Friday, January 11, 2019

Living below your means - No rocket science

The secret to building up financial assets that may make you become a ‘financial adult’ starts with living below your means. You may say: “oh no! No budgeting and no extreme frugality please.”  I agree, and most can achieve ‘Living below your means’ in a fairly simple way.

According to the Fraser Institute, the Average Canadian Household makes $105,236 per year and pays 43% in taxes. Taxes used to compute Tax Freedom Day by the institute include income taxes, payroll taxes, health taxes, sales taxes, property taxes, profit taxes, taxes on the consumption of alcohol and tobacco, fuel taxes and motor vehicle licence fees, import duties, natural resource fees, and a host of other levies.

Click on Table to magnify
For our purpose we need to know what the net annual pay cheque (after income tax, CPP, EI and healthcare premiums) is. In Canada these taxes average: $24,775 or 23.5% of gross income. Thus, the average household ‘take home’ salary in Canada is: $ 80,246.  Now, your employer may offer you other ‘employment benefits’; many in my books are more a burden than a benefit. But true benefits are a company savings plan and stock options in your employer’s corporation. Let’s first discuss those.
You can save without excruciating budgeting. The trick is to ‘pay yourself first’ then pay for your lifestyle. Many employers let you put up to 10% of your gross salary into the ‘corporate savings plan’ and they will match dollar for dollar or even better. Of course, you must realize that this is just another way of compensation that comes out of your beneficial contribution to the company. I call this your ‘gross-gross salary’ and it often is included in your taxable income.  You must also realize that you can use this money to invest in your employer’s publicly traded shares but, unless you believe strongly in the place of your employment there is no real advantage in doing so. 
I have learned the hard way, that buying shares in your employer’s company can be a disaster. I would first check with the guru’s on say ‘BNN’ what the consensus opinion on your employer’s corporation is before taking the plunge (and keep close tabs on this). If many are critical of your employer’s company, odds are that shares will fall going onwards or at least makes this investment much riskier. Therefor, I suggest that you collect the cash from what you have put in plus your employer’s contribution as soon as you can. Typically, within a year. That by itself is already a 100% gain compared to an employee who elected not to participate. Use it first to pay for your annual TSFA contribution. I personally feel that the loss of dividend tax credits or capital gains tax and loss credits are considerable arguments to keeping the rest of your savings outside an RRSP, especially when you are in the upper margin tax brackets.
Stock option grants are another form of compensation. They can be adding a fortune to your savings as long as your employment is in a booming sector. Again, check the BNN pundits to see what the attitude towards the company is before deciding to accept a job offer. My rule of thumb is to let stock options ride until the value of your options has risen to the point that it is difficult for you to sleep at night. Then sell some off until you can sleep again!  A lot depends on your risk tolerance, but I must say that colleagues who cash in all their options early in a rising market will develop envy and other nasty attitudes towards their fellow employees once they realize they have foregone a major opportunity to achieving wealth. That may go so far as that they may decide to quit a perfectly fine place of employment.  Holding on too long to your options may end up in significant opportunity losses, while selling too early may result in extreme job dissatisfaction.
Many people feel this form of saving is enough to get to retirement. My view is that you can not become a financial adults fast enough and then build towards a ‘stash of cash’ to develop the means for doing what you feel is worthwhile to do. An old Monsanto study once showed that having the means to say ‘goodbye’ makes you feel successful and in control. That feeling is one of the most valuable things to achieve. The study showed that those who feel in ‘control’ tend to live much longer while those who feel they are victimized by their bosses often pass away within 6 months of reaching the mandatory 65-year retirement age. Feeling in control is one of the best ways to enjoy your savings.
You may decide that even with a company savings plan you do not save enough. If so then you can use a simple compound rate of return to determine how much more you must save to build the asset value that makes you feel comfortable and in control. Use a reasonable rate of return in this exercise such as 4 to 7% plus inflation depending on the asset class or better classes you plan to accumulate. This exercise may help you to decide that you need 5% additional savings to achieve your goal. 
The solution is simple: Your after-tax income is around $80,246 and your contribution of 10% from your gross income of $105,000 to your corporate savings account or $10,500 results in 21,000 savings (including your employer’s contribution). Now take another 5% from the 105,000 or $5,262 and use it to pay down your residential mortgage. 
The accelerated mortgage paydown ensures you make a tax-free return on your money that is equal to your current mortgage rate (which for this post we assume to be 4%). This is typically higher than the return on most GICs plus it is (as said) ‘tax free’. Say you pay down the mortgage by $5262 then you save annually another $210.36 in interest payments and it compounds! In year 1 you pay down your mortgage by $5472.4 and in year two your total mortgage reduction would be $8,355 and in year three you have reduced in addition to the regular principal pay down the outstanding principal by close to $14,000, thus saving in the 3rd year nearly $553 in interest payments. I am sure that you see how fast this pays your mortgage off.  And.. there is very little investment risk because your debt reduction is secure. Once your mortgage is paid off, you could open a Line-of-credit (LOC or HELOC when secured by your residence) for buying additional investment assets; the returns on these assets (after interest expenses) are in addition to the interest payments savings on the now paid-for mortgage. 
Since the Line-of-Credit is used for investment purposes the interest that you do pay is now tax-deductible]. If for the residential mortgage we assumed you paid 4% interest then for the same amount of credit taken out using a LOC, now you pay often 50% or less as your after-tax interest rate on borrowed investment money or just under 2%. The 'after-tax' interest rate depends also on your tax bracket. Neat trick eh?

Following these strategies, your savings rate will easily grow to close of 30% of your gross income. Hmmm. Make a habit to use salary increases and year-end bonus to add to your savings. First though splurge a bit to award yourself with a fancy celebratory meal at a good restaurant – but the rest goes towards savings. 

This way you deduct from your (assumed average Canadian Household) gross income of $105,000 around 15% for savings (10% for the company savings plan and another 5% for additional savings to pay down your mortgage). After taxes $80246 - $15,875 = $64,451 remains to live from. Then add to your savings part of the money from the annual salary increase and bonus thanks to your employer and BANG within a few years your annual savings rate will reach 30%! And… those savings, when properly invested will bring between 4 to 7% plus inflation in average annual returns. This is building a substantial nest egg without excessive budgeting or frugality. Just pay attention to what you pay for things – every discount on expenditure can be used to improve lifestyle (as you already reached your annual saving target).

Once used to discretionary spending of $64,451, you probably won’t notice that you have achieved a decent lifestyle while saving like crazy. Yes, you may not go every year on vacation to Mexico or Hawaii but from personal experience I can tell you that, a nice camping vacation in a provincial park is often much better remembered by your children than a rushed and stressful trip to a tropical resort that easily costs you $10,000. Oops, by just staying in Canada during your children’s younger years you probably live a lifestyle here in Canada for $64K that others have for $74K
Now that is a very nice way to live below your means! Financial adulthood here we come!

No comments:

Post a Comment