management fees in regular investment accounts, even small percentages on a loan will decimate your long term earnings.

Put simply, if you do this every year and are paying 4.25% on your loan and your RRSP is earning 8% (after inflation) then your RRSP (or pension) is actually only growing at a rate of 3.75%. Or in other words, the bank is taking over half your profits and you’re taking on all the risk.

Over 30 years this means you end up with 70% less in your RRSP if you do not use your tax refund to pay down the loan than if you had maxed it out without a loan.

The other down side is that you now have a loan to repay which is an added risk and stress if you should get sick or lose your job.

If you are planning on using your tax refund to pay off part of the loan, this is a better option but still results in 30% – 56% less in your RRSP over 30 years depending on various income brackets which I’ll go into below.

Assumptions

• I used Ontario tax rates as an example
• I assumed a loan is taken out for the full contribution room for one year. Currently 18% of your gross income
• The loan interest rate is 4.25% as per the offer I saw today (prime + 0.5%)
• RRSP growth at 8% (average 10% historical stock market growth minus 2% for inflation)

Below is a table showing how the numbers work out depending on various income levels.

Walking through one example, say you are earning 50,000$, you take out a loan for 9,000$ and get a tax refund of 2,779$ which you use to pay down the loan.

You now need to pay down 518$ each month to pay off the remaining 6,221$ of your loan.

Your remaining loan incurs 264$ of interest where your RRSP earns 720$ leaving you with a net earning of 456$ in year 1.

Option 1: Don’t borrow and contribute through the year

If you hadn’t borrowed and made contributions through the year your 9,000$ would grow to 90,564$ over 30 years.

Option 2: Borrow full amount and use tax refund to pay back part of the loan

If you borrow the full amount and repeat this process every year your 9,000$ contributed in year 1 will have grown to 39,596$ in 30 years. This is 56% less than if you had just contributed throughout the year.

Option 3: Borrow full amount but use tax refund for something else

If you were tempted to keep the tax refund of 2,779$ to spend on something else then your 9,000$ would only grow to 27,157$ over 30 years. Resulting in 70% less than if you maxed it out through the year instead.

Option 4: Borrow full amount and contribute your tax refund to your RRSP

I’ve seen in other calculators that borrowing to max out your RRSP and using the tax refund to add to your RRSP as well results in more money than if you contribute through the year without borrowing but this didn’t add up in my calculations as you are still paying the full 4.25% on your loan every year and even though your initial sum invested is higher, you’re still only growing at 3.75%. You also have increased risk by having higher loan repayments through the year.

By my calculations this approach results in your 11,779$ (9,000$ + 2,779$ tax refund) growing to 35,543$ after 30 years or 67% less than if you contributed through the year.

There’s also the question of this value being over your max contribution room for the year which results in you having to pay a tax of 1% per month on excess contributions that exceed your RRSP deduction limit by more than $2,000 unless you withdrew the excess amounts.

See how these figures play out for various income levels below.

When does it make sense?

Make your interest tax deductible

One hack is to sell off some other investments (if you have some outside of your RRSP) and use that to max your RRSP. Then, consider borrowing to replace the investments outside your RRSP. This way, the interest on your loan will be deductible (since you’ll be using the borrowed money to earn income in a taxable account). You’ll be entitled to a deduction for the market value of the assets contributed to your RRSP, assuming you have sufficient RRSP contribution room.

Some things to keep in mind here:

Capital gains

First, you’ll be deemed to have sold those investments you transfer to your RRSP, so you might trigger taxable capital gains if they’ve appreciated in value. Having said this, your RRSP deduction will more than offset the taxable amount in this case.

Capital loss

Second, if the investments have declined in value, your loss will be denied when you transfer the assets to your RRSP (as a registered transfer between fund providers), so you’d be better to sell those assets first, then contribute the cash to your RRSP, which will allow you to claim the capital loss.

If you do sell your assets at a loss, be careful not to reacquire those same securities inside or outside your RRSP within 30 days of your sale, otherwise the superficial-loss rules will kick in to deny the loss.

Interest free loans

Another option to consider is if you could get a credit card where you pay 0% interest on cash advances for 6 months, use that to max out your RRSP and then pay off the credit card before you incur any interest.

Your growth wouldn’t be affected but you would be under additional pressure to pay of the loan before interest kicks in.

Smaller top ups

Say you’ve contributed through work throughout the year and you only need to top up your contribution by the same amount as your tax refund, then you should be able to pay off the loan in full once you get your tax refund and it shouldn’t reduce your growth unless the interest is charged in full regardless of when you pay it off.

So in the 50,000$ income example, say you’ve contributed 6,221$ throughout the year (or 239$ over 26 pay periods), then you only need 2,779$ to max out your contribution room. If you took out a loan for that amount and got that same amount as a refund, then the only interest you’d incur would be that which accumulated between taking out the loan and getting your tax refund.

I’ve seen some loans offer the option to delay the start date of your repayments by up to 90 days (enough time to get a tax refund), but not sure how the interest works on those, I’m assuming you are still being charged interest even if you aren’t making repayments yet.

Summing it up

Here is a summary of the different options using the 50,000$ income example above:

Personally I think any of the options that “make it worth it”, are too much effort and risk. I would just start as you mean to go on and try to max out your contribution room going forward throughout the year.

Keep it simple!

As a result, if life throws you something unexpected and you need to stop contributing as much, then you have the breathing room to make those adjustments, which is not the case if you’d taken out a loan.

Calculators

If you’d like to run your own figures through here are some tools I used to help with my calculations:

Used to calculate tax rates per Province (it shows all Provinces in one calculation, just enter your gross income and hit enter)

Used to calculate estimated tax refund

This shows the difference in the first 4 options in the table depending on variables you enter. I’m not sure about the Plan 1 option as I couldn’t get the numbers to work out the same.

Investing

Questrade – The online trading platform I use for RRSP, TFSA and non-registered trading.

Online Shopping

Honey – A Chrome add-on which automatically searches for discount codes. You save money on purchases you were going to make anyway and also gain points from certain websites (like booking.com) which you can exchange for vouchers for places like Amazon.

Mortgage

Ratehub.ca – A great website for comparing mortgage rates come renewal time. They also compare bank accounts, GIC investments, home and life insurance and credit cards.

Expense Tracking

YNAB – This is the tool I use for expense tracking. It allows you to split expenses so I can easily track expenses between my husband and myself. They sync with your bank account as well so keeping it up to date is easy (for Canadian accounts at least). The reports are handy too. I used to use the desktop version which had a once off fee but now they’ve moved to a cloud based paid subscription of 84$/year. I struggled with this cost but I’ve also struggled to find an alternative that suits my needs. I also convert the cost into my hourly wage and figure it will save at least that amount of time per year in maintenance as it has the auto syncing and our historical transactions from the desktop version.

Travel – Accommodation

Air B’n’B – If you don’t already have an account – get 60$ off your first trip!

Booking.com – Great site for finding cheaper accommodation. I usually compare between both Air B’n’B and Booking.com. As mentioned above, if you use the Honey chrome-extension you can earn points which you can convert to Amazon vouchers. So far I’ve earned 40£ just by booking accommodation I would have booked anyway.

Travel – Fights

Google Flights – One of the quickest easiest ways to find flights with easy search filters for max duration, stop overs, price etc. Also really handy to explore destinations by putting in one or two starting airports and seeing where you can get to for little money. Great if you are just getting ideas of where you want to go, or where it’s cheap to get to from your airport. They also have price tracking notifications so you can be notified when prices increase or drop if you have a specific flight/date in mind.

Skyscanner – Similar to Google Flights, easy to search multiple airlines and sometimes has better prices than Google Flights.

Travel – Getting Around

Google Maps – Google Maps is great for showing how to get around a new place, it includes public transport, walking and even Uber prices and times. Street view is also a great way to explore an area before you get there.

Rome2Rio – Sometimes better at the public transport options than Google Maps and even shows much longer journey price and booking options from country to country.

Ex-pat/Cross-border Tax Advice

Trowbridge – When I was struggling to make heads or tails of the non-residents tax filing requirements for rental income from abroad, I received extremely helpful.

Investing your hard earned money can be scary! I read up on investing extensively for 2 years before I took the plunge. I suffered from something called analysis paralysis where the more I read the more I was unsure how and where to start. By hesitating I lost out on 2 years of having my money work for me instead of losing money to inflation in my account and so I’m writing this guide as a summary of my findings and experience in the hopes that it will help a few more people get off the fence and start investing.

Warning: This is a LONG post but I wanted it to be a one stop shop so you can check back and re-read all in one place, as you need to, instead of keeping track of multiple links.

To help you skip around, here is a table of contents

Preamble

This post covers a high level summary of investing concepts. A lot of the concepts could have full blog posts of their own so if you want to know more about any of them, you can research further but this post should give you the overall concept at a high level.

There are tons of resources out there for US folk but very few for Canadian specific strategies and even fewer in Ireland. This guide will focus on the Canadian side and as I muddle my way through the Irish side I will share my findings as I go. That said, a lot of what I talk about here, aside from the tax specifics and investing platforms are applicable anywhere.

This guide includes references to reaching financial independence where your portfolio is large enough (25 times your annual expenses) to cover your annual expenses by withdrawing only 4% per year. This may or may not be your goal but this guide applies to everyone who wants to start investing regardless of the end goal.

Start by paying off existing debt

If you have existing debts, it’s best to focus on those first as they typically have higher interest rates than you will achieve in an investment account. For example: If you have 100$ and you pay down your credit card you will save 21$ of interest (at 21%), but if you invest that 100$ instead you may only make 7$ (at 7$ real rate of return after inflation).

Focus on the debt with the highest interest rate first – typically in this order

• credit cards
• car loans
• student loans

Mortgages are usually lower than what you can get in an investment account so mortgages can be an exception to this rule. A good rule of thumb is if your mortgage rate is over 4% you would be better paying it down before investing.

See if you can consolidate your debt into products with lower rates. There are a lot of credit cards that offer 0% interest for the first 6 months or get a line of credit with a lower rate (say 5%) to pay off credit cards with a higher rate (say 21%).

Remember the power of compounding is working against you when you have existing debt. Using the rule of 72 (a calculation used to figure out how many years it will take for your money (or debt in this case) to double), a typical credit card of 21% left unpaid will double every 3.4 years or quadruple every 6.8 years!

What to invest in and why

Why traditional investments aren’t great

A lot of people (including me before I found a better way) think of their home as their retirement plan or invest in products sold to them by the bank or their employer, but there are major downsides to this approach.

Your home can certainly go up in value over time but it can also go down and there are plenty of costs associated with owning a home that you wouldn’t have while renting. I’m not going to go into the rent vs. own debate here as that warrants a post in itself but banking on your home as an investment puts all your eggs into one basket which is very risky. It’s also very illiquid and doesn’t give you many options should you need to free up equity.

Bank and employer investment products are usually products that work out best for the bank or employer rather than for you, they typically have much higher fees or lower returns than you could get on your own using something called index investing.

Fees are often brushed over but they become very important when compounding over time. For every 0.25% of a fee you lose out on 5% of your overall portfolio’s value. So if you pay the typical 2.5% for a Canadian fund, your portfolio will be worth almost 50% less than it would be if you had invested in a fund with lower fees!

What is index investing and why is is better?

Index investing is a way for you to essentially bet on the whole stock market.

An example of an index fund is the S&P500. This is an active index where the value of the 500 largest US publicly traded companies is calculated and tracked. Over 15 year time periods, the S&P500 has never lost money, and has had a median return of 12.2%.

There are many passive funds with lower management fees which try to mimic and track these underlying active funds. There are also many other funds which track other sections of the market so you can pick and choose a diversification you are comfortable with.

Since the inception of the stock market, it has always recovered from every downturn given enough time. If you have time to leave your investments grow, you don’t need to overly worry about market downturns, though you need to have the confidence to leave your money invested, especially in a downturn. That said, there are ways to mitigate losses which I will cover below.

Main selling points of index funds are:

• lower fees
• they outperform actively managed funds by 85%
• they allow for passive investing, in that you can invest and forget (aside from re-investing dividends and rebalancing once a year)
• you can access them as needed without penalty

Figuring out your comfort with risk

The two main elements of a balanced portfolio are stocks (equities) and bonds (fixed income).

• Stocks are shares in a specific company usually with higher risk and higher gains
• Bonds are essentially loans where the investor (you), loans governments or corporations money and they agree to pay you back in fixed income by a certain date. These are lower risk but also lower return. Bonds are used to balance out the risk of a stock heavy portfolio and are one of the ways to mitigate against stock market crashes.

A typical investment rule of thumb is to keep bonds in the percentage of your age. So if you are 30 years old you should have a portfolio with 70% stocks and 30% bonds. This reduces your risk as you near retirement but keeps your portfolio growing with higher percentages in higher performing stocks.

I have read mixed reviews of this for early retirees with some maintaining 100% stock portfolios to achieve maximum gains even in early retirement knowing they plan to keep working in some regard and therefore do not need a mitigation strategy.

Others are more risk averse and even though they are retired in their 30s, maintain a 60% stock/40% bond split for the first 5 years of retirement and then will only go as high as an 80% stock/20% split after that even though they are continuing to make money in retirement from passion projects.

At the end of the day you need to figure out which split works for your own level of risk aversion.

You can see my portfolio, which indexes I have invested in and why here, but here is a summary:

I currently have no bonds but think I will up this percentage to at least 10% of my portfolio after reading how useful it is to weather any stock market crashes (more on that below).

How to Invest

Setup a brokerage account

In order to invest yourself you need to setup an online brokerage account. I use Questrade as it allows free buying of any Canadian or US-listed ETF (exchange traded index funds). Selling an ETF incurs the normal trading commission of $4.95 to $9.95 (depending on the number of shares sold), but the idea with this model is that you will not be selling very often as you are building your portfolio. This essentially allows you free trading as an average long-term ETF investor.

You can sign up to Questrade here.

Select self-directed, standard individual and “no” for options trading. Complete the rest of the application and send in the paper signed forms as required. It can take a little while to complete the process.

If you are transferring from an RRSP or TFSA there is usually a fee of 150$ to transfer funds under 25,000$ but there is an offer on until September to waive this. Read more on how to transfer from these accounts here.

Fund your account

You can transfer money to your Questrade account by adding them as a bill payee on your online banking, this should avoid any banking fees. Test with a small amount first just to make sure it’s setup correctly.

Buy your ETFs

Once you figure out the ETFs you want to buy and the allocation you want, you’ll need to figure out how many of each you can buy with the money you have to invest. Say you have 1,000$ to start with, I did up a spreadsheet with some basic formulas where I entered the current unit price of each ETF and figured out how many shares of each I would need to buy to make up my desired allocation split. This way each time I have money to invest I just update the unit price and it calculates what I need to buy.

For example: For the Global Factor ETF I wanted that to be 33% of my portfolio so 33% of 1,000$ = 330$. If the unit price is currently 32.37$ then I can buy 10 shares (330$/32.27$ = 10.22$). As you cannot buy portions of shares you need to round down all of your numbers in the last column.

To test the waters you can choose to buy 1 or 2 shares and watch it grow for a while to help ease your concerns. In my case, in both my portfolios (Canadian and Irish), I saw a drop in value more or less straight away but over time the market has recovered. You need to be comfortable with your portfolio losing money from time to time and rest assured that the market goes up twice as frequently as it goes down over long periods of time.

Structure your portfolio to be tax efficient

In Canada there are two investment vehicles that allow you to defer and shelter taxes.

RRSP

A Registered Retirement Savings Plan (RRSP) is a tax deferral tool which allows you to reduce your taxable income in your higher earning years so that you can pay less tax when you withdraw at a lower income bracket in retirement. Your investment growth (capital gains) and dividends are tax free but you pay income tax on the final amounts when you withdraw. You have a maximum contribution room of 18% of your previous years salary up to 26,500$ (a salary of almost 150,000$). Check your notice of assessment to see how much room you currently have available.

TFSA

A Tax Free Savings Account (TFSA) is a tool to shelter your investments from taxes but only makes sense to use if you are investing in something. Do not use this account to just store money as it defeats its purpose. You can only contribute after tax money but your dividends and gains are tax free and there is no tax on your withdrawals. You have a max contribution room of 6,000$/year as of 2019. If you don’t have an account yet you can sign up and you get all the contribution room from 2008 when this account type was created.

You can hold both account types in your Questrade self directed investment account so you can choose what you want to invest in.

There is a certain order which you should invest in these accounts:

1. If your employer has an RRSP matching program max that out first
2. If you’re already in the lowest tax bracket (currently up to a salary of 47,630$) then fund your TFSA next as contributing to your RRSP will be a waste of your tax deferral (ie contributing at 15% tax bracket and withdrawing at 15% tax bracket), you are better holding onto your contribution room for a year you may be earning more
3. If you’re in the 20.5% tax bracket and higher, then fund your RRSP
4. If you manage to max out your RRSP then contribute the rest to your TFSA

Using these two tools will make your portfolio accumulation phase as tax efficient as possible. When it comes time to withdraw, there will be another way to structure your investments in order to further reduce or even eradicate the taxes you would need to pay.

How to maintain your investments

Don’t worry about timing the market

When it comes to investing, hindsight is a wonderful thing, if only you could know when the market was going to rise or fall. There are people who spend their days trying to predict this but save yourself some trouble and follow either one of two approaches depending on your comfort with seeing your portfolio drop in value from time to time.

Emotional option: dollar cost averaging

If you are really emotional about seeing your portfolio decrease in value, you can rely on something called dollar cost averaging. The idea is that instead of investing large lump sums on any given day you average it out over time so that you can reduce some of the risk of buying high only for stocks to crash the next day. Instead you buy little and often and you will naturally end up buying some stocks at a high but some at a low and it will average out over time.

Rational option: time IN the market is better than TIMING the market.

If you have gotten to the point where you are comfortable with seeing dips in your portfolio then rely on the fact that time IN the market is better than TIMING the market.

Other interesting stats about the market: (courtesy of www.retirehappy.ca)

1. Markets go up more often than they go down
2. Not only do markets rise more frequently, but they tend to increase in higher magnitude than the drops.

Over the last 90 years:

• Markets have gone up 73.9% of the time
• Markets have gone down 26.1% of the time
• The market gained more than 20% in 33% of the time
• The market lost more than 20% in 4.5% of the time
• The gains in positive years produce more than double the losses in the negative years

(This data is based on calendar year returns of the TSX from 1920 to 2010).

In addition (courtesy of Rob Carrick of the Globe and Mail),

• In 34 of the 37 corrections of 10%+ since 1950, the stock market was up 12 months later by 26.8% on average.
• Average decline for the 37 market plunges of 10%+ since 1950 is 19.7% or almost one every 20 months.

Either way your money will be working for you so pick the approach that works best for where you are at in your investment journey.

Keep adding to your investments

Buy as much as you can, as often as you can and watch your investments grow.

Try not to look at your portfolio too often as it can be off putting to see market dips but if you want to keep an eye on things in a visually pleasing way I use a website called Wealthica to see my overall portfolio progress. You can sync multiple brokerage and bank accounts to it and view the trends over time in nice graphs. It’s easier to see the overall progress of your investments.

Reinvest your dividends every quarter

There are some funds and accounts you can get with robo-advisors that will automatically re-invest your dividends but I have yet to delve into those options. For now I’m keeping it simple and manually re-investing my dividends. All but one of my ETFs pay out quarterly (you can see this on the fact sheet of each ETF), so I check back once a quarter and buy more with the dividends that are paid out.

Rebalance once a year

Throughout the year your stocks will likely outperform your bonds or certain ETFs will outperform others and your asset allocation will shift.

Say you started out with a 70% stock 30% bond split. Through the year your stocks performed really well and now they make up 80% of your portfolios value and bonds have fallen to 20%.

In order to maintain the asset allocation you are comfortable with you will need to sell some of your high performing stocks and buy some of the low performing bonds to rebalance your portfolio back to the original allocation.

This can be done once a year (I read a really good article on why any more than that actually increased your volatility while reducing your return but can’t for the life of me find it again). Keep an eye on trade commissions and creating tax events from sales.

Weathering a crash

When the market is crashing, it is very hard to leave your money invested but based on the facts, the stock market always recovers so the best thing for you to do is wait, alternatively there are two things you can do to lessen the blow:

Sell bonds at a high and buy stocks “on sale”

If you hold bonds as well as stocks, a crash may be a good time to rebalance as during a crash, money flows out of stocks (risky) and into bonds (safer), this devalues stocks and increases the value of bonds. So if you hold bonds now would be a good time to sell (high) and buy stocks (low) and rebalance your portfolio to your desired split. This means that once the market recovers you will own more stocks which you got “on sale” and will benefit more from the upswing in the market. If you don’t own any bonds you will simply need to wait for the market to recover (usually 2 years).

This is why it’s important to hold at least some bonds as you will be in a stronger position to benefit from market recovery than if you only held stocks.

Sell at a loss to offset future gains

This is something called capital loss harvesting (or tax loss selling). This idea is that you take advantage of the downturn by selling some of your assets which have lost value compared to when you bought them. At the same time you should buy back a similar ETF at the lower value so that you maintain your original market exposure to ensure you can take advantage of the future gains when the market does recover. The reason you wouldn’t buy back the same ETF is because there is a stipulation where you have to wait 30 days before buying the exact same thing again, or it is dismissed as a “superficial loss (or gain)”.

Capital losses can be applied to your current tax year, 3 years in the past and indefinitely in the future. This means you can basically “buy tax credits” in the down years which you can use to lower your taxable income in future years when your income may be higher.

How long to financial independence?

For those of you interested in achieving financial independence, you may be wondering how long it will take using the above investment model, well the chart below shows how many years it will take for you to reach financial independence depending on your current assets and different monthly savings amounts. Financial independence (FI) means your portfolio is large enough to withdraw a safe withdrawal rate of 4% to cover your annual living expenses, in this case we are looking at a portfolio of 500,000$ for an annual cost of living of 20,000$ for 1 person. To apply this chart to a couple simply double the monthly savings amount in the first column to reach FI in the same number of years.

Assumptions:

• Amount of time to grow portfolio to 500,000$
• Safe withdrawal rate of 4%
• Annual living expenses on withdrawal of 20,000$ for one person
• No income tax on withdrawal as portfolio will be structured to avoid tax (detailed below)
• Real rate of return used is 6.77% (average stock market performance over its lifetime has been 9-11% so being conservative I took 9% minus the average inflation for Canada over the last 30 years of 2% minus MER fees of my sample portfolio of 0.23% = 6.77%)

So for a single person starting from 0$ in assets and saving 500$/month it will take 28 years to reach financial independence compared to 13 years if you save 2,000$/month.

If you already have 100,000$ in assets and you save 2,000$/month it will take you 9.5 years to reach financial independence.

This just goes to show how much of an impact your savings rate can have. It can shave years off your journey to FI. Not fast enough? There are a few more options on how to reach FI sooner.

Ways to reach financial independence sooner

There are a few other options if your time to FI is too far away. This is a quick list but you can google more on each bullet point to find many resources on each topic if some of them interest you.

You could:

• Make more money with a side passion project in order to increase your savings rate and decrease your time to FI – google side hustles for ideas or check out the book Financial Freedom for a great guide on figuring out profitable side hustles. One exercise in the book is to make a list of your hobbies and a list of your skills and take a step back and see if any side projects appear that make use of a cross between your skills and hobbies.
• Cut expenses to increase your savings rate.
• Do partial FI where you increase your withdrawal rate beyond the safe rate of withdrawal with the caveat that you would need to earn a certain amount through the year which would not require a full time job, offering you and your partner more flexibility. For example: say you and your partner want to live off 40,000$/year – for a safe withdrawal rate of 4% you’d need a portfolio of 1 million but if you decide to take out 6% per year you’d only need a portfolio worth 640,000$ BUT you’d also need to top up your portfolio/investments with another 15,000$ per year to ensure it wouldn’t run out. So you or your partner could work part time or take on contract work for a few months if that was something you’d rather do then wait your full time to FI. This approach practically cuts your time to financial independence in half while still achieving the flexibility you may want.
• Take mini-retirements once you’ve reached some degree of passive income or savings and you can afford to take a prolonged time away from work to pursue other things, be it travel, time with family, going back to school etc. This is a great option if you want a change sooner than later. It also gives you a chance to try out early retirement to see if it’s something you’d actually like to do full time.
• If your job allows you to work remotely 100% of the time, consider moving to a place where cost of living is much cheaper. I know someone who contracts for a company in London, earns GBP and lives in Malta where there is no corporate tax. Other stories I have come across are where a couple moved from San Fransisco to Mexico while still earning US dollar from their silicone valley companies and significantly reduced their time to FI that way.

There are probably lots of other ways but these are the main ones I’ve come across.

How to withdraw

Once you’ve reached your version of financial independence and you’re ready to start withdrawing from your portfolio there are a few things to consider in order to protect your portfolio from something called sequence of return risk and also how to make your withdrawals tax-free.

Protect your portfolio in the first 5 years of retirement

Your retirement portfolio is at most risk of failing in the first five years of retirement. Even if you only withdraw at the safe withdrawal rate of 4% (which has a success rate of 95%) there is a 5% chance it will fail in the long-term and your portfolio will run out of money in 30 years time. This can happen if you retire right when the market crashes and you are forced to withdraw/sell at a loss and even in the upcoming “up” years your portfolio cannot recover and eventually over 30 years you will run out of money (unless you go back to work and top it back up again). This is something called the sequence of return risk. Never fear – there are ways to mitigate this.

1: Least ideal: Go back to work to top up your portfolio

2: Slightly more appealing: Cut expenses or move somewhere cheaper so that you don’t need to withdraw as much to live off of

3: Least impact: Hold a cash cushion of 1-3 years of living expenses that is invested in something outside of the stock market (like a “high” interest savings account). Using this cash cushion for your living expenses in the down years means you do not HAVE to sell at a loss and you can wait for the market to recover keeping in mind that stock market crashes tend not to last more than 2 years of continuous declines.

1-3 years of living expenses can be a lot (say 40,000$ – 120,000$), which would further add to the time to financial independence but there is a way you can reduce the amount needed with something called a yield shield.

The idea is that you temporarily pivot your investments to high yielding (though lower performing) assets for the short term. Things like preferred shares, real estate investment trusts (REITs), corporate bonds and dividend stocks. This can mean that your portfolio goes from returning dividends of something like 2.3% to closer to 3%, which if you have 1 million in your portfolio means the difference between 23,000$ to 30,000$. So if you need 40,000$ to live on you can use the 30,000$ from your dividends and only withdraw 10,000$ from your cash cushion meaning you only need 30,000$ extra as a cash cushion to weather 3 years of a market downturn.

Holding a yield shield means your portfolio is slightly more complicated to maintain as you are invested in a larger number of asset classes but once you have passed your first 5 years in retirement you can pivot your assets back to a simpler spread of ETFs.

How to withdraw tax free…legally

At a high level, there are different tax rates and tax brackets applied investment income than there is to employment income or interest earned from savings accounts. Income taxes are mostly unavoidable if you are earning an income (unless you figure out some life hack where you work remotely from another country with lower living expenses and pay lower tax rates in the country you live in) but if you are no longer earning an income and you are living off your portfolio withdrawals then you can reduce your tax bill by:

1. withdrawing from your tax free account
2. making sure your investments are in the right accounts for tax optimization
3. using your annual eligible dividend withdrawal allowances
4. withdrawing your annual personal exemption from your RRSP
5. harvesting your capital losses

Firstly, to clarify some terminology:

A dividend is an amount of money a company pays out to its share/stock holders at a set schedule (usually quarterly or annually)

A dividend is considered eligible for tax purposes depending on how the corporation structures and pays tax on them. Corporations have to designate each eligible dividend that they pay, before or at the time the dividends are paid, and notify shareholders in writing that the dividend is eligible, as required by subsection 89(14) of the Income Tax Act. A corporation must make every effort to notify shareholders of an eligible dividend. Examples of notification could include:

• identifying eligible dividends through letters to shareholders
• dividend cheque stubs
• on the corporation’s website
  in corporate quarterly or annual reports
  in shareholder publications

A capital gain is an increase in value of shares you own compared to when you bought. So if you bought something for 10$ and when you sell it it’s worth 25$ you have a capital gain of 15$ which you need to pay capital gains tax on. You only realize a gain or a loss once you sell the share/stock while dividends are paid at the set schedule identified in the fact sheet of the fund.

Withdraw from your TFSA

Any gains made in your TFSA are tax free, so you can sell ETFs you have made gains on to fund your annual living expenses as needed.

Put the right assets in the right account to reduce tax

You need to ensure certain asset classes are invested in the right vehicle due to the way they are taxed.

For example: Bonds pay out fixed income which is treated as interest and is taxable the same way employment income is – you can avoid paying this tax if the bond portion of your portfolio is invested using your RRSP as RRSPs grow tax free. Here is a sample of what asset classes should be invested in which tools (courtesy of Millennial Revolution): Read their blog post on this for much more detail as to why each asset class is most efficient for tax purposes as per the table below.

Use up your annual dividend tax withdrawal limits

In Canada, as of 2019, provided you are earning no other income, an individual can earn up to $47,630 per year in eligible dividends and pay no tax, or a married couple can earn up to $95,260 in eligible dividends tax-free.

If your portfolio throws off dividends each year, and you are earning no other income, you should withdraw these as part of your annual living expenses up to the annual eligible amounts so that you do not pay tax. These limits do not carry over so if you don’t use them you lose them.

Use up your annual personal tax exemptions

In Canada, as of 2019, at a federal level you can earn an income of 12,069$ per person (or 24,138 per married couple) each year for which you do not need to pay tax. If you are earning no other employment income, this can be withdrawn from your RRSP tax free. The added bonus is you do not need to be of retirement age to avail of this so works well for early retirees too.

There are slight variations per province so you’ll have to look into each of those for your particular province.

Note that when you withdraw from your RRSP, the government withholds 20% until you file your taxes at the end of the tax year, at which point you should get it back considering you’ve no other taxes due.

A good explanatory post with visuals on how to withdraw can be found here.

Harvest your capital losses

As mentioned earlier in the post you can purposely sell your assets at a loss in market crashes in order to carry the tax “credit” into years when your income is higher. If you need to withdraw more than your personal tax exemption and your dividend allowance per year, you can use your tax losses which you accrued in previous years to reduce your taxable income to zero.

Sense checking for the long haul

At the beginning of each year of retirement, it’s a good idea to re-check the chances of success of your current portfolio. There is a handy calculator called FIREcalc which cycles through 119 different scenarios based on criteria you enter and tells you the current rate of success where your portfolio will not run out of money in the next 30 years.

If the rate of success is lower than you’d like, you can always carry out some of the back up plans mentioned above in the “how to withdraw” section.

ANNNDDD that’s a wrap!

Hopefully this will be a post that you read and re-read through your investing journey. I actually learned more myself by writing it so I got something out of it too

I’d love your feedback, if you found this helpful or if there is something you’d like me to elaborate on in future posts, please leave a comment below.