Wednesday, December 29, 2010

After Tax and Inflation Returns on Stocks

Previously we compared the after tax and inflation returns (ROITI) of a plain interest bearing investment. It was concluded that the use of TSFA vs. RRSP accounts was dependent on the financial situation of the individual investor as well as whether we were in an regime of rising or falling income taxes and inflation. A typical fixed-income investment yielding 5% resulted in anemic real after tax returns.ROITI). Top tax margin rate investors and low margin rate investors who over time moved into higher tax brackets were most like to lose money in RRSPs while returns in TSFA were not tax bracket dependent.

In this posting we look at ROITI for stocks. We look at this year's performance and the long term performance based on data from Jeremy Siegel's "The Future for Investors". Last year's S&P TSX60 stock index returned approximately 11.5% appreciation plus an average dividend yield of 2.6%. Over the last 200 years the average stock market return including dividends was 11.18% assuming an average dividend yield of 2.5% that means appreciation was around 8.7% annually. Jeremy's real stock return is 6.5-7% implying an average inflation of 4.3%.

Those are the numbers entered in the Excel spreadsheet below:

The yellow fields on the spreadsheet let us enter our assumptions. Based on Alberta's 2010 income tax data, the top marginal tax rate is 39% - i.e. the maximum tax rate on salaried income or interest income. Rental income would be taxed at this rate as well. However, this income can be deferred using the depreciation (CCA). Capital gains are taxed at 50% of the marginal tax rate. Dividends in Canada are the most difficult to calculate. Basically the actual dividend income is first increased by 'gross-up' factor which can be changed annually. Next the dividend tax which is the grossed-up dividend yield multiplied with the top marginal tax rate of the investor. Then a tax credit is deducted which comprises a provincial and a federal tax credit rate multiplied with the grossed-up dividend. The result is the dividend tax payable. After all is said and done, in Alberta the dividend tax rate is less than the marginal rate ranging from -4.02% for the lowest tax bracket to 15.88% for the highest bracket. If you have a significant amount of investments, it is certainly worth your while to sit down with your account and figure out what investment type provides you the best returns and cash flows.

The spreadsheet shows you what your after tax and after inflation returns are on stocks when you are in the top tax bracket in Alberta. In most other provinces your returns are likely poorer. Stock investment profits are derived from two sources: Appreciation (capital gains) and dividends (cash flow). Both profit types are taxed differently and both lose purchasing value over time due to inflation. To calculate your return on a stock investment of say $100 in 2010 with a return equal to that of the TSX60 index, you have to determine both appreciation and dividend income. That is $100 x 11.5% plus $100 x 2.5%, i.e. $11.51 and $2.60 respectively. Taxes due on those returns are 11.51x0.5x39%= $2.24 (top marginal tax rate) for the appreciation plus $2.60*15.88% = $0.41 on the dividends. Total after tax income is: $11.51+ $2.60 - $2.24 - $0.41 = $8.85. In other words, you paid 19% taxes on your total income of $11.51 + $2.60 = $14.11. If you had earned $14.11 through employment you would have to pay 39% taxes instead.

So you made last year $8.85 after tax, but there was also a bit of inflation. Your $8.85 at year's end was worth 1.9% less than it was at the start of the year. Also, the purchase power of your $100 investment money lost 1.9% in purchasing power. So after inflation you only made $6.82 or an after tax and after inflation return of 6.82%. If you had put the same money in an TSFA you would not have to pay taxes on your investment income but you would have lost some of that income due to inflation. After inflation your profits would have been $9.43 on a $100 investment or 9.43%. Unfortunately, you are only allowed to put a maximum of $5000 of your savings per year in your TSFA. The rest you have to keep in a normal investment account or... in an RRSP.

Clear as mud! Yes Sir, 5% interest bearing investments with a 1.55% ROITI clearly doesn't cut it. But... in 2008 you probably would have howled differently, wouldn't you? Yes, of course, stocks are much more volatile than fixed income and if you panicked and sold your stocks at the bottom of the bear market you lost a lot more than only earning 1.55%! That is why we always tell you that stocks are for the long run. Here is where Jeremy Siegel's work proves to be so valuable. Jeremy found that if you held stock over the last 200 years and always re-invested your dividends, your return on investment would have averaged 11.2% per year comprising of 8.7% appreciation and 2.5% dividend yield. We have discussed this elsewhere in this blog and we will not go here into more detail.

How would Jeremy's returns have worked for the top margin Alberta investor in a non-sheltered investment account and how would that compare when held in a TSFA or in a RRSP? The answer, my friend, is blowing in the wind or in the above spreadsheet. You chose. His returns for the regular investment account and the TSFA are similar to that of the one year calculations and result in an annual ROITI of 5.81% and 6.62% respectively. Returns for the RRSP are a bit more complex. $100 invested in an RRSP is pre-tax money and thus if you invest $100 of your after tax savings, you get a tax refund equal to $100 x top marginal tax rate or $39 in Alberta. This of course makes life more complex. Not only do you have to pay taxes at your marginal tax rate (39%) when you withdraw both your investment and your profits from your RRSP, you also have to decide what to do with the tax refund.

In our earlier posting "The Struggle of Tax Shelter Giants" we assumed that your tax refund was not invested, instead of $100 you invested $71 after tax dollars. In the spreadsheet above it was assumed that you invested $100 after tax dollars or $100 within your RRSP and the $39 refund you invested in a regular investment account in the same stock investment. So other than taxes, you invested with the same return and inflation rates. For 20 years you see the worth of your RRSP outperforming the non-tax sheltered and even the TSFA returns, but when you withdraw your RRSP money you have to pay the piper! Every penny you withdraw is at you marginal tax rate which if it hasn't changed over the years is... 39%. When combined with the after tax returns on your regular account, you pay close to 36,4% in taxes and your after tax return falls between that of the TSFA and a regular account. Then you get hit by your loss in purchasing power and on an after inflation basis, your ROITI is 6.05%. That is better than a non-sheltered investment in stocks but worse than a TSFA. Pity you can only put $5000 in your TSFA, but you have still a lot of shelter room left in your RRSP before you need a regular account. With a long term investment, stocks on an after tax and after inflation basis will outperform fixed income investments every time. What does destroy those returns is selling in stock market crashes and investing in just a few stocks rather than a diversified portfolio.

BTW since we are expecting inflation and taxes to go up over the coming decade or so, the top marginal tax rate is likely to go up as well. This will not only reduce you returns on your regular investment accounts, but also on your RRSP investments. The returns on your TSFA will not be affected.

Saturday, December 25, 2010

2011 Outlook as guessed by GW

It is yearend so let's see what may lie in store for us in next year's investment universe. Let's start with energy prices. Oil prices are likely to continue going up, but if it shoots up too high it would limit economic growth. The two keep each other in check. When oil prices are too high, economic growth would slow down and that reduces oil demand; too much economic growth would drive the oil price up and slow economic growth. China is trying to control its economic growth and it has tried to do so unsuccessfully for many years. However, the balance between oil prices and economic growth may do the trick.

I see oil prices gradually increase; trading in a $85 to $110 price range with possibly some spikes during the summer driving season. Gas prices will be affected by drilling rig count, economic demand in N. America and the weather. I expect prices in the 4 to $6 dollar range. Also affecting gas demand is electricity generation – gas will become an increasingly more important fuel source for electricity over the coming decade and with the advance of electric cars demand for electricity could easily double in 10 to 20 years. However, over the short term this is not likely to have much influence. Also, consider that creating power generating capacity is something that takes years of planning. In terms of stock market performance, I think oil producing companies will shine. In Canada, the issue will be whether labour costs, land prices and construction prices will escalate even faster than oil prices.

Natural gas companies will remain laggards in the 2011 stock market. However, their profitability may somewhat improve. We still will be in a world of cheap prices for gas companies in 2011; thereafter in 2012 and 2013 prices could rise dramatically though. Consider bargain hunting in 2011 for gas producers or for oil companies with significant gas holdings using profits taken from other sectors– only buy the best managed companies and see them as intermediary to long term holds.
Canadian banks will continue buying 'cheap' international assets in their drive to benefit of their 'advantaged position' in the banking world. However, new acquisitions will reduce earnings power due to decreased leverage. Return on equity for Canadian banks will likely go down and so will the banks' lofty P/Es. With limited upside to increase dividends especially when combined with rising interest rates and more acquisitions, banks will be modestly attractive investments for some time to come. They are not likely to crash; instead they will be market performers or laggards. So a diversified portfolio should be underweight in Canadian banks.

The Canadian Dollar will remain strong which will be good for productivity growth but not for exports. Future growth prospects, especially when combined with limited leverage and high energy prices will result in muted stock market performance of the manufacturing sector. However, hi-tech gadget manufacturers like Blackberry's RIM spurned because of the Apple craze, may surprise pleasantly in 2011 contrary to guru sentiment.

The growing world economy and the growing world middle class spells well for agriculture. However, here too the Canadian Dollar may dampen the fun a bit. Don't panic though; previous analyses showed that most of the Canadian Dollar's appreciation was visa vie the U.S. Dollar and a lot less against other currencies. The Chinese Rembini may be loosened up somewhat further to reflect its true value against other currencies, in particular the U.S. Dollar. This may be beneficial to Canadian manufacturing and agriculture. So overall, don't be too afraid of a 'strong' Canadian Dollar. Expect companies such as Potash, Agrium, and food producers or other agricultural exporters to do well.

Real Estate oriented companies should benefit from a gradually improving economy too, especially in Western Canada. Right now, though REITs are not exactly cheap. Gold is likely to peak and possibly even crash. It is overvalued to the point of bubbly.

The real surprise of 2011 will be the good performance of the U.S. economy and that will put gold into the doldrums even further. So next year's investment theme will be to avoid gold; modest growth for Eastern Canadian manufacturing and banking; good performance in the Oil and Gas industry (especially oil). Real estate trusts may outperform because of low interest rates combined with better occupancy in both retail and rental real estate.

The U.S. economy will surprise many. The numbers are ever improving while expectations are low. Hi-tech companies such as Cisco and Microsoft are dirt cheap, maybe their time has come.Have you seen Xbox with Kinetics (kinetically driven computer operating systems as seen in SF movies like Pay Check may not be far off)? Apple may lead in gadgetry and depends on one man (Steve or is it Stephen?); Google is hitting the search engine ceiling, but Microsoft and Cisco are leading to a new way of computer, gaming and TV interfacing – something not recognized in today's stock market. Many of the Dow Jones Industrial valuations don't reflect its companies' exposure to an improving world economy, to an U.S. economy growing 3 to 4% in GDP, nor do they reflect their large cash holdings. This is where the money will be made. GE has turned the corner and will perform with, if not outperform, the market.

Emerging market economies will continue to grow but their stock market expectations are too high. With the unwinding of the European crises and returning stock and bond market confidence in the EU during 2011,stock markets in that part of the world may perform comparatively well– many experts paint the EU's issues too dark – don't forget in total the EU is a larger economy that the U.S., while Greece, Ireland, Iceland and Portugal have always been on the fringe. Europe's real core countries are Germany, England, France and the Benelux.

In terms of real estate, I foresee an excellent year in the West for landlords and modest real estate price increases along with the recovering Alberta economy. Also, this part of the country lagged last year's excellent performance in Eastern Canada and B.C. due to HST fears, Olympics and rising interest anxiety. In 2011 the West Canadian real estate will outperform. Alberta will rise and fall with China's and other BRIC country performance. It may also benefit, along with the Rest of Canada, from the U.S. recovery and improving U.S. consumer confidence. Expect low interest rates that will gradually increase throughout 2011 along with the improving North American economy.

In summary, apart from having a diversified investment portfolio that is low in fixed income (especially medium and long term fixed income), it is time to put your cash to work. Invest in Western Canadian real estate, especially between now and early spring. This may be the end of the low real estate valuation window for Western Canada. Invest in oil and in some gas companies on the stock market. Banks should be underweighted. Overweight the U.S. – Dow Jones Industrials and Hi-tech giants. Reduce cash. I expect Canadian stock market returns in the 10% range; same for Europe and Asia. Best returns will likely be in the U.S. 10 – 15%. I could be wrong, but don't worry - I correct that through frequent weekly, daily and hourly forecasts.

Wednesday, December 15, 2010

The Struggle of Tax Shelter Giants – Conclusion in plain words or is there more?

So how do all those contorted numbers of the previous posts translate in real situations? It depends on your current income and tax bracket and on how you see the future. Based on the previous posts income tax rates are likely to increase over time. Currently in Alberta , we have the following income tax brackets:
first $40,97025%
over $40,970 up to $81,94132%
over $81,941 up to $127,02136%
over $127,02139%

For a person starting out in his/her career with a salary below $40, 970 the current income tax rate is 25%. Say that person is successful and in twenty years time he/she is in the top marginal tax bracket which by then has increased to 50%. Such a person would on an after tax and after inflation basis lose money if savings were invested at a 5% in an RRSP while there would be a 1.55% profit when invested at the same interest rate through a TSFA.

A person currently in the top marginal tax bracket (a salary over $127,021) would also lose when investing through an RRSP in a 5% bearing investment but less (-0.37% versus -1.38% per year). While that person's TSFA would yield the same 1.55% per year, the same as for the first person.

If the person making less than $40,970 would remain in the same tax bracket and income tax rates would not change (i.e. stay at 25%), he/she would make both 1.55% per year on the investment when either deposited in a RRSP or a TSFA. This would also be better than not sheltering the investment.

There is one scenario where an RRSP would make you better off. That is if you expect to be in a lower tax bracket when you retire than today. Say your marginal tax rate falls from 38.8% to 25% then you will walk away with a real after tax return of 2.59% per year.

Thus for most investors it is recommended to first invest to the maximum into your TSFA and then use up your contribution room in the RRSP. Top marginal tax investors who expect that their future income tax rates are to increase should sit down with their accountants and consider whether contributing to an RRSP makes financial sense.

Over the past 20 years or so income tax rates fell and as such, people investing in an RRSP were better off, but that is likely to change as mentioned above. Also, if you invest in bonds these days, as pointed out in an earlier post, your risk of losing money has increased dramatically. That is why investing your money in a fixed income RRSP investment is not advisable right now.

On an after tax basis, dividend income is much more attractive. It is why so many investors are chasing preferred or high dividend yielding common shares. The top marginal tax rate on dividend income is right now 15.88% and next year 17.72%. Lower income earners (less than $40,970 per annum) have even a negative tax rate. So this is something one should consider for investment. Capital gains are in a very tax attractive regime as well (50% of the normal marginal tax rate). Hence, investing in the stock market, especially with the economy likely to gradually improve, is quite attractive for the near to medium (1 to 4 years) term.

Rental Real Estate has also certain tax advantages (deferred taxes on rental profits using Capital Cost Allowance plus potential tax advantaged capital gains) and with the currently depressed prices in Western Canada (Calgary and Alberta) this may be a good time to invest in this asset class as well.

Were it not that the contribution limit is low for TSFAs, it would be ideal for higher yielding stocks of good blue-chip quality. Especially international stocks, but this should always been done with a long investment time horizon – 5, 10 even better 20 years. While you collect dividends your stocks will appreciate. However, if you are like Warren Buffett and you never sell your good investments and only sell your mistakes; you will defer your capital gains taxes in non-sheltered accounts while you can recoup some of your capital losses. An investor has a lot of options and investments to choose from and what is best depends on your individual circumstances.

For us to make better informed investment decisions that provide a positive inflation adjusted after tax return, we should weigh our options carefully. In the next posts, we will continue our comparisons of after tax returns on stocks and dividends outside and inside tax sheltered accounts.

Monday, December 13, 2010

Taxation and Inflation – Economic macrotrends

After 1945, North America was in a stage of growing capitalism. With new technologies after World War II and a relative new economy, it was booming, requiring ever increasing amounts of resources. Europe was rebuilding its war ravaged countries as well and rebuilding its former prosperity took all its energy. It boomed as well and it also required ever more resources. BRIC and other developing countries were off the radar screen and mired in economic misery with the exception of Japan that also tried to recover from World War II. Europe, with an older economy and influenced by socialism focussed using the fruits of its boom into an extensive social network; while North America was more focused on creation of individual wealth (the American Dream).

By the 1970s, the world became aware of the limits of its resources. Energy and materials earlier on taken for granted became suddenly 'scarce'. The resource economies started to demand respect through OPEC and with an ever growing world population and ever increasing consumption, especially in Europe and North America, commodity prices sky rocketed. Simultaneously, the Baby boom generation was growing up and required expensive education programs before it could contribute to GDP and this combination forced many western governments into large debts. Rising commodity prices made life more expensive and increased debt required governments to pay higher interest rates in order to compete for money in an ever capital hungry world. Citizens demanded ever growing prosperity but were also confronted with higher expenses. The inflation cycle hit full bloom.

In the late 1970s, inflation from higher commodities, inflation from higher wage demands to continue or increase the standard of living, and corresponding high interest rates, kept driving up government interest payments and increased government deficits. The response was higher taxation, which in turn increased the cost of living of its citizenry and the inflation cycle became a maelstrom. Economies faltered as illustrated by the 1974 and the 1979-1980 recessions. Inflation and commodity prices got out of control and only a dramatic increase of interest rates to near absurd levels by Paul Volcker around 1982 broke the cycle.
Energy conservation, falling inflation, lower interest rates, the rise of cheap BRIC country labour, reduction of social programs, the end of the cold war, government debt reduction and lower taxes. These were the things that brought commodity prices and inflation down. Inflation kept falling until... the first decade of the 21st Century.

After a period of amazing prosperity starting in the 1990s fuelled by low commodity prices and ever falling interest rates combined with ever more deregulation in North America and Europe, in 2000 – 2005 the lessons of the past were forgotten. The world, benefiting also from the new computer technologies, took prosperity for granted and adored unbridled greedy executives who often did not much more than riding the boom. We saw the era of easy money and unlimited unthinking credit. It all culminated in the 2007-2009 crash. We underestimated the ever higher commodity prices starting in the late 1990s; we ignored normal economic conservatism and long term investing practices. This was a new economy where everyone would be rich; especially those greedy and by 'success' blinded leaders of Wall Street and the laissez-fair politicians. Nobody saw the crash coming except a few outside-the-box thinking dissidents.

By now we are standing in the first half of a new era of new rising commodity prices, increasing government deficits and pretty soon we will see inflation sticking up its ugly head again. The cycle has started over, with higher interest rates and higher taxes for the coming decade or two. Governments have run the money printing presses at a very high clip. This combined with artificially low interest rates however justified in the short term. will lead us into a new period of higher inflation. So how will this affect our personal finances in the future?

We have already started on this blog with looking at RRSPs versus TSFAs. Now with the scenario described in this post, we will be able to see how this translates in investment strategies and tax strategies.

Inflation and taxation – Clashing economies

Although we live in an era of globalization, we also live in an era of diverting economic styles. What I mean by that is that North American economies are running in a different set of circumstances than those of the BRIC countries or those of Europe. Even within Europe there are different economies when comparing Germany to, for example, Iceland or Greece.

Overall, North American economies are relatively young and they are closer to the stereotypical capitalist society than Europe which has a free market economy with an extensive and expensive social network. China offers, in spite of its communist history, a much rawer form of capitalism than both North America and Europe. These Chinese markets have a 'just getting started' feel to them. There is no social network to protect its citizens from economic adversity. So let's take the economies of those three areas, Europe, North America and China as simplified examples of the globe's economic diversity.

Europe is characterized as the old world where capitalism has evolved in a hybrid beast with lots of government regulation and extensive social services. As a result, Europe's population is much more egalitarian (in terms of economic wealth) than that of the U.S. and certainly than the population of China. China counts now numerous millionaires and billionaires with on the other side of the spectrum a large portion of the population that still lives in the abject poverty of a primitive agricultural setting. Chinese people have no pension plans, insurance, or U.I. to speak of; they need to save their own nest egg for poorer economic times. Taxation is relatively low because governments only look after the army and the country's economic interests. It has no expensive social burdens to carry.

In Europe we have the opposite and here economic wealth is much more evenly distributed and social net works are extensive. But this is only possible because of high taxes and high social insurance premiums that leave its citizens with relatively little means to build their individual wealth. But then they don't need it. The state is taking care of them. The problem is evident these days – the state does still not collect enough money from its citizens to finance all that social protection and so, in spite of all its revenue, it is heavily indebted. The high debt levels in the weaker Economies of Europe such as the U.K. Greece and Italy lies at the roots of the so-called 'European Debt Crises'.

The North America's economy style, the third economic style, is yet another form of capitalism. Governments extensively regulate the economy with ever more intricate laws and accounting guidelines. This society is becoming so litigatious that everyone feels the need to protect against personal liability and exposed privacy; Litigation fears have reach the point that it nearly stifles all initiative. Simultaneously, economic power and the possession of goods are sources of personal status admired by all. Consumerism and leverage are ideals to be pursued regardless of sustainability. The social protection network is not as extensive as in Europe but combined Government and private social obligations (i.e. pension plans), has led to staggering debt levels. The contrast between rich and poor is stark, although the North American middle class is nearly as large as that of Europe. However, contrary to Europe, taxation levels are moderate and even the thought of raising taxes is political suicide. Consequently, North American government revenue is inadequate to cover its social obligations; that and the expectations of its citizenry of ever higher standards of life are causing increasingly higher levels of debt.

Savings rates in the newest capitalist economies are excessive resulting in enormous trade surpluses; while Europe is characterized by over reliance on the state, resulted in low levels of saving and lessened entrepreneurial spirit. In North America entrepreneurship and economic control are pursuit by technocrat abusing other people's money and leverage. Governments finance social obligations and war efforts with an inadequate level of taxation and consumers try to keep up with the Joneses regardless of debt. Now, in the face of economic collapse shell shocked North American citizens are increasing their savings level again, while their governments use excessive amounts of debt try to keep the economy afloat and to recover from an era of irresponsible economic greed.

While North America, in particular the U.S., tries to lessen its debt burden by devaluing its currency over the last decade by more than 40%; many others such as Europe, Japan and Canada carry a significant part of this through investment write offs and a crumbling banking system. The latter bought too much 'safe' North American debt while undertaking risky financing in their own overheated real estate markets. China and several other countries who own a large portion of U.S. debt have tried to stave off paying for U.S. sins by tying their currencies to the U.S. dollar while simultaneously converting their U.S. debentures into hard assets throughout the world.

In fact there is a fourth type of economic style that we ought to consider. Europe, North America and the BRIC countries are producers of consumer goods. They require input from resource economies such as the Middle East (oil), Australia, and Canada. Many of these resource economies differ from each other. Australia and Canada are highly developed economies with a democratic system in many ways akin to the overall North American economy. Saudi Arabia and e.g. Venezuela are developing economies under dictatorships. But for now, let's group these resource economies together and consider how the interests of resource economies clash with those of the resource consuming economies (Europe, North America and BRIC).

The different economic styles clash everyday in the Global economy and are the source of significant economic distortion. Only time and worldwide cooperation may lead to a more stable and predictable economy. In the next posting we'll examine how these fourth economic styles evolved and clashed over the last century or so.

Wednesday, December 8, 2010

The Struggle of Tax Shelter Giants - 8 percent

If you like to have a copy of the actual spreadsheet, please, e-mail me at

The Struggle of Tax Shelter Giants - 3.4 percent

If you like a copy of the actual spreadsheet, please, e-mail me at

The Struggle of Tax Shelter Giants - 5 percent

If you like a copy of the actual spreadsheet, please, e-mail me at

The Struggle of Tax Shelter Giants

There seems to be an eternal tug of war about whether it is better to invest into an RRSP or in a TSFA. The answer is: "It depends!"

First of all it depends on the type of investment return: Interest (fully taxed); Dividends (tax advantaged) or capital gains (50% of top margin tax rate). It also depends on the inflation rate and your annual rate of return on investment (ROI). If your ROI equals inflation both shelters break even on a after inflation and after tax basis. Those who invest for interest in a non-sheltered vehicle are the big losers. Surprisingly those investors in the lowest tax brackets lose most.

How do I know? I simulated various tax scenarios and income cases in a spreadsheet. The results truly depend on your personal circumstances. For example, the top marginal tax rate in Alberta is 38.8%. This is the lowest tax rate in decades. We seem now to be at a turning point. With increased government debt and politicians such as Obama Barack in charge we likely will see higher tax rates in the future. Say we go back to 50% tax rates; would the RRSP still be so advantageous for high income earners? Plonk, plonk the numbers are entered in my wily computerized wizard: 3.4% (historical average Canadian inflation), interest rates of 5% average) and a tax rate that changes from 38.8% to 50%, invested over 20 years.

Crunch, crunch, voila! The result is... starting with a $12,600 (maximum contribution for $70,000 annual income) you will have a RRSP tax refund of $4,888.80 and thus your real or net investment is $7,711.20. Inflating over 20 years would result in a nominal value of your net investment of $15,049.87 and... crunch, crunch... The future value of your 5% investment would have been $33,431.55. Hmmm, not bad, after 20 years your profit is $33,431.55 minus $15,0948.87 = $18,381.68! BUT it is still in your RRSP and to live of it you will have to withdraw your money! Oops, thou must pay Godzilla the Taxman!

What is your tax rate 20 years from now? The same as today? Well then you have to pay 38.8% taxes upon your withdrawal (0.388x33,431.55= $12,971.44 in taxes). The result, on an after tax and after inflation basis, is that you made $5,410 profit or a ROI of 1.55% per year By the way if you had invested that money in a TSFA your results would have been the same. If you had not sheltered your interest bearing investment your profits would have been $300.64 (obviously every penny counts) or an after inflation and after tax ROI of 0.15%.

BUT suppose the top marginal tax rate increases over time and after 20 years it is back at 50%. In that case your RRSP would have returned 0.53% annually and if the tax rate had escalated to 58% your return would have been NEGATIVE (-0.37%). At least your TSFA would have still given you the best return; it stayed the same at 1.55% (regardless of tax bracket). The real losers are those who contributed to their RRSP while NOT in the top tax bracket, say their tax bracket was only 25% when they deposited their money into their RRSP and after 20 years they ended up in the 50% tax bracket. They lost 0.49% per year.

The next posts are some images of various spreadsheets split by income groups at the top marginal tax rate (Case I) and those below (Case II). I made three runs: Average ROI before taxes and inflation of 3.4% (equalling inflation), 5% and 8%. I am sure you see why I am such a fan of the TSFA! You can now decide for your circumstances what is best for you.

If you like to have a copy of the actual spreadsheet, please, e-mail me at

Thursday, December 2, 2010

Mr. Wasser (yes, people really call me that), could tell me how to start investing?

Sure I love to! Lately this blog has covered mostly current issues. But many readers may wonder where to start, just like the writer of the e-mail summarized in this post's title. My early postings discuss many basic investment concepts so I refer everyone to that portion of this blog.

But for those who don't have the time, here is my Quick Start manual. If you don't have time, then don't invest! Hahaha! Sorry, I couldn't stop myself. This is how I answered Bob:

Hi Bob (not his real name),

Nice to hear from you. Sure, I can give you a couple of tips on investing. Investing is like building a business in that it will provide you income from your assets. It differs from a business in that your money is supposed to work for you while in most businesses you work in it to make money. Real Estate investing as taught by REIN is kind of a hybrid because you have a lot of hands-on involvement. What I mean by this is illustrated in the next two examples:
  1. You invest in a GIC. Basically you put your money in this investment and every once in a while you receive interest income. You don't do anything but sitting in your chair and collect mullah!
  2. You invest in a rental property. The property appreciates over time and as such you make a profit (hopefully). But you also use it for running a rental operation which provides cash flow to cover expenses and mortgage payments and maybe a bit of the cash remains in your pocket. To do so you have to work though; you manage the investment: find renters and oversee the rental operation. You do maintenance; drive back and forth to show the place. Etc. So in fact owning rental properties is a lot less passive and requires your time and efforts. For this you get paid in addition to the appreciation profits
Best way to start is building a strong financial base. That is to own a house where you live. You are the best tenant you can ever get as a landlord. So especially in the beginning see your house as an investment and only buy what you need not what your ultimate dream is. Because your near term goal is to build the foundation of your wealth. It is much easier to start living a modest affordable lifestyle and later in life, when you can afford it, to add more luxury. That doesn't mean you should squeeze every penny into your savings either; live has to be enjoyable.

It is like wine. In the beginning you may enjoy your wine even though it is a bit cheap. Since you don't know much about wine, you probably enjoy it as well as an expensive wine. But if you start out drinking expensive wines and later on you are forced to start drinking cheap wines instead that may be a tough thing to do. So always live below your means but still allow yourself a decent life.

That is how you get savings. So the next question is what to do with your savings. In my view paying off the mortgage on your residence is the best thing you can do. Once paid off nobody can take it away and so it is a rock solid part of your financial foundation. Guess what? Interest paid on your residential mortgage is not tax deductible. Even worse, if you put your savings in a GIC or savings account you have to pay taxes on the interest you make plus the interest you earn on your GIC is a lot less than the interest you pay on your mortgage. I used to say that once I paid off my mortgage, I could buy every month a new dish washer or TV without noticing the financial difference. Or... you can add that money into your savings.

Also, you can buy a residence with a basement that you may rent out as a rental suite. Say for $800 per month. That would add another dishwasher per month (an expensive one). So this would accelerate your mortgage pay down dramatically.

While paying off your mortgage, learn about investing. Read books, go to REIN seminars (you don't have to be a member). Don't read only about real estate, but about stocks and bonds as well. An investment portfolio ought to be diversified - this in my mind is critical. You can open a play account with Canadian Shareowner Association. They also provide investment education similar to REIN but quite a bit cheaper (membership is $90 per year vs REIN $2400).

Once you paid off your house, you can start looking into other investments and if you rented out your basement you have build already some experience as a landlord. You can then decide whether you like being a landlord or not. Hope this helps, if you want to we could meet over coffee.

I would like to stress that I am not a professional investment advisor and as such, you are liable for whatever you do with my advice. I do not recommend stocks and I won't take any responsibility for my recommendations or ideas. I did have a Realtor License but I cancelled it - it is not for me. I love to BS about investments and you can find a lot of my thinking on my blog . Good news is my blog is for free. Bad news is that I am not a professional writer and it may be in places unreadable :)

I forgot to mention one thing to Bob and that is the most well kept investment secret in the whole wide world! And... I am going to reveal this secret if you subscribe to my new investment letter. Which you may buy for a measly $2500 per year. Yes I am just kidding. That is... about the investment letter.

But I am not kidding about the secret that I am about to reveal. No not in my next posting, but right now in the next few lines. Are you ready to learn about the most reliable and predictable source of cash flow?

Something that no self-respecting investment advisor will ever tell you about. Say: "Yes"! Shout "Yes I want to know!". Well the answer is: your job. Now how is that for a let down? But it is true. You do not need to invest money for this, the ROI is virually infinite and you don't have to use leverage! The only investment is your time. Now time is a priceless commodity and it is irreplacable so don't waste it on a job you don't like.

But as a semi-retiree, I can bear witness of the incredible impact a job has on your investment cash flow. Your job finances your lifestyle and what will be left of your salary will go into financing investment opportunities. While you work, your investment cash flow will accumulate into even more investment capital. And in a non-monetary sense, your job is an endless source of social entertainment.