Financial planning – Page 2

My Money Mirror comes into 2020 focus

From the Today Show to The View and innumerable points in between, Barbara Walters’ voice has been heard by millions of us over the last half century or so.

And while it’s hard not to conjure up Gilda Radner’s “Baba Wawa”, the iconic phrase that the real Barbara is best known for is her crisply enunciated welcome to the ABC TV newsmagazine 20/20. Of course the show title is an allusion to 20-20 visual acuity, which her careful phrasing so effectively captures.

This all came to mind for me as we turned the calendar over into the current 2020 year and decade, while reflecting on My Money Mirror.

What is My Money Mirror?

Whether it came out of a dream or is a remnant of a sci-fi/fantasy moviescape (or both), I’ve long had this notion of a money mirror out in the distance before me. It runs infinitely from left to right, and I’m always moving steadily toward it.

At a younger age, it doesn’t even appear that there’s a mirror at all. Being so far off, it could very well just be continuing sky. But as time and I myself roll forward, a dot appears on the horizon that grows and begins to take form, eventually blocking part of the view. I want to see past it, but as I drift to the left, it follows my move. Then I tack to the right, and it matches me again.

What is this thing, and why is it getting in my way? And that’s when it comes to me — it’s me.

Why a mirror?

Unless you were born into large wealth, you will spend much of your early life saving up a store of your excess labour — what we call money — that will be needed to sustain you in your later life. At some point you will (hopefully) cross over from the need-to-save to the freedom-to-spend. Maybe that’s more like an inflection than a reflection, but then my cute aliteration would be lost, so I’m sticking with my money mirror.

It’s the notion of retirement being the point at which there is enough stored wealth to comfortably and confidently fund the rest of your life. That’s a very different thing from merely reaching a chosen age or ceasing to work. The mirror is a way of visualizing the distinction between the purpose of your journey and the observations along the route.

Specifically, I want and need to visualize who I am on the other side of that divide. Ideally the image will be sharply defined well before reaching the mirror’s surface. Otherwise, without adequate preparation I might find myself on a collision course with an ever-growing dark mass with undulating edges —yeah, maybe this did originate as a nightmare.

Practical reflections on the year, and decade that was

The blurry blob aside, this journey toward clarity truly is the background visual when we look over the family finances each year-end. Note the “we” in that sentence, as this really is a team exercise.

Years ago when I was on my own, my attention was simply on saving something. I had no particular goals other than to be in a regular and reasonably informed habit, and I don’t apologize for that. To require more of a young person could lead to a very unhealthy stressful relationship with money.

These days as a couple dependent on one another and a family to raise, we have to be that much better informed and more targeted. We’re also learning from our experiences, so we have better intuition without having to be constantly looking, but we still run the numbers.

The difference this year is that it’s also a decennial marker, as we enter 2020. Looking back at our net worth progress over the last decade gives us confidence as we pivot from past to future. There’s no question that we’re still on the journey, but things really are getting clearer by the year.

Magic Number – What are some advisor assumptions on how much to save?

How much do I need to save for retirement? It’s the most common question asked of financial planners.

Of course, the response depends on how much you’ve already set aside, how much you need to live on now, and how much you want to (or must) spend in those later years. That’s the core of financial planning, and there’s a lot of information to be gathered, decisions and assumptions to be made, and calculations to be applied to come up with viable options and sound recommendations — and even then, there is still some degree of uncertainty.

This doesn’t mean that you don’t go to the effort, particularly if you are the financial planner tasked to make those recommendations. The critical step of any plan though, is putting it in motion.

Heuristics – The appeal of simplicity

In the face of what may feel like a laborious and elusive task, people often prefer to use a heuristic, for example “save 10 per cent of your income.” This is also known as the 10 per cent rule. Because it is so simple, it may very well get things moving, which in fairness, is a victory in itself.

Once good saving habits are established and experience gained, adjustments can be made that cater to changing circumstances.

Even so, 10 per cent is just a nice, round, but otherwise arbitrary figure. The aura that surrounds it should not be confused with the principled due diligence that informs good financial planning.

Do you apply it before or after…?

If we’re not careful, the apparent simplicity can be misleading. How you apply it is equally and arguably more important than the rate you choose in the first place. Too little and there’s not enough when you need it. Too much and the budget stress could be overwhelming, perhaps leading you to abandon the initiative you have taken. Consider these key tax issues:

Is the 10 per cent set before or after income tax?

In other words, are you applying it to gross income or net income? As a rough example (which varies by province), the average tax rate at $100,000 is about 25 per cent.

So, do you target $10,000 based on the gross, or about $7,500 based on the net? That could hinge on the mechanics of how you save.

If you pre-calculated $10,000 then you could pre-authorize a proportionate dollar amount from each paycheque/auto-deposit.

If instead you took 10 per cent off each deposit after it is in your account, it would come out to $7,500.

Are you saving with before-tax or after-tax dollars?

As compared to the first question, which was about the amount to save, this is about deductibility. Put in more familiar terms, you could make a deductible RRSP contribution, or a non-deductible TFSA deposit.

While you can get more into the RRSP to begin, eventually that is taxed on withdrawal before you can spend. TFSAs face no further tax. You’ll need to look at tax rates now (known) and in retirement (assumed) to properly compare. If you’re doing some of each, the arithmetic is more challenging.

Pre- or post-payroll?

If you contribute to a workplace group RRSP, your employer will generally reduce its withholding tax, as it knows of this deduction. When you contribute to your own RRSP, the annual withholding will likely exceed your actual tax due, resulting in you receiving a tax refund. While you don’t have to, reinvesting the refund effectively boosts your savings rate.

Canada Pension Plan?

The CPP is a savings program, with a base premium of 4.95 per cent. It is withheld by your employer, so most people wouldn’t notice or think of it as saving, per se. But depending on your response on the preceding questions, it could be quietly baked into your savings rate. And with premiums increasing to 5.95 per cent over the next few years, and an additional four per cent premium on higher income levels after that, it warrants a closer look to make sure it dovetails with your intentions.

Housing and mortgage?

What does housing have to do with it? Well, equity in a house is a type of saving, usually by first saving a down payment then servicing a mortgage. As an owner, you defray some of your future shelter costs, whereas otherwise you would need more savings to pay future rent. Whether this is before, after, or part of your 10 per cent depends on your circumstances, which is why a holistic financial plan should underlie your efforts.

Financial literacy is taxing … Or is that, “taxing” is financial literacy?

Whichever, it’s important either way.

I’ve been following with great interest the recent efforts in this country to look into and improve financial literacy.

At time of writing, there is eager anticipation – and it’s not just me – for the release of the Task Force on Financial Literacy report, slated for the end of 2010. As you are reading this then, hopefully the industry and the public in general are abuzz with the recommendations placed before the Minister of Finance.

As participants in the financial advice field, we obviously have an active interest in the present and future state of financial literacy. Combined with the concurrent federal-provincial dialogue on reforming the pension and retirement system, I’d go so far as to say that this year will be viewed in hindsight as a maturity point in the development of the industry.

On an individual advisor level, this public spotlight presents the ideal platform for reinforcing to clients the value of your professional advice.

Advisor as educator

Perhaps I would be in the minority for suggesting this, but I believe that the number one skill for an advisor is the ability to educate.

But shouldn’t expertise such as arithmetic talent, market familiarity and product knowledge be at least on an equal plane? Without downgrading those requirements, I would contend that those are exactly that: “requirements”. They are table stakes to get the license, but to really be a good advisor, you must be a good teacher.

Without that facility to build interest, foster comprehension and motivate action, all the rest is academic.

Speaking of tax

Similarly, I hold myself to that standard in communicating with advisors on matters of tax and estate planning. If I can’t explain it to you so you can explain it to them, then I need to go back to the drawing board.

To state the obvious, literally half of a person’s income could be spent in taxes. The importance of having at least a working knowledge cannot be overstated. As reinforcement (as if we need it), one of the most frequently mentioned items during the Financial Literacy consultation was “knowledge of the tax system, especially as it relates to credits and deductions that are designed to encourage saving”.

Here then are some fundamental tax learning points for you to share with your clients. You’ll recognize most, if not all of these, and hopefully this will help you enunciate them that much more effectively with your clients. If they can digest these guidelines then that should help pave the route from financial literacy to financial prosperity.

1. Marginal versus average tax rates

An obvious starting point is that the amount of taxes paid divided by income is your average or effective tax rate (ETR). The rate you pay on the next or last dollar earned is the marginal tax rate (MTR). A $75,000 income taxpayer has an ETR of 25% and an MTR of 35%. (All figures here and below are approximate 2010 national averages.)

2. METR

Building on the prior point, we now consider “marginal effective tax rate”. An often cited example of this is the Old Age Security (OAS) clawback, which causes 15% of OAS benefits to be returned to the government when earnings are over a specified income level. To illustrate, a $75,000 income retiree has an MTR of 35% on the next dollar out of a RRIF, but an METR with the clawback of almost 45% once you lose the after-tax value of the OAS clawback. (Plan carefully or lobby the government… or both.)

3. Income by source

RRSP/RRIF income is taxed at a person’s MTR at progressive rates as one moves up through the federal-provincial brackets. Outside of tax-sheltered structures, interest is similarly taxed at MTR, but only one-half of capital gains is taxable, and the rate on Canadian eligible dividends (those generally arising in an investment portfolio) can range from to zero to a little more than the rate on capital gains. At a $75,000 income level, the rate on these dividends can be as little as a third of the rate applying to interest or even less, depending on province.

4. Income splitting with RRSPs

We income split with ourselves using an RRSP, pushing income from high MTR working years to expected lower MTR retirement. A spousal RRSP likewise splits from now to retirement, and also with another person. If a person expects to be at a higher MTR when the funds will be used, a tax free savings account (TFSA) will produce a better result relative to an RRSP. Strategically, TFSA and RRSP complement rather than compete with one another

5. Understanding TFSA

The $5,000 of TFSA contribution room is an after-tax allotment, whereas RRSP room is pre-tax. Let’s say a $75,000 income taxpayer had maxed out her RRSP and wanted to know how much more of her current income she could get into a tax sheltered investment. At 35% MTR, approximately $7,692 would allow her to make full use of her $5,000 TFSA room.