Continue reading "Annual Retirement Savings Targets"
The post Annual Retirement Savings Targets appeared first on Financial IQ by Susie Q.
]]>There are several variables that will impact how much you’ll want to target as contributions to your retirement savings each year. They are:
Some of these variables are fairly straightforward. For example, you can check the balances of any accounts with retirement savings that you already have and you can estimate (within a few years, at least) how many years until you retire.
Other variables are more challenging to estimate. For example, I dedicated a whole separate post to the topic of setting your retirement savings target.
Your risk tolerance is a measure of how much volatility you are willing to take in your investments. As indicated in my post on risk, the more risk you take the higher your expected return but the wider the possible range of results. My post on diversification and investing shows that the longer period of time over which you invest, the less volatility has been seen historically in the annualized returns.
Here are a few thoughts that might guide you as you figure out your personal risk tolerance.
As can be seen, the more risk you take, the higher the average return. As you are estimating how much you need to save each year for retirement, you’ll need to select an assumption about your average annual investment return based on these (or other) insights and your personal risk tolerance.
In addition to considering your risk tolerance, you’ll need to adjust your investment returns for any taxes you need to pay between the time you put the money in the account and your retirement date. For this post, I’ve assumed that your savings amount target includes income taxes, as suggested in my post on that topic. If it does, you only need to be concerned with taxes until you retire in estimating how much you need to save each year.
In the previous section, you selected an average annual investment return. The table below provides approximations for adjusting that return for Federal income taxes based on the type of financial instruments you plan to buy and the type of account in which you hold it.
US – Taxable 
Canada – Taxable 
All TaxDeferred & TaxFree Accounts 

Money Market 
Multiply by 0.75 
Multiply by 0.75 
No adjustment 
Bonds and Bond Mutual Funds 
Multiply by 0.75 
Multiply by 0.75 
No adjustment 
Equity Mutual Funds 
Multiply by 0.85 
Multiply by 0.87 
No adjustment 
Equities and Index Funds 
Multiply by 0.85 
Multiply by 0.87 
No adjustment 
You’ll need to subtract your state or provincial income tax rate from each multiplier. For example, if you state or provincial income tax rate is 10%, you would subtract 0.10 from each multiplier. For Equities and Index Funds, the 0.85 multiplier in the USTaxable column would be reduced to 0.75.
The assumptions in this table for equities and index funds in particularly and, to a lesser extent, equity mutual funds, are conservative. Specifically, if you don’t sell your positions every year and reinvest the proceeds, you will pay taxes less than every year. By doing so, you reduce the impact of income taxes. Nonetheless, given all of the risks involved in savings for retirement, I think these approximations are useful even if they cause the estimates of how to save every year to be a bit high.
Also, the tax rates for bonds and bond mutual funds could also be conservative depending on the types of bonds you own. The adjustment factors shown apply to corporate bonds. The tax rates on interest on government bonds and some municipal bonds are lower.
From the table above, it is clear that calculating your aftertax investment return depends on both the types of investments you plan to buy and the type of account in which you plan to hold them. The table below will help you calculate your overall aftertax investment return.
Investment Type 
Account Type 
Percent of Portfolio  Pretax Return  Tax Adjustment 
Product 
Money Market, Bonds or Bond Mutual Funds 
Taxable 
0.75 

Equity Mutual Funds, Equities, Index Funds 
Taxable 
0.85 if US; 0.87 if Canada 

All 
Other than Taxable 
1.00 

Total 
There are three assumptions you need to enter into this table that reflect the types of financial instruments you will buy (i.e., reflecting your risk tolerance) and the types of accounts in which you will hold those assets in the Percent of Portfolio column. These assumptions are the percentages of your retirement savings you will invest in:
For each of these three groups of assets, you’ll put the average annual return you selected from the Risk Tolerance section above in the PreTax return column. You also may need to adjust the multipliers as discussed above.
Once you have filled in those six boxes, you will multiply the three numbers in each row together to get a single product in the last column of each row. Your weighted average aftertax investment return will be the sum of the three values in the last column.
I have created an illustration in the table below. For this illustration, I have assumed that you will invest 50% of your portfolio in bonds and 50% in equities. You are able to put 60% of your portfolio in taxdeferred and taxfree accounts. Although not consistent with my post on taxefficient investing, you split your bonds and stocks between account types in the same proportion as the total. As such, you have 20% of your portfolio in taxable accounts invested in each of bonds and equities. The 60% you put in your taxdeferred and taxfree accounts goes in the All Other row.
Investment Type 
Account Type 
Percent of Portfolio  Pretax Return  Tax Adjustment 
Product 
Money Market, Bonds or Bond Mutual Funds 
Taxable 
20%  3%  0.75 
0.5% 
Equity Mutual Funds, Equities, Index Funds 
Taxable 
20%  8%  0.85 if US; 0.87 if Canada 
1.4% 
All 
Other than Taxable 
60%  5.5%  1.00 
3.3% 
Total 
5.2% 
I’ll use a pretax return on bonds of 3% and equities of 8%. Because the All Other category is 50/50 stocks and bonds, the average pretax return for that row is the average of 3% and 8% or 5.5%.
I then calculated the products for each row. For example, in the first row, I calculated 0.5% = 20% x 3% x 0.75. The weighted average aftertax investment return is the sum of the three values in the product column or 5.2% = 0.5% + 1.4% + 3.3%. The 5.2% will be used to help estimate how much we need to save each year to meet our retirement savings target.
By this point, we have talked about how to estimate:
With that information, you can now estimate how much you need to save each year if you don’t have any savings yet. I’ll talk about adjusting the calculation for any savings you already have below.
I assumed that you will increase your savings by 3% every year which would be consistent with saving a constant percentage of your earnings each year if your wages go up by 3% each year. For example, if you put $1,000 in your retirement savings this year, you will put another $1,030 next year, $1,061 in the following year and so on. In this way, your annual retirement savings contribution will be closer to a constant percentage of your income.
The graph and table below both show the same information – the percentage of your retirement savings goal that you need to save in your first year of savings based on your number of years until you retire and aftertax annual average investment return.
Aftertax Return 
Years to Retirement  
5  10  15  20  25  30  35 
40 

2% 
17.6%  7.8%  4.6%  3.0%  2.1%  1.6%  1.2%  0.9% 
3% 
17.3%  7.4%  4.3%  2.8%  1.9%  1.4%  1.0%  0.8% 
4% 
16.9%  7.1%  4.0%  2.5%  1.7%  1.2%  0.9%  0.6% 
5% 
16.6%  6.8%  3.7%  2.3%  1.5%  1.0%  0.7% 
0.5% 
6%  16.3%  6.5%  3.5%  2.1%  1.3%  0.9%  0.6% 
0.4% 
7%  16.0%  6.2%  3.2%  1.9%  1.2%  0.7%  0.5% 
0.3% 
8%  15.7%  6.0%  3.0%  1.7%  1.0%  0.6%  0.4% 
0.3% 
As you can see, the more risk you take, the less you need to save on average. That is, as you go down each column in the table or towards the back of the graph, the percentage of your target you need to save in the first year gets smaller. Also, the longer you have until you retire (as you move right in the table and graph), the smaller the savings percentage. I caution those of you who have only a few years until retirement, though, that you will want to think carefully about your risk tolerance and may want to use the values in the upper rows of the table corresponding to lower risk/lower return investments, as there is a fairly high chance that your savings will be less than your target due to market volatility if you purchase risky assets.
First find the percentage in the cell with a row that corresponds to your aftertax investment return and a column that corresponds to your time to retirement. You multiply this percentage by your total retirement savings target. The result of that calculation is how much you need to save in your first year of saving. To find out how much to save in the second year, multiply by 1.03. Keep multiplying by 1.03 to find out how much to save in each subsequent year.
Earlier in this post, I created an example with a 5.2% aftertax investment return. 5.2% is fairly close to 5%, so we will look at the row in the table corresponding to 5% to continue this example. I have calculated your first and secondyear savings amounts for several combinations of years to retirement and total retirement savings targets for someone with a 5% aftertax investment return below.
Years to Retirement 
Savings % from Table (5% Row)  Total Retirement Savings Target  FirstYear Savings Amount  SecondYear Savings Amount 
5 
16.6%  $500,000  $83,000  $85,490 
15 
3.7%  2,000,000  74,000 
76,220 
30  1.0%  500,000  5,000 
5,150 
40  0.5%  1,000,000  5,000 
5,150 
The firstyear savings amounts in this table highlight the benefits of starting to save for retirement “early and often.” It is a lot easier to save $5,000 a year than $75,000 or $85,000 a year. By comparing the last two rows, you can see the benefits of the extra 10 years between 30 years of savings and 40 years of savings. With the same starting contributions, on average, you end up with twice as much if you save consistently for 40 years than if you do so for 30 years.
The calculations above don’t take into account that you might already have started saving for retirement. If you already have some retirement savings, you can reduce the amount your need to save each year.
The math is a bit complicated if you don’t like exponents, but I’ll provide a table that will make it a bit easier. To adjust the annual savings calculation for the amount you already have saved, you need to subtract the future value of your existing savings from your total retirement savings target. The future value is the amount to which your existing savings will grow by your retirement date. The formula for future savings is:
where n is the number of years until you retire. The annual return is the same return you’ve been using in the formulas above. If you don’t want to deal with the exponent, the table below will help you figure out the factor by which to multiply your current amount saved.
Aftertax Return 
Years to Retirement  
5  10  15  20  25  30  35 
40 

2% 
1.10  1.22  1.35  1.49  1.64  1.81  2.00  2.21 
3% 
1.16  1.34  1.56  1.81  2.09  2.43  2.81  3.26 
4% 
1.22  1.48  1.80  2.19  2.67  3.24  3.95  4.80 
5%  1.28  1.63  2.08  2.65  3.39  4.32  5.52 
7.04 
6%  1.34  1.79  2.40  3.21  4.29  5.74  7.69 
10.29 
7%  1.40  1.97  2.76  3.87  5.43  7.61  10.68 
14.97 
8%  1.47  2.16  3.17  4.66  6.85  10.06  14.79 
21.72 
Let’s say you have $50,000 in retirement savings, 25 years until you retire and have selected an annual return of 5%. You would use the factor from the 5% row in the 25 years column of 3.39. You multiply $50,000 by 3.39 to get $169,500.
If your total retirement savings target is $1,000,000, you subtract $169,500 and use an adjusted target of $830,500. Using the same time to retirement and annual return, your annual savings target is 1.5% of $830,500 or $12,458. This annual savings amount compares to $15,000 if you haven’t saved any money for retirement yet.
Having been subject to Actuarial Standards of Practice for most of my career (which started before the standards existed), I can’t finish this post without providing a caution. All of the amounts that I’ve estimated in this post assume that you earn the average return in every year. There aren’t any financial instruments that can guarantee that you’ll earn the same return year in and year out. As mentioned above, riskier assets have more volatility in their returns. That means that, while the average return is higher, the actual returns in any one year are likely to be further from the average than for less risky assets.
As such, you should be aware that the amounts shown for annual savings will NOT assure you that you will have your target amount in savings when you retire. I suggest that, if possible, you set a higher target for your total retirement savings than you think you’ll really need or save more each year than the amounts resulting from these calculations.
The post Annual Retirement Savings Targets appeared first on Financial IQ by Susie Q.
]]>Continue reading "Retirement Savings: How Much Do You Need"
The post Retirement Savings: How Much Do You Need appeared first on Financial IQ by Susie Q.
]]>I retired a little over a year ago and realized that, even though I have a lot of money saved, it wasn’t enough to give me confidence we wouldn’t run out. I took on a large consulting project to help cover our expenses for the next year or two. Researching this post, though, added even more confidence as we have more than enough to meet some of the simple rules of thumb. We will see what happens.
In this post, I’ll provide some insights about how to think about a target you might want to set for your retirement savings. As a follow up, I’ll talk about how much you need to save to meet your retirement savings goal in this post.
As I checked to see what others were saying on this topic, I found a very common theme for determining how much you need to save for retirement. In some places, it was called the 4% Rule and, in others, the Multiply by 25 Rule. Being the math geek that I am, my first thought was that 4% = 1/25 so they are the same thing! It turns out that, in the nitty gritty details, the Multiply by 25 Rule is intended to tell you how much you need to have available on the day you retire while the 4% Rule guides you in how much you can spend in your first year of retirement. Nonetheless, as explained below, they both result in the same amount needed in savings on your retirement date.
The 4% rule is intended to tell you how much you can spend from your retirement savings each year. Let’s say you have $1,000,000 in invested assets when you retire. It says you can spend 4% of that amount or $40,000 (including all of your expenses and taxes) in your first year of retirement. In each subsequent year of your retirement, you can spend $40,000 increased for the cumulative impact of inflation since you retired. The 4% Rule assumes that you are invested 50% in stocks and 50% in bonds.
The graph below shows the amount you can spend each year (blue bars which use the left axis scale) and the amount you’ll have remaining at each age (red line which uses the right axis scale) if you retire at 65, inflation is 3% per year, bonds earn 2.5% and stocks earn 7% annually. These assumptions are similar to longterm average assumptions that are common these days.
As you can see, in this scenario, the amount you can spend increases from $40,000 when you are 65 to almost $100,000 a year when you are 95 solely due to inflation. In the first few years, your spending is less than your investment returns, so your savings increases. After you turn 72, your savings exceeds your investment returns so your savings starts to decrease.
The 4% rule was developed by William Bengen and is presented in detail in a 1994 study published in the Journal of Financial Planning. (If you like numbers and graphs, check out this paper. It is a surprisingly easy read.)
Using historical data from 1926 to 1991, Bengen found that there were no 50year periods in which a retiree would run out of money if his or her initial withdrawal rate was 3.5% or lower. With a 4% initial withdrawal rate, the shortest time period in which the savings ran out was 33 years. In only 10% of the scenarios did the money last for less than 40 years.
If you turn this rule around and know how much you want to spend in your first year of retirement, say $60,000, you can calculate the amount you need to have saved by dividing that amount by 4% (=0.04). In this example, you need $1,500,000 (=$60,000/0.04) in savings on the day you retire using this rule.
The Multiply by 25 Rule says that the amount you need in retirement savings is 25 times the amount you want to spend in the first year of retirement. Using the example above in which you want to spend $60,000 in your first year of retirement, you would calculate that you need $1,500,000 (=25 x $60,000) in savings. As I said, the math is the same for determining how much you need to save because multiplying by 25 is the same as dividing by 0.04. It is just that the rules are stated from different perspectives (how much you can spend given the amount saved as opposed to how much you need to save giving how much you want to spend).
As indicated, those rules make assumptions that might not be right for you. There are a number of personal factors that impact how much you need in retirement savings.
The 4% Rule assumes that you invest half in bonds and half in stocks. Some people are willing to take more risk by investing more heavily in stocks. Other people can’t tolerate the ups and downs of the stock market, so invest more heavily in bonds. As shown in this chart below, taken from my post on diversification and investing, the higher percentage of stocks in your portfolio, the higher your average return (the blue lines) but the more likely you are to lose some of your principal (the portion of the whiskers that fall below 0).
If you plan to put more than 50% of your retirement assets in stocks, you can withdraw a bit more than 4% each year. Turning that around, it means you need a bit less than 25 times your estimated expenses in your first year of retirement. The table below was copied with permission from a March 19, 2019 article from Schwab found at this link. It shows how your time horizon (see below) and investment risk impact the 4% Rule.
The analysis underlying the 4% Rule focuses on a retirement period of 30 years. If you retire in your mid60s, it would imply that you would most likely have enough money to last through your mid90s. If you are in poor health or have a family history of dying early, you could consider spending a bit more than 4% (that is, multiply by less than 25 to determine how much you need to save).
On the other hand, if you plan to retire at 45 and want to have enough money to last until you are 95, you’ll need to save more. The Schwab table above shows planning horizons up to 30 years. Based on the numbers in the table, it looks like you could subtract about 0.1 percentage points from the numbers in the 30year row for each year your planning horizon extends beyond 30 years to estimate how much you need to save.
For example, if you want to be highly confident (90% sure in this case) you will have enough money to last for 50 years, you would be looking at 20 years beyond the 30year horizon. Multiplying 20 years by 0.1 percentage point is 2.0%. According to the table, you can spend 4.2% of your savings in the first year with a Moderately Conservative portfolio and 90% (highly) confident that you won’t run out of money in 30 years. My approximation would subtract 2.0% from 4.2% to estimate that you could spend about 2.2% of your savings in the first year if you wanted to be 90% confident you won’t run out of money in 50 years. You could then divide your estimated first year expenses by 2.2% or multiply by 45 to estimate how much you need to save.
Some people’s employers provide defined benefit retirement plans. These plans generally pay a flat amount every month starting at normal retirement age (as defined by the employer) until death. In the US, people who have worked or whose spouses have worked are eligible for Social Security benefits, as discussed in this post. Many other countries have similar programs.
When you are estimating how much you need to save for retirement, you can consider these sources of income. If all of your other sources of income increase with inflation, it is a fairly straightforward adjustment. You just need to subtract the income from these other sources from your firstyearofretirement expenses before applying the 4% Rule (as adjusted for other considerations).
For example, if you plan to spend $100,000 a year in retirement and have $40,000 of Social Security and defined benefit plan benefits, you would subtract $40,000 from $100,000 to get $60,000. Using the Multiply by 25 Rule, you would multiply $60,000 by 25 to get $$1.5 million instead of multiplying the full $100,000 by 25 which would indicate you need $2.5 million in savings. In this example, you need $1 million less in savings because you have other sources of income.
Unfortunately, most defined benefit plan benefits do not increase with inflation. The math for adjusting the Multiply by 25 Rule is fairly complicated. I’ve developed a simple approximation that you can use that will get you close to the correct percentage. To approximate the adjustment to the amount you Multiply by 25, divide your defined benefit plan income by 2 before subtracting it from your firstyear expenses.
I remember being a teenager and having my father explain to me how much I needed to save for retirement. The approach he proposed was that you could spend 2% of your assets which is equivalent to a Multiply by 50 Rule. (No wonder I was nervous about my finances when I retired!) His logic was as follows:
So, if you are like my father, you will want to save closer to 50 times your firstyear retirement expenses, rather than 25 times. It is important to remember that my father’s Multiply by 50 rule applies to your expenses excluding income taxes and the Multiply by 25 Rule applies to your expenses including income taxes, so they aren’t quite directly comparable.
As indicated above, the 4% Rule assumes your assets are invested 50% in stocks and 50% in bonds. You may have other assets that contribute to your net worth, such as equity in your home, your personal property, a family farm and rental property, among others. These other assets are all consider illiquid – that is, you can’t convert them to cash easily. Further, some of them are assets that you never want to have to convert to cash to cover expenses, such as your home and personal property.
As you project how much you will have in retirement savings, you’ll want to exclude any equity in your house as it isn’t available to invest. A portion of it may be available at some point if you plan to downsize, but you’ll want to be cautious about including it in your savings plan. Other of these assets, such as rental property, could be liquidated to cover retirement expenses. In your planning, though, you’ll need to make sure you consider the selling costs (e.g., real estate agent’s commission) and taxes you need to pay on capital gains and that they may not generate a return as high as underlies the 4% Rule.
The analysis that supports the 4% Rule assumes that you have the same expenses every year and that they change due only to inflation. That’s not how life works! You may want to be like me and want to take an expensive vacation every three or four years in retirement, you’ll likely have to replace your car at least once in retirement or you could have major home repairs if you own your home. In addition, endoflife medical bills can be very expensive.
As you are determining your firstyear retirement expenses, you’ll want to include amounts for any such expenses in your budget at their average annual cost. For example, let’s say I want to take a vacation (in addition to my already budgeted travel expenses) every five years that has a total cost of $10,000. I need to add $2,000 (= $10,000 per vacation divided by one vacation every 5 years) to my regular annual expenses for these big vacations. Similarly, if I plan to buy a $25,000 car every 15 years, I need to add $1,667 (= $25,000/15) to my annual expenses. In both cases, you would add these amounts to your budgeted expenses before you divided by 4%.
So, what can you do to estimate your personal retirement savings target? Follow the following steps.
It is hard to estimate your expenses in retirement, but it is very helpful to understand what you are spending today. If you don’t have a budget or haven’t tracked your expenses to see where your money is going, I suggest starting there. Here is a link to a post I wrote with a spreadsheet to help you monitor your expenses.
Next, look at your current budget and/or spending and estimate how it would change if you were retired today. On what types of things might you want to spend money in the future that you don’t spend now? Might you want to buy special gifts for your grandchildren that are more extravagant than what you spend for your children’s gifts now? Also think about expenses you have now that you won’t have in the future, such as commute expenses and possibly a separate wardrobe for work.
Be sure to think about Social Security (or equivalent) and income taxes. In addition to Federal income taxes, you may pay state or provincial and possibly local income taxes. If you plan to live somewhere else in retirement, it might have a higher or lower tax rate. In the US, Social Security taxes are 6.2% (12.4% I you are selfemployed) of your wages up to the limit ($128,400 in 2019). As you adjust your budget, you can eliminate Social Security taxes and will want to think about whether your state or provincial and local tax rate will be substantially different from their current rates.
Some people say that your expenses will decrease by 20% when you retire. In my very short retirement, I find I’m spending more than I expected as I have more time to do things and many of them cost money. This post from Financial Samurai provide some insights as to how retirement might impact your expenses.
Do you want to travel? How often do you think you’ll need to buy replacement cars and how much do you think you’d spend if you bought one today? What other expenses might you have that aren’t in your budget? For each of these expenses, divide the amount by the time between them to estimate an average annual cost, as I illustrated earlier in this post.
All of the amounts you’ve estimated so far are in today’s dollars. That is, they reflect the current prices of every item. You’ll want to increase these amounts for inflation between now and the time you retire. Over long periods of time, annual inflation has averaged 3% to 3.5% though it has been a bit lower recently. To adjust your budget for inflation, you’ll want to multiply it by 1.03^{n}, where n is the number of years until you retire. Don’t like exponents? The table below provides approximate multipliers by number of years until you plan to retire.
Years  5  10  15  20  25  30  35  40  45 
Factor  1.15  1.35  1.55  1.80  2.10  2.45  2.80  3.25  3.80 
If you think you’ll have a defined pension plan benefit or will receive social insurance (Social Security) benefit, you can subtract those amounts from your inflationadjusted budget. My post on Social Security provides insights on how to estimate your benefits for my US readers.
If you want to be almost 100% confident you will have enough money to last for your full retirement, regardless of how long it is, and leave most or all of your principal to your heirs, multiply the difference between your inflated budget (excluding income taxes) and other sources of income by 50 to derive your retirement savings target.
If you plan to be retired for only 10 years, you can multiply by a number as low as 10, according to the chart from Schwab. Where between those two numbers you choose is up to you. The longer you expect to be retired, the more conservative your investments and the more confident you want to be that you won’t run out of money, the higher your multiplier.
The post Retirement Savings: How Much Do You Need appeared first on Financial IQ by Susie Q.
]]>Continue reading "The Best Ways to Pay Off Your Debt"
The post The Best Ways to Pay Off Your Debt appeared first on Financial IQ by Susie Q.
]]>Both of these methods apply when you have more than one debt that needs to be repaid. If you have only one debt to repay, the best strategy is to pay it down as quickly as possible, making the minimum payments as often as you can to avoid finance charges which will be added to your principal in addition to the interest charges on any portion of your balance you don’t pay.
In this post, I’ll describe how the two debtrepayment methods work using some illustrations. I will then help you understand which approach might be better for you. For more information about the fundamentals of debt, check out my posts on loans and credit cards.
The debts covered by this post include credit cards (one kind of revolving debt), personal loans, car loans and other bills that are overdue. While longerterm loans, such as mortgages, are referenced in the budgeting process, I haven’t included them in the debt repayment examples. If you have unpaid shortterm debt, you’ll want to keep up with the payments on these longerterm loans first, but don’t need to prepay them. For this discussion, I will assume that you intend to repay all of your debts to your current debtholders. That is, you haven’t dug a hole so deep you need to declare bankruptcy and you don’t feel you’ll benefit from transferring some or all of your highinterest rate loan balances to one with a lower interest (i.e., debt consolidation).
Dave Ramsay, a wellknown author on financial literacy topics, proposed the Debt Snowball method for paying off your debts. Under this method, you do the following:
The Debt Avalanche method is very similar to the Debt Snowball method, except you repay your debts in a different order.
The first three steps under the Debt Avalanche method are the same as the first three steps under the Debt Snowball method. It differs from the Debt Snowball method in that you pay the minimum payment on all of your debts except the one with the highest interest rate at any given time instead of the one with the smallest balance.
I’ve created the two examples to compare the two methods. In both examples, I have assumed that you use a different credit card or pay cash for all new purchases until your current credit card balances are repaid. That is, to make progress on getting out of debt, you need to not only make extra payments on your existing debts, but also not create additional debt by borrowing to pay for new purchases. It’s tough!
In this example, you have two debts with the balances due, interest rates and minimum payments shown in the table below.
Example 1  Balance Due  Interest Rate  Minimum Payment 
Debt 1  $1,500  20%  $30 
Debt 2  500  10%  10 
You have determined you have $100 available to pay off these two debts. The minimum payments total $40 in this example, so you have $60 available to pay off more of the principal on your debts.
Under the Debt Snowball method, you will use the additional $60 a month you have to pay off Debt 2 first, as it has the smaller balance. That is, you will pay the minimum payment of $30 a month on Debt 1 and $70 a month on Debt 2 for 8 months, at which point Debt 2 will be fully repaid. You will then apply the full $100 a month to Debt 1 for the next 17 months until it is fully repaid
Under this approach, you will have fully repaid both debts in 25 months and will pay $428 in interest charges.
In Example 1, you will use the additional $60 a month you have to pay off Debt 1 first under the Debt Avalanche method, as it has the higher interest rate, whereas you used the additional amount to pay off Debt 2 first under the Debt Snowball method. That is, you will pay the minimum balance of $10 a month on Debt 2 and $90 a month on Debt 1 for 20 months, at which point Debt 1 will be fully repaid. You will then apply the full $100 a month to Debt 2 for the next 4 months until it is fully repaid
Under this approach, you will have fully repaid both debts in 24 months and will pay $352 in interest charges.
In this example, you have five debts with the balances due, interest rates and minimum payments shown in the table below.
Example 2  Balance Due  Interest Rate  Minimum Payment 
Debt 1  $1,000  10%  $40 
Debt 2  500  0%  25 
Debt 3  10,000  20%  100 
Debt 4  3,000  15%  75 
Debt 5  750  5%  30 
You have $500 available to pay off these debts. In this example, the minimum payments total $270, so you have $230 available to pay off the principal on your debts in addition to the principal included in the minimum payments.
Example 2 is a bit more complicated because there are more debts. As a reminder, under this approach, you apply all of your extra payments ($230 in this example) to the smallest debt at each point in time. In this example, you will make the additional payments on your debts in the following order:
Debt 2
Debt 5
Debt 1
Debt 4
Debt 3
It takes only two months to pay off Debt 2 and another four months to pay off Debt 4. As such, you will have fully repaid two of your debts in six months. In total, it will take 43 months to repay all of your loans and you will pay $5,800 in interest.
In this example, you will make the additional payments on your debts in the following order:
Debt 3
Debt 4
Debt 1
Debt 5
Debt 2
It turns out that Debt 2 is fully repaid in 20 months even just making the minimum payments. Debt 5 is paid off 7 months later again with only minimum payments, followed by Debt 1 2 months later. As each of these debts is repaid, the amounts of their minimum payments are added to the payment on Debt 3 until it is fully repaid after 39 months. At that point, the full $500 a month is applied towards Debt 4 which then takes only 2 additional months to fully repay. In total, it will take 41 months to repay all of your loans and you will pay $5,094 in interest.
Looking at the two examples, we can get a sense for how much more interest you will pay if you use the Debt Snowball method instead of the Debt Avalanche method. The table below compares the two methods under both examples.
Example 1  Example 2  
Interest Paid  Months of Payments  Interest Paid  Months of Payments  
Snowball  $428  25  $5,800  43 
Avalanche  352  24  5,094  41 
Difference  74  1  706  2 
In these two examples, you pay more than 10% more interest if you use the Debt Snowball method than the Debt Avalanche method, leading to one or two additional months before your debts are fully repaid.
The difference in the amount of additional interest depends on whether your debts are similar in size and the differences in the interest rates. I’ll take that statement apart to help you understand it.
The graph below illustrates the impact of the differences in interest rates and sizes of two loans on the difference in the total interest paid. To create this graph, I took different variations of Example 1. That is, you have two loans with outstanding balances totaling $2,000 and the interest rate on the larger debt is 20%.
The interest rate on the smaller loan was calculated as 20% minus the increment shown on the axis labeled on the right. That is, the interest rate on the smaller loan for scenarios near the “front” of the graph was 18% or 2 percentage points lower than the 20% interest rate on the larger loan. Near the “back” of the graph, the interest rate on the smaller loan is 0% or 20 percentage points lower than the interest rate on the larger loan.
The loan balance on the smaller loan divided by the total debt amount of $2,000 is shown on the axis that goes from left to right. The small loan is $40 (2% of $2,000) at the far left of the graph and increases as you move to the right to $960 (48% of $2,000) on the far right. Note that, if the small loan exceeded $1,000, it would have become the bigger loan!
The green curve corresponds to the total interest paid using the Debt Snowball method minus the total interest paid using the Debt Avalanche method. For example, at the front left, corresponding to the small loan being $40 with an 18% (=20% – 2%) interest rate, there is a $2 difference in the amount of interest paid. At the other extreme, in the back right of the graph (0% interest rate on a small loan with a balance of $960), you will pay $167 more in interest ($308 versus $140 or more than twice as much) if you use the Debt Snowball method rather than the Debt Avalanche method.
Interestingly, moving along only one axis – that is, only decreasing the interest rate on the small loan or only increasing the size of the smaller loan – doesn’t make very much difference. In the back left and front right, the interest rate differences are only $15 and $22, respectively. The savings from the Debt Avalanche method becomes most important when there is a large difference in the interest rates on the loans and the outstanding balances on the loans are similar in size.
For many people, debt is an emotional or “mentalstate” issue rather than a financial problem. In those situations, it is more important to gain a sense of accomplishment than it is to save money on interest. If you are one of those people and have one or more small debts that you can fully repay fairly quickly (such as Debts 2 and 5 in Example 2 both of which were paid off in six months under the Debt Snowball method), using the Debt Snowball method is likely to be much more successful.
Here are the key points from this post:
The post The Best Ways to Pay Off Your Debt appeared first on Financial IQ by Susie Q.
]]>Continue reading "Credit Cards: What You Need to Know"
The post Credit Cards: What You Need to Know appeared first on Financial IQ by Susie Q.
]]>In this post, I’ll explain how credit cards work, including how finance and interest charges normally apply. Every credit card is different, so you’ll want to look closely at the terms of any credit cards you currently carry or for which you plan to apply.
When a financial institution issues you a credit card, it is offering you a loan in an amount that you can choose based on the amount of your purchases up to your credit limit.
From your perspective, you:
In addition, you have the option to transfer your balance from one credit card to another. Many people make this type of transfer when they have at least one credit card with a very high interest rate and one with a low interest rate. By transferring the balance from the highrate card to the lowrate card, you can reduce the amount of interest you will pay. Most issuers charge a fee of roughly 3% of the amount transferred when you make a transfer. If your interest rate decreases by more than 3 percentage points and you are paying off your credit card debt fairly slowly, though, your interest savings will be more in one year or a little longer than the transfer fee. As discussed below, though, the transfer could impact the interest charged on other purchases, so you’ll want to look at the whole picture before making a transfer.
The credit card issuer generates revenue from several sources:
Credit card issuers have four primary expenses – their overhead costs (salaries, rent, etc.), the cost of the rewards they give customers, the cost of borrowing the money that they “loan” you between the time you make a charge and pay your bill, and the amount of money they have to write off because customers don’t pay their bills.
If you pay your credit card bill in full every month, you don’t transfer a balance from another card and you don’t get a cash advance from your credit card, you won’t pay any interest. When you do any of those things, you’ll get interest charges.
You pay interest on unpaid balances from the day they are due until the day the issuer receives your payment for those charges. Once you haven’t paid your previous bill in full by its due date, though, the issuer starts charging interest on the day you make each future purchase rather than starting on the day the bill is due until all charges have been paid in full. I’ll provide an example of this difference below.
You pay interest on cash advances from the day you withdraw the money until the day the credit card company receives your payment. I looked at one of my credit cards and it has a higher interest rate on cash advances in addition to having interest charges from the date of the withdrawal. The same is true with other credit cards I’ve seen on line or discussed with my friends.
Some issuers allow you to transfer the balance from one credit card to another. You might want to do this type of transfer if the interest rate on one card with a balance is significantly higher than another card you hold. When you make this type of transfer, the issuer starts charging you interest on the day of the transfer and continues to do so until you pay the balance in full.
In addition, even if you had previously paid off the balance on the card to which you transferred your balance, you will pay interest on all new purchases starting on the date of purchase. That is, until you have fully paid off your credit card balance including the amount transferred, you do not get a grace period between the date of purchase and the due date of your bill. The additional interest could offset some or all of the savings you attain by reducing your interest rate when you transfer a balance. This article from creditcards.com provides more details about some of the risks and benefits of transferring a balance.
Still confused about how and when interest is calculated? Hopefully these examples will help. Before going into the examples, I need to explain what the interest rate or APR (annual percentage rate) really means.
A 24% APR, for example, doesn’t mean you pay 24% interest if you carry your balance for a full year. The 24% is divided by 365 (number of days in a year) to get a daily rate. The daily rate is multiplied by your balance on each day and added to the balance for the next day. As such, if you didn’t pay or charge anything on your balance for a year, the interest rate on the beginning balance would not be 24%, but rather 27.1%! I calculated 27.1% as (1+.24/365)^{365 }– 1. By raising the term inside the parentheses to the 365 power, I’m compounding the daily interest charge for a full year (365 days).
In the first example, I’ll show how interest is calculated if you paid your bill in full at the end of the previous billing cycle. Here are the assumptions for this example:
In this example, you don’t pay any interest on the $500 purchase during this billing cycle.
The cash advance is different. First, you are charged the cash advance fee. 5% of your cash advance is $5 which is less than the $10 minimum, so you will be charged $10 as a cash advance fee. In addition, you will pay interest at a 24% APR. The interest charge is $2.19 which is calculated as:
As such, you will repay the issuer $112.19 for the $100 cash advance you received. This example illustrates why it is often better to tap sources of cash other than your credit card, if at all possible.
In this example, I’ll show how interest is calculated if you didn’t pay your bill in full at the end of the previous billing cycle. Here are the assumptions for this example:
I haven’t included a cash advance in this example because it will cost you the same amount regardless of whether you paid your bill in full in the previous month.
In this example, you will pay interest on your unpaid balance for the 30 days in the month plus the 10 days into the next billing cycle, for a total of 40 days. The interest on this balance totals $14.93 and is calculated as:
In addition, you pay interest on the $500 purchase for 25 days in this billing cycle plus the 10 days in the next billing cycle, for a total of 35 days. The interest charge on this purchase is $8.70 for a total interest charge of $23.63. If you have gotten behind on your credit card balances, check on this post for strategies that will help you get caught up.
As with every financial decision, picking the best credit card for you requires balancing the costs and benefits. In large part, the best credit card for you depends on how you will use it. The bottom line is that you want the credit card that will have the greatest net benefit or lowest net cost for you. Here’s how you can calculate that benefit/cost.
The plus in the equation that determines your net benefit is the value of any rewards you earn. Some credit cards provide no rewards, so the total plusses equal 0. Other credit cards provide rewards, such as 1% of all purchases or 5% of gas purchases plus 3% of food purchases plus 1% of everything else.
To calculate the value of the benefits, you’ll need to estimate how much you expect to charge on your credit for each category of expense. You can then multiply those benefits by the corresponding reward percentage. As an illustration, I’ll use the 5% for gas, 3% for food and 1% of everything else example I mentioned above. The table below shows three different combinations of monthly expenses in those categories and the rewards you would earn.
Category  Scenario 1  Scenario 2  Scenario 3 
Gas  100  200  500 
Food  300  500  300 
Other  600  300  200 
Monthly Rewards  17  23  33 
Annual Rewards  204  276  396 
By comparison, you would receive $10 a month or $120 a year with a credit card that provides 1% back on every purchase under all 3 scenarios. I note that most credit cards do not give rewards for cash advances, so I have not included them in the table above.
Some rewards are harder than others to access or might be in a form that isn’t useful for you. If that is the case with one of the credit cards you are considering, you might reduce the annual benefit by some amount, such as 50%, for the chance that you don’t use it.
Offsetting the rewards are all of the fees and charges I mentioned above – the annual fee, cash advance fees, finance fees, foreign exchange fees and interest charges.
The table below shows the fees I’ve used for illustration for the two cards above.
Rewards  5%/3%/1%  1% 
Annual fee  $75  $0 
Cash advance fee  $10  $10 
Cash advance APR  24%  18% 
Purchase APR  18%  12% 
To keep the examples simpler, I’ve assumed you make at least the minimum payment every month so there are no finance charges and you have no foreign transactions.
In the first example, you have $1,000 a month in charges plus a $200 cash advance 30 days before your issuer receives your payment. You pay your bill in full every month.
In this example, your annual costs are $243 using the higher reward card and $150 using the lower reward card. The table below shows the net cost of using your credit card under each of the 3 scenarios above for both cards, remembering that the lowerreward card has the same rewards under all three scenarios. A negative net cost means that you pay more in fees than you get in rewards, whereas a positive net cost means you get more in rewards than you pay in fees.
Card  5%/3%/1%  5%/3%/1%  5%/3%/1%  1% 
Scenario  1  2  3  All 
Rewards  +240  +276  +396  +120 
Costs  243  243  243  150 
Net Cost  3  +93  +189  30 
In this example, you don’t incur many fees, so the lower fees in the lowerreward credit card don’t help you. As such, you are better off with the higherreward credit card under all three spending scenarios.
In the second example, you have $1,000 a month in charges plus a $200 cash advance 30 days before your issuer receives your payment. Unfortunately, you got behind on your credit card payments so you average 60 days between the time you make each purchase and take out your cash advance and pay your bill.
Your annual costs are $652 using the higher reward card and $379 using the lower reward card. The table below shows the net cost of using your credit card under each of the 3 scenarios above for both cards.
Card  5%/3%/1%  5%/3%/1%  5%/3%/1%  1% 
Scenario  1  2  3  All 
Rewards  +240  +276  +396  +120 
Costs  652  652  652  379 
Net Cost  412  316  220  259 
In this example, the lowerrewards credit card has a lower net cost than the higherrewards card, unless you buy a lot of gas in which case you are somewhat better off using the higherrewards card.
This comparison illustrates that highrewards credit cards are not always the best. To select the best credit card, you’ll want to balance the fees you are likely to pay based on your spending and payment patterns with the available rewards and their usefulness to you.
The post Credit Cards: What You Need to Know appeared first on Financial IQ by Susie Q.
]]>Continue reading "TaxEfficient Investing Strategies – Canada"
The post TaxEfficient Investing Strategies – Canada appeared first on Financial IQ by Susie Q.
]]>The strategy for taxefficient investing differs from one country to the next due to differences in tax laws so I’ll talk about taxefficient investing strategies in the Canada in this post. For information about taxefficient investing in the US, check out this post.
I will look at four different types of investments:
I will not look at individual stocks with little or no dividends. The returns on those stocks are essentially the same as the returns on ETFs and are taxed in the same manner.
The table below shows the different types of returns on each of these investments.
Type of Distribution:  Interest  Dividends  Capital Gains  Capital Gain Distributions 
High dividend stocks  x  x  
Mutual Funds  x  x  x  
ETFs  x  
Bonds  x  x 
Interest and dividends are cash payments that the issuers of financial instruments (i.e., stocks, mutual funds or bonds) make to owners.
Capital gains come from changes in the value of your investment. You pay taxes on capital gains only when you sell the financial instrument which then makes them realized capital gains. The taxable amount of the realized capital gain is the difference between the amount you receive when you sell the financial instrument and the amount you paid for it when you bought it. Unrealized capital gains are changes in the value of any investment you haven’t yet sold. If the value of an investment is less than what you paid for it, you are said to have a capital loss which can be thought of as a negative capital gain.
Mutual funds are a bit different from stocks and ETFs. They can have the following types of taxable returns.
The four types of distributions are taxed differently depending on the type of account in which they are held – Taxable, Registered Retirement Savings Plan (RRSP) or TaxFree Savings Account (TFSA).
I’ll refer to accounts that aren’t retirement accounts as taxable accounts. You pay taxes every year on dividends and realized capital gains in a taxable account, whereas you pay them either when you contribute to or withdraw from a retirement account. The table below shows how the different types of investment returns are taxed when they are earned in a taxable account.
Type of Investment Return  Tax Rates 
Interest & Dividends  Same as wages 
Realized capital gains & capital gain distributions  50% of capital gains and capital gain distributions are added to wages 
The marginal Federal tax rate on wages, and therefore on interest and dividends, for many employed Canadian residents is likely to be 20.5% or 26%.
In a taxable account, you pay taxes on investment returns when you receive them. In the case of capital gains, you are considered to have received them when you sell the financial instrument.
Before you put money into a TFSA, you pay taxes on it. Once it has been put into the TFSA, you pay no more income taxes regardless of the type of investment return. As such, the tax rate on all investment returns held in a TFSA is 0%.
You pay income taxes on the total amount of your withdrawal from an RRSP at your ordinary income tax rate. Between the time you make a contribution and withdraw the money, you don’t pay any income taxes on your investment returns.
To illustrate the differences in taxes on each of these four financial instruments, I’ll look at how much you would have if you have $1,000 to invest in each type of account at the end of one year and the end of 10 years.
Here are the assumptions I made regarding pretax investment returns.
Annual Pretax Investment Return %  Interest  Dividends  Capital Gains 
Stocks  0%  3%  5% 
ETFs  0%  0%  8% 
Mutual Funds  0%  3%  5% 
Bonds  4%  0%  0% 
Mutual funds usually distribute some or all of realized capital gains to owners. That is, if you own a mutual fund, you are likely to get receive cash from the mutual fund manager related to realized capital gains. Whenever those distributions are made, you have to pay tax on them. For this illustration, I’ve assumed that the mutual fund manager distributes all capital gains to owners, so they are taxed every year.
Here are the tax rates I used for this illustration.
Type of Income  Tax Rate 
Wages  26% 
Interest & Dividends  26% 
Capital Gains  13% 
Let’s say you have $1,000 in each account. If you put it in a taxable account, I assume you pay taxes at the end of the year on the investment returns. If you put the money in an RRSP, I assume that you withdraw all of your money and pay taxes at the end of the year on the entire amount at your ordinary income tax rate. (I’ve assumed you are old enough that you don’t have to pay a penalty on withdrawals without penalty from the retirement accounts.)
The table below shows your aftertax investment returns after one year from your initial $1,000. Note that the pretax returns are the same as the returns in the TFSA row, as you don’t pay income taxes on returns you earn in your TFSA.
OneYear Aftertax Investment Returns ($)  Stocks  Mutual Funds  ETFs  Bonds 
Taxable  $66  $66  $70  $30 
RRSP  59  59  59  30 
TFSA  80  80  80  40 
This table below shows the taxes you paid on your returns during that year.
Taxes Paid  Stocks  Mutual Funds  ETFs  Bonds 
Taxable  $14  $14  $10  $10 
RRSP  21  21  21  10 
TFSA  0  0  0  0 
When looking at these charts, remember that you paid income taxes on the money you contributed to your Taxable account and TFSA before you put it in the account. Those taxes are not considered in these comparisons. This post focuses on only the taxes you pay on your investment returns.
Looking at across the rows, you can see that, for each type of account, stocks and mutual funds have the same oneyear returns and tax payments. In this illustration, both stocks and mutual funds have the same split between dividends and appreciation. Your aftertax return on ETFs is higher than either stocks or mutual funds. All of the ETF return is assumed to be in the form of appreciation (i.e., no dividends), so only the lower capitalgain tax rate applies to your returns.
In all accounts, bonds have a lower aftertax return than any of the other three investments. Recall, though, that bonds generally provide a lower return on investment than stocks because they are less risky.
Looking down the columns, you can see the impact of the differences in tax rates by type of account for each financial instrument. You have more savings at the end of the year if you purchase a financial instrument in a TFSA than if you purchase it in either of the other two accounts for each type of investment.
The returns on investments in a taxable account are higher than on stocks, mutual funds and ETFs held in an RRSP. You pay taxes on the returns in a taxable account at their respective tax rates, i.e., at 50% of your usual rate on the capital gain portion of your investment return. However, you pay taxes on RRSP withdrawals at your full ordinary income tax rate. Because the ordinary income tax rate is higher than the capital gain tax rate, you have a higher aftertax return if you invest in a taxable account than an RRSP for one year. For bonds, the taxes and aftertax returns are the same in an RRSP and a taxable account because you pay taxes on returns in taxable accounts and distributions from RRSPs at your marginal ordinary income tax rate.
Remember, though, that you had to pay income taxes on the money you put into your account before you made the contribution, whereas you didn’t pay income taxes on the money before you put it into your RRSP.
I’ve used the same assumptions in the 10year table below, with the exception that I’ve assumed that you will pay ordinary income taxes at a lower rate in 10 years because you will have retired by then. I’ve assumed that your marginal tax rate on ordinary income in retirement will be 20.5%.
TenYear AfterTax Investment Returns ($)  Stocks  Mutual Funds  ETFs  Bonds 
Taxable  $917  $890  $1,008  $339 
RRSP  921  921  921  382 
TFSA  1,159  1,159  1,159  480 
If you look across the rows, you see that you end up with the same amount of savings by owning stocks, mutual funds and ETFs if you put them in either of the retirement account options. The mix between capital gains, capital gain distributions and dividends doesn’t impact taxes paid in a taxsheltered account, whereas it makes a big difference in taxable accounts, as can be seen by looking in the Taxable row.
In taxable accounts, ETFs provide the highest aftertax return because they don’t have any taxable transactions until you sell them. As discussed above, I have assumed that the stocks pay dividends every year. You have to pay taxes on the dividends before you can reinvest them, thereby reducing your overall savings as compared to an ETF. You have to pay taxes on both dividends and capital gain distributions from mutual funds before you can reinvest those proceeds, so they provide the least amount of savings of the three stocklike financial instruments in a taxable account.
Looking down the columns, we can compare your ending savings after 10 years from each financial instrument by type of account. You earn the highest aftertax return for every financial instrument if it is held in a TFSA, as you don’t pay any taxes.
For bonds, you earn a higher aftertax return in an RRSP than in a taxable account. The tax rate on interest is about the same as the tax rate on RRSP withdrawals. When you hold a bond in a taxable account, you have to pay income taxes every year on the coupons you earn before you can reinvest them. In an RRSP, you don’t pay tax until you withdraw the money, so you get the benefit of interest compounding (discussed in this post) before taxes. In addition, I have assumed that your ordinary income tax rate is lower in retirement, i.e., when you make your RRSP withdrawals.
Your aftertax return is slightly lower in a taxable account than in an RRSP for the three stocklike investments. The ability to compound your returns on a pretax basis more than offsets the higher tax rate you pay in the RRSP.
The ability to compound your investment returns on a taxdeferred basis is an important one, so I’ll provide an illustration. To keep the illustration simple, let’s assume you have an asset that has a taxable return of 8% every year and that your tax rate is constant at 26% (regardless of the type of account).
The table below shows what happens over a threeyear period.
Returns and Taxes by Year  Taxable Account  RRSP 
Initial Investment  $1,000  $1,000 
Return – Year 1  80  80 
Tax – Year 1  21  0 
Balance – Year 1  1,059  1,080 
Return – Year 2  85  86 
Tax – Year 2  22  0 
Balance – Year 2  1,122  1,166 
Return – Year 3  90  94 
Tax – Year 3  23  0 
Balance – Year 3  1,188  1,260 
By paying taxes in each year, you reduce the amount you have available to invest in subsequent years so you have less return.
The total return earned in the taxable account over three years is $255; in the taxdeferred account, $260. The total of the taxes for the taxable account is $66. Multiplying the $260 of return in the taxdeferred account by the 26% tax rate gives us $68 of taxes from that account. As such, the aftertax returns after three years are $188 in the taxable account and $192 in the taxdeferred account.
These differences might not seem very large, but they continue to compound the longer you hold your investments. For example, after 10 years, your aftertax returns on the taxdeferred account, using the above assumptions, would be almost 10% higher than on the taxable account.
It is great to know that you get to keep the highest amount of your investment returns if you hold your financial instruments in a TFSA. However, there are limits on how much you can put in TFSAs each year. Also, some employers offer only an RRSP option. As a result, you may have savings that are currently invested in more than one of TFSA, RRSP or taxable account. You therefore will need to buy financial instruments in all three accounts, not just in a TFSA.
Here are some guidelines that will help you figure out which financial instruments to buy in each account:
Let’s see how to apply these guidelines in practice using a couple of examples. To make the examples a bit more interesting, I’ve increased the annual appreciation on the ETF to 10% from 8%, assuming it is a higher risk/higher return type of ETF than the one discussed above. All of the other returns and tax assumptions are the same as in the table earlier in this post.
In the first example, you have $10,000 in each of a taxable account, an RRSP and a TFSA. You’ve decided that you want to invest equally in stocks, mutual funds and ETFs.
You will put your investment with the lowest taxable distributions each year – the ETF – in your taxable account. The stocks and mutual fund have higher taxable distributions each year, so it is better to put them in your taxsheltered accounts. Because they have similar total returns in this example, it doesn’t matter how you allocate your stocks and mutual funds between your TFSA and RRSP.
In the second example, you again have $10,000 in each of a taxable account, an RRSP and a TFSA. In this example, you want to invest $15,000 in the highyielding ETFs but offset the risk of that increased investment by buying $5,000 in bonds. You’ll split the remaining $10,000 evenly between stocks and mutual funds.
You again buy as much of your ETFs as you can in your taxable account. The remainder is best put in your TFSA, as the ETFs have the highest total return so you don’t want to pay any tax on the money when you withdraw it. The bonds have the lowest return, so it is best to put them in your RRSP as you will pay less tax on the lower bond returns than the higher stock or mutual fund returns. As in Example 1, it doesn’t matter how you allocate your stocks and mutual funds between your TFSA and RRSP.
There is a very important factor I’ve ignored in all of the above discussion – RISK (a topic I cover in great detail in this post). The investment returns I used above are all risky. That is, you won’t earn 3% dividends and 5% appreciation every year on the stocks or mutual funds or 10% on the ETFs. Those may be the longterm averages for the particular financial instruments I’ve used in the illustration, but you will earn a different percentage every year.
If your time horizon is short, say less than five to ten years, you’ll want to consider the chance that one or more of your financial instruments will lose value over that time frame. If you had perfect foresight, you would put your moneylosing investments in your RRSP because you would reduce the portion of your taxable income taxed at the higher ordinary income tax by the amount of the loss when you withdraw the money. Just as the government gets a share of your profits, it also shares in your losses.
The caution is that financial instruments with higher returns also tend to be riskier. If you put your highest return investments – the ETFs in my example – in your TFSA, their value might decrease over a short time horizon. If they decrease, your aftertax loss is the full amount of the loss. If, instead, you had put that financial instrument in your RRSP, the government would share 26% of the loss in my example.
In conclusion, if you plan to allocate your investments using the above guidelines, be sure to adjust them if your time horizon is shorter than about 10 years to minimize the chance that you will have to keep all of a loss on any one financial instrument.
The post TaxEfficient Investing Strategies – Canada appeared first on Financial IQ by Susie Q.
]]>Continue reading "6 Ways to Slay Your Student Debt This Year"
The post 6 Ways to Slay Your Student Debt This Year appeared first on Financial IQ by Susie Q.
]]>Unless you’ve been living under a rock, you’re probably aware that we’ve got a bit of a student loan crisis on our hands. The amount currently owed by borrowers isn’t in the billions…nope, it’s actually past the $1 trillion mark!
Chances are, you don’t want to be saddled with your own student debt forever. Debt can hold you back from buying a home, starting a family, traveling the world, and other exciting parts of life. Don’t let student loans ruin your dreams – it’s time to start slaying your student debt this year.
Think it’s impossible? Check out the following ways to attack your student loans with a vengeance.
A budget is an essential financial tool that gives a job to every dollar you earn. Get yourself on track by making and following a smart budget. Be sure to account for all necessary expenses, including your student loan payments.
Balance out how much you’re earning with how much you’re spending (and don’t spend money you don’t have). When you’re stuck with student loan debt, it’s key to eliminate luxury spending. Put every spare dollar, after necessities, into paying off your loans.
While it’s tempting to overspend when you get your first “real” job, it’s a bad move. Don’t make the mistake of financing new cars or spending too much on stuff you don’t need. Living within – or below – your means could make a big dent in your student debt. Just live like a college kid for a little longer.
Susie Q adds: For a more detailed discussion of how budgets can be helpful, check out this post or start here for my weekbyweek guidance on creating a budget using a spreadsheet template I’ve provided.
Trust me, it’ll be worth it! The faster you pay off your loans, the sooner you can get started building wealth and planning for your next big goal!
That little grace period from your lender is appealing, but don’t hang out there too long. The sooner you can begin repayment, the better.
Even during the grace period, interest accrues for many types of loans. So, while you’re allowed to postpone repayment for a time (usually 6 months), it’s prudent to begin repayment as soon as possible.
Susie Q adds: As an example, if you have a $30,000 balance on a 5% loan with 15 years left in the term and don’t defer your payments during the grace period, your payments will be $237 a month. You’ll pay a total of $12,703 in interest over the life of the loan. If you make the same payments and defer your loan, you’ll pay an extra $1,628 in interest payments and extend your loan by 13 months (6 months of grace period and 7 months of extra payments to cover the extra interest).
Once you know what your minimum payment amount is every month, don’t get too comfy with it. If you push yourself to increase that amount by even $25 or $50 more each month, you could destroy those loans much faster! At the very least, round up to the nearest $10 or $50 mark. So, a minimum payment of $62 could be rounded up to $70 or $100.
Just be sure that, if you’re making extra payments, they’re applied to the principal, not the interest. If you’re in doubt, talk directly to your lender or loan provider to find out how you can go about doing this.
Susie Q adds: Using the same example as above, if you don’t defer your loan for the grace period and round up to $250 a month, you’ll save over $1,000 as you’ll pay only $11,676 in interest and will pay off your loan a full year earlier. You can include your student debt in your debt repayment strategy to figure out how much you can prepay each month, as discussed in this post.
Another tip: make biweekly payments rather than monthly. After one year, this simple step will add up to having slashed an extra month’s payment off your total. However you choose to set it up, paying more than the minimum will lead to student loan freedom sooner!
One strategy for paying off your loans faster is to refinance your student loans. The general idea is that if you refinance to a lower interest rate, you’ll end up paying less over the life of the loan. Plus, you can pay them off faster, since you won’t owe as much in interest! Winwin!
A couple of factors to beware of: you usually don’t want to refinance if your credit score has taken a recent hit. That will likely only get you a higher interest rate – you definitely don’t want that! Also, if you plan on utilizing student loan forgiveness programs, you typically need to stay away from refinancing. Most of the forgiveness programs will disqualify you if you’ve refinanced.
If you’re unsure about how to go forward with refinancing, Credible is an online loan marketplace that can make that decision easier. Compare interest rates for which you may qualify with different lenders in order to make the best choice.
Susie Q adds: Using the same example as above, if you are able to refinance your loan at 3.5% and continue to make the same $237amonth payment, you’ll save over $5,000 as you’ll pay only $7,485 in interest and will pay off your loan almost two years earlier. This savings will be offset by any fees you need to pay when you refinance your loan.
Now, if you’re such a rock star that you plan to pay off the full balance within a really short time, like 2 or 3 years, refinancing might not be worth the trouble. Just pay those babies off and be done with them!
One of the best ways to pay off any debt fast is to increase your income. I’m a big proponent of side hustles. You can make extra cash to pay down debt and side hustles are often super flexible with your other responsibilities.
If you’re looking to begin your own side hustle, you can check out these workfromhome jobs and see which might be a good fit. The possibilities are nearly limitless, so be creative and think about your skills and things you enjoy doing anyway.
You could start doing freelance writing or blogging from home (our favorites!). Or start selling your todiefor cakes for special occasions. Try your hand at bookkeeping, photography, or proofreading or any number of other ways people are raising their income.
Susie Q adds: For more ideas about ways to increase income or reduce expenses to help free up money to reduce your student loan debt, check out this post. Also, if you decide to pursue a side hustle, you’ll want to make sure you don’t spend more money than you earn!
Just imagine how much extra money you could throw at your student debt by starting a side hustle!
Some companies are looking to build positive relationships with employees by offering student loan repayment assistance. So, before you decide to take a job, it might be beneficial to ask if it offers this option. If you’ve already signed on to work somewhere, talk to your HR department to see if it’s available.
You should also explore various government student loan forgiveness programs. Though it’s extremely important to follow all of their rules to be eligible, if you’re working in a career field that allows you loan forgiveness, you might as well go for it!
A piece of advice: save enough during your repayment period that you could pay the entire loan balance off just in case the forgiveness doesn’t come through! Most applications for forgiveness so far have been rejected, so those borrowers are still on the hook for the full balance.
Debt sucks. You know you don’t want to keep your student loans around forever, so use any and all of these tips to slay your student debt as fast as you can!
The post 6 Ways to Slay Your Student Debt This Year appeared first on Financial IQ by Susie Q.
]]>Continue reading "TaxEfficient Investing Strategies – USA"
The post TaxEfficient Investing Strategies – USA appeared first on Financial IQ by Susie Q.
]]>The strategy for taxefficient investing differs from one country to the next due to differences in tax laws so I’ll talk about taxefficient investing strategies in the US in this post and in Canada in this post.
I will look at four different types of investments:
I will not look at individual stocks with little or no dividends. The returns on those stocks are essentially the same as the returns on ETFs and are taxed in the same manner.
The table below shows the different types of returns on each of these investments.
Distributions by Investment  Interest  Dividends  Capital Gains  Capital Gain Distributions 
High dividend stocks  x  x  
Mutual Funds  x  x  x  
ETFs  x  
Bonds  x  x 
Interest and dividends are cash payments that the issuers of the financial instrument (i.e., stock, fund or bond) make to owners.
Capital gains come from changes in the value of your investment. You pay taxes on capital gains only when you sell the financial instrument which then makes them realized capital gains. The taxable amount of the realized capital gain is the difference between the amount you receive when you sell the financial instrument and the amount you paid for it when you bought it. Unrealized capital gains are changes in the value of any investment you haven’t yet sold. If the value of an investment is less than what you paid for it, you are said to have a capital loss which can be thought of as a negative capital gain.
Mutual funds are a bit different from stocks and ETFs. They can have the following types of taxable returns.
The four types of distributions are taxed differently depending on the type of account in which they are held – Taxable, Roth or Traditional. 401(k)s and Individual Retirement Accounts (IRAs) are forms of retirement accounts that can be either Roth or Traditional accounts and are discussed in more detail in in this post.
I’ll refer to accounts that aren’t retirement accounts as taxable accounts. You pay taxes every year on dividends and realized capital gains in a taxable account, whereas you pay them either when you contribute to or make a withdrawal from a retirement account. The table below shows how the different types of investment returns are taxed when they are earned in a taxable account.
Type of Investment Return  Tax Rates 
Interest  Same as wages 
Dividends, realized capital gains & capital gain distributions  · 0% if dividends, capital gains & capital gain distributions are less than $38,600 minus wages minus income from other sources.
· 15% up to roughly $425,000. · 20% if higher 
For many employed US residents (i.e., individuals with taxable income between $38,700 and $157,500 and couple with taxable income between $77,400 and $315,000 in 2018), their marginal Federal tax rate wages and therefore on interest is likely to be 22% or 24%.
In a taxable account, you pay taxes on investment returns when you receive them. You are considered to have received capital gains when you sell the financial instrument.
Before you put money into a Roth account, you pay taxes on it. Once it has been put into the Roth account, you pay no more income taxes regardless of the type of investment return unless you withdraw the investment returns before you attain age 59.5 in which case there is a penalty. As such, the tax rate on all investment returns held in a Roth account is 0%.
You pay income taxes on the total amount of your withdrawal from a Traditional retirement account at your ordinary income tax rate. Between the time you make a contribution and withdraw the money, you don’t pay any income taxes on your investment returns.
To illustrate the differences in how taxes apply to each of these four financial instruments, I’ll look at how much you would have if you have $1,000 to invest in each type of account at the end of one year and the end of 10 years.
Here are the assumptions I made regarding pretax investment returns.
Annual Pretax Investment Return %  Interest  Dividends  Capital Gains 
Stocks  0%  3%  5% 
ETFs  0%  0%  8% 
Mutual Funds  0%  3%  5% 
Bonds  4%  0%  0% 
Mutual funds usually distribute some or all of realized capital gains to owners. That is, if you own a mutual fund, you are likely to get receive cash from the mutual fund manager related to realized capital gains in the form of capital gain distributions. Whenever those distributions are made, you pay tax on them. For this illustration, I’ve assumed that the mutual fund manager distributes all capital gains to owners, so they are taxed every year.
Here are the tax rates I used for this illustration.
Type of Income  Tax Rate 
Ordinary Income – This Year  24% 
Dividends  15% 
Capital Gains  15% 
Let’s say you have $1,000 in each account. I assume you pay taxes at the end of the year on the investment returns in your Taxable account. If you put the money in a Traditional account, I assume that you withdraw all of your money and pay taxes at the end of the year on the entire amount at your ordinary income tax rate. (I’ve assumed you are old enough that you don’t have to pay a penalty on withdrawals without penalty from the retirement accounts.)
The table below shows your aftertax investment returns after one year from your initial $1,000. Note that the pretax returns are the same as the returns in the Roth row, as you don’t pay income taxes on returns you earn in your Roth account.
OneYear Aftertax Investment Returns ($)  Stocks  Mutual Funds  ETFs  Bonds 
Taxable  $68  $68  $68  $30 
Traditional  61  61  61  30 
Roth  80  80  80  40 
The table below shows the taxes you paid on your returns during that year.
Taxes Paid  Stocks  Mutual Funds  ETFs  Bonds 
Taxable  $12  $12  $12  $10 
Traditional  19  19  19  10 
Roth  0  0  0  0 
When looking at these charts, remember that you paid income taxes on the money you contributed to your Taxable and Roth accounts and that those taxes are not considered in these comparisons. This post focuses on only the taxes you pay on your investment returns.
Looking across the rows, you can see that, for each type of account, stocks, mutual funds and ETFs have the same oneyear returns and tax payments. In this illustration, all three of stocks, mutual funds and ETFs have a total return of 8%. It is just the mix between appreciation, capital gain distributions and dividends that varies. The tax rates applicable to dividends and capital gains are the same so there is no impact on the aftertax return in a oneyear scenario.
In all accounts, bonds have a lower aftertax return than any of the other three investments. Recall, though, that bonds generally provide a lower return on investment than stocks because they are less risky.
Looking down the columns, you can see the impact of the differences in tax rates by type of account for each financial instrument. You have more savings at the end of the year if you invest in a Roth account than if you invest in either of the other two accounts for each type of investment. Recall that you don’t pay any taxes on returns on investments in a Roth account.
The returns on a taxable account are slightly higher than on a Traditional account for stocks, mutual funds and ETFs. You pay taxes on the returns in a taxable account at their respective tax rates – usually 15% in the US for dividends and capital gains. However, you pay taxes on Traditional account withdrawals at your ordinary income tax rate – assumed to be 24%. Because the ordinary income tax rates are higher than the dividend and capital gain tax rates, you have a higher aftertax return if you invest in a taxable account than a Traditional account for one year. For bonds, the taxes and aftertax returns are the same in a Traditional and taxable account because you pay taxes on interest income in taxable accounts and distributions from Traditional accounts at your marginal ordinary income tax rate.
Remember, though, that you had to pay income taxes on the money you put into your taxable account before you made the contribution, whereas you didn’t pay income taxes on the money before you put it into your Traditional retirement account.
I’ve used the same assumptions in the 10year table below, with the exception that I’ve assumed that you will pay ordinary income taxes at a lower rate in 10 years because you will have retired by then. I’ve assumed that your marginal tax rate on ordinary income in retirement will be 22%.
TenYear AfterTax Investment Returns ($)  Stocks  Mutual Funds  ETFs  Bonds 
Taxable  $964  $931  $985  $349 
Traditional  904  904  904  375 
Roth  1,159  1,159  1,159  480 
If you look across the rows, you see that you end up with the same amount of savings by owning any of stocks, mutual funds and ETFs if you put them in either of the retirement account. The mix between capital gains, capital gain distributions and dividends doesn’t impact taxes paid in a taxsheltered account, whereas it makes a big difference in taxable accounts, as can be seen by looking in the Taxable row.
In taxable accounts, ETFs provide the highest aftertax return because they don’t have any taxable transactions until you sell them. I have assumed that the stocks pay dividends every year. You have to pay taxes on the dividends before you can reinvest them, thereby reducing your overall savings as compared to an ETF. You have to pay taxes on both dividends and capital gain distributions from mutual funds before you can reinvest those proceeds, so they provide the least amount of savings of the three stocklike financial instruments in a taxable account.
Looking down the columns, we can compare your ending savings after 10 years from each financial instrument by type of account. You earn the highest aftertax return for every financial instrument if it is held in a Roth account, as you don’t pay any taxes on the returns.
For bonds, you earn a higher aftertax return in a Traditional account than in a taxable account. The tax rate on interest is about the same as the tax rate on Traditional account withdrawals. When you hold a bond in a taxable account, you have to pay income taxes every year on the coupons you earn before you can reinvest them. In a Traditional account, you don’t pay tax until you withdraw the money, so you get the benefit of interest compounding (discussed in this post) before taxes.
Your aftertax return is higher in a taxable account than in a Traditional account for the three stocklike investments. The lower tax rate on dividends and capital gains in the taxable account, even capital gain distributions, more than offsets the fact that you have to pay taxes on dividends and mutual fund capital gain distributions before you reinvest them.
The ability to compound your investment returns on a taxdeferred basis is an important one, so I’ll provide an illustration. To keep the illustration simple, let’s assume you have an asset that has a taxable return of 8% every year and that your tax rate is constant at 24% (regardless of the type of account).
The table below shows what happens over a threeyear period.
Returns and Taxes by Year  Taxable Account  Retirement Account 
Initial Investment  $1,000  $1,000 
Return – Year 1  80  80 
Tax – Year 1  19  0 
Balance – Year 1  1,061  1,080 
Return – Year 2  85  86 
Tax – Year 2  20  0 
Balance – Year 2  1,125  1,166 
Return – Year 3  90  94 
Tax – Year 3  22  0 
Balance – Year 3  1,194  1,260 
By paying taxes in each year, you reduce the amount you have available to invest in subsequent years so you have less return.
The total return earned in the taxable account over three years is $255; in the taxdeferred account, $260. The total of the taxes for the taxable account is $61. Multiplying the $260 of return in the taxdeferred account by the 24% tax rate gives us $62 of taxes from that account. As such, the aftertax returns after three years are $194 in the taxable account and $197 in the taxdeferred account.
These differences might not seem very large, but they continue to compound the longer you hold your investments. For example, after 10 years, your aftertax returns on the taxdeferred account, using the above assumptions, would be almost 10% higher than on the taxable account.
It is great to know that you get to keep the highest amount of your investment returns if you hold your financial instruments in a Roth. However, there are limits on how much you can put in Roth accounts each year. Also, many employers offer only a Traditional 401(k) option. As a result, you may have savings that are currently invested in more than one of Roth, Traditional or taxable accounts. You therefore will need to buy financial instruments in all three accounts, not just in a Roth.
Here are some guidelines that will help you figure out which financial instruments to buy in each account:
Let’s see how to apply these guidelines in practice using a couple of examples. To make the examples a bit more interesting, I’ve increased the annual appreciation on the ETF to 10% from 8%, assuming it is a higher risk/higher return type of ETF than the one discussed above. All of the other returns and tax assumptions are the same as in the table earlier in this post.
In the first example, you have $10,000 in each of a taxable account, a Traditional account and a Roth account. You’ve decided that you want to invest equally in stocks, mutual funds and ETFs.
You will put your highest yielding investment – the ETFs, in your Roth account. The stocks and mutual fund have the same total return, but the mutual fund has more taxable distributions every year. Therefore, you put your mutual funds in your Traditional account and your stocks in your taxable account.
In the second example, you again have $10,000 in each of a taxable account, a Traditional account and a Roth account. In this example, you want to invest $15,000 in the highyielding ETFs but offset the risk of that increased investment by buying $5,000 in bonds. You’ll split the remaining $10,000 evenly between stocks and mutual funds.
First, you buy as much of your ETFs as you can in your Roth account. Then, you put the remainder in your taxable account, as the tax rate on the higher return from the ETFs is lower in your taxable account (the 15% capital gains rate) than your Traditional account (your ordinary income tax rate). Next, you put your lowyielding bonds in your Traditional account. You now have $5,000 left to invest in each of your taxable and Traditional accounts. You will invest in mutual funds in your Traditional account, as you don’t want to pay taxes on the capital gain distributions every year if they were in your taxable account. That means your stocks will go in your taxable account.
There is a very important factor I’ve ignored in all of the above discussion – RISK (a topic I cover in great detail in this post). The investment returns I used above are all risky. That is, you won’t earn 3% dividends and 5% appreciation every year on the stocks or mutual funds or 10% on the ETFs. Those may be the longterm averages for the particular financial instruments I’ve used in the illustration, but you will earn a different percentage every year.
If your time horizon is short, say less than five to ten years, you’ll want to consider the chance that one or more of your financial instruments will lose value over that time frame. With perfect foresight, you would put your moneylosing investments in your Traditional account because you would reduce the portion of your taxable income taxed at the higher ordinary income tax by the amount of the loss when you withdraw the money. Just as the government gets a share of your profits, it also shares in your losses.
The caution is that financial instruments with higher returns also tend to be riskier. If, in the US, you put your highest return investments – the ETFs in my example – in your Roth account, their value might decrease over a short time horizon. In that case, your aftertax loss is the full amount of the loss. If, instead, you had put that financial instrument in your Traditional account, the government would share 24% (your marginal ordinary tax rate) of the loss in my example.
In conclusion, if you plan to allocate your investments using the above guidelines, be sure to adjust them if your time horizon is shorter than about 10 years to minimize the chance that you will have to keep all of a loss on any one financial instrument.
The post TaxEfficient Investing Strategies – USA appeared first on Financial IQ by Susie Q.
]]>Continue reading "New vs Used Cars"
The post New vs Used Cars appeared first on Financial IQ by Susie Q.
]]>Here are the important things I learned from studying this question.
The chart at the very end of this post illustrates these points (so keep reading).
How much you pay for a car depends on several factors – its make and model, how old it is, how many miles it has on it, whether it has been in an accident, among other things. It also depends on how you pay for it – cash, lease or borrowing – as discussed in my post on that topic. If one of your goals is to save as much as possible, you’ll want to buy the least expensive car that meets your needs, regardless of whether it is new or used.
The biggest argument against buying new vs used cars is that the value of the car decreases more per year when it is brand new than when it is older. This decrease in value is called depreciation.
The chart below illustrates estimates of the patterns of depreciation for five different makes and models – a Subaru Impreza, a Ford Fusion, a Toyota RAV4, a Ford F150 and a BMW M4.
These estimates are based on a combination of data from Edmunds and the National Automotive Dealers Association (NADA). These two data sources didn’t have always values that were consistent, so I applied some judgment in deriving these curves.
The graph shows that all five models depreciate between 18% (Impreza) and 29% (F150) in the first year. In the next 10 years, depreciation is generally between 13% and 17% per year and is even lower when the cars are older than that.
To look at these values from a different perspective, I created the next graph that shows the dollar amount of estimated depreciation each year.
This chart shows that, even though the Fusion has the second highest percentage depreciation in the first year, it has the smallest dollar depreciation. When considering how much a car will cost you, it is the dollar depreciation that is important.
These graphs make it fairly clear that, if you plan to reduce the cost of a car purchase by buying used, you save the most money by buying a car when it is one year old. The amount you will save gets smaller with each additional year the car ages.
In addition to depreciation and, if applicable, finance or lease costs, there are five other major costs of owning a car – fuel, insurance, taxes and fees, maintenance, and repairs.
The cost of fuel (e.g, regular, premium or ethanolfree gas, diesel or electricity) will generally stay constant for each mile you drive, other than inflationary changes in fuel prices. For modeling the total cost of ownership, I assumed you will drive the same number of miles every year so the real cost of fuel will be constant. I used the firstyear fuel cost from Edmunds True Cost to Own as the real cost of fuel in every year.
The portion of insurance that covers liability will likely be constant for a particular car in real dollars. The cost of liability insurance will be higher for makes and models of cars that are in more accidents (e.g., sporty ones) and larger cars (e.g., pickups that will cause more damage to another vehicle or more severe injuries). For my analysis below, I have used the firstyear insurance cost from Edmunds True Cost to Own. I assumed that 40% of that amount was for liability insurance and would stay constant in real dollars. That leaves the remaining 60% for physical damage coverage which I assumed would decrease, in real dollars, in proportion to the value of the car.
Taxes and fees can be constant over time or decrease with the value of the car, depending on the state in which it is registered. For my analysis below, I used the firstyear amount for taxes and fees from the Edmunds True Cost to Own. For subsequent years, I have assumed that taxes and fees, in real dollars, would decrease with the value of the car.
This component of the cost of owning a car includes regularly scheduled maintenance and parts replacement, such as oil and other fluid changes, tire rotation, balancing, alignments and replacement, brakes, transmissions, tuneups and anything else included in the maintenance schedule provided by the dealer when new. It excludes repairs for damage to the car and repair or replacement of parts not on the schedule.
I have assumed that the real cost for maintenance is fairly constant per mile over the life of the car. Because I am assuming that your annual mileage is fairly stable, I can assume that the real cost of maintenance is constant from year to year.
The significant exception is that many manufacturers include the cost of up to five years of maintenance in the purchase price of a new car. In my analysis below, I have relied on the information in the Edmunds True Cost to Own for the length of time that maintenance is covered by the manufacturer. After that, I used the average maintenance cost for the remaining years included in the Edmunds data and assumed it was constant in real dollars for the rest of the life of the car. I also assumed that the maintenance provided by the manufacturer is transferrable to a new owner.
If you are comparing the cost of a new car with that of a used car, you will want to make sure you understand which maintenance costs are covered by the warranty for each vehicle. For most of the cars in this comparison, the average annual cost of scheduled maintenance was estimated by Edmunds to be between $750 and $1,150 a year. The exception is the BMW for which the average annual cost after the warranty ends was closer to $3,000 a year. The maintenance covered by the dealer could offset some of the higher depreciation you experience in the first few years of owning a new car.
Repair costs include repair of damage to your car, such as cracked windshields, and repairs or replacement of parts that break. For my analysis below, I used the repair costs provided by Edmunds for each of the first five years after the car is new. I then looked at the results of a Consumers Report study to estimate how much repair costs would increase as the car got older. Based on that study, I estimated that repair costs increased about 4% per year in real dollars.
The graphs below show the components of the cost of ownership (excluding purchase price, financing cost and depreciation) for the five illustrative cars in each of the first and fifth years of ownership.
A comparison of these charts shows the much lower cost of owning a new car than a fiveyear old car if the costs related to its purchase are excluded. While the insurance goes down from the first year to the fifth year, the cost of maintenance increases significantly as the manufacturer is no longer paying for it. In addition, Edmunds shows no repair costs in the first year after it is first sold, but they can be significant, especially for the BMW M4, by the fifth year.
The chart below shows the total of these costs for each car by the number of years since it was new.
For most of these cars, the ownership cost is fairly constant starting in the second year. The Impreza, Rav 4 and Fusion all have annual ownership costs of about $3,500. The F150 has a similar pattern, but its annual ownership cost is closer to $4,500. The BMW M4 ownership cost is similar to that of the F150 for the first three years, but increases dramatically when BMW stops covering the costs of maintenance and repairs.
To provide insights on the longterm costs of different carbuying decisions, I calculated the total cost (in real dollars, i.e., without adjustment for inflation) of owning a car assuming the same choice was made for 60 years. I used 60 years as I thought it fairly closely represented the length of time people own cars – from the time they are about 20 until they are about 80.
In these comparisons, I included the initial purchase price of each car (using the new car costs from Edmunds and used car costs using my approximation of depreciation) and the other costs of ownership as discussed in the previous section. Also, whenever a replacement car was purchased, I assumed that the preceding car could be sold at the depreciated price.
The two graphs below show the total cost over 60 years of owning each of the five cars. The three bars for each car correspond to buying a new car, a oneyear old car and a threeyear old car. The first graph compares the total cost if you buy a replacement car every five years; the second, every 15 years.
If you replace your car every five years, it is clearly less expensive to buy a threeyearold car than a oneyearold car or a new one, though it becomes less important if you are buying inexpensive cars such as the Fusion. The difference between buying a new car and a oneyearold car is quite large for the F150 and the BMW, both of which have high depreciation in the first year.
If you own each car for 15 years, the benefits of buying a used car are much smaller. In fact, the increased maintenance and repair costs of buying a oneyearold car essentially offset the high firstyear depreciation for the Subaru, Toyota and Fusion. Buying a threeyearold car is still clearly less expensive for all models.
The Subaru and Fusion are fairly similar cars – both are basic 4door sedans, though the Subaru has allwheel drive. If you don’t need allwheel drive, you might be indifferent between the two cars. By comparing the total costs of the Subaru and Fusion in the above charts, you can see that the longterm cost of ownership of the Fusion is less than that of the Subaru. In particular, the cost of buying new Fusions is less expensive than buying threeyearold Subarus.
This comparison emphasizes the point I made in the Summary that the initial purchase price of your vehicle is a more important factor than whether you buy new vs used cars.
The graph below compares the total cost of ownership if you buy new cars and own them for different lengths of time.
The longer you own your cars, the fewer times you need to replace them. Replacing cars fewer times is less expensive over the long run, even though you get less for them when you sell them. One consideration when you own your cars for a long time is that you’ll need to save up more for the replacement car because you will get less when you sell the old car.
For the Subaru, Toyota and Fusion, there is a small difference in total cost between replacing your car every three years and replacing it every five years. For the BMW and F150, which have higher depreciation, the benefit of keeping your car for five years is larger.
For all five cars, you will save a significant amount over your lifetime if you replace your cars every 15 years as compared to replacing them every three or five years.
The graph below emphasizes the importance of how long you own your car. The blue bars represent the total cost of ownership if you buy new cars and own them for 15 years. The orange bars correspond to buying a threeyear old car and replacing it every five years.
For all fives makes and models, replacing a new car every 15 years is about the same total cost or slightly less expensive than replacing threeyear old cars every five years.
Many of my readers look at how much more money they will have when they retire if they make certain financial decisions. I think this perspective is terrific, as it focuses on longterm financial objectives. It also encourages financial responsibility in that these analyses assume that you will save the money in a taxadvantaged retirement account, such as an IRA or 401(k), rather than spend your savings on something else. My post at this link provides more information about taxadvantaged retirement accounts.
I’ve read a few other posts that look at how much money will accumulate if you buy used cars instead of new cars and invest the difference in stocks. These posts tend to make the following assumptions:
There are a few aspects of this process that most posts I’ve seen overlooked.
In the discussions below, I will use essentially the same paradigm, but will refine some of the assumptions. In particular, I will revise the investment assumptions so they:
This analysis is simpler than it could be. In the entire analysis, I stated all of the cash flows in current or real dollars. That is, your actual savings will likely be higher than is estimated in this analysis because, with inflation, the cost of the more expensive strategy will be even more expensive than if we had assumed that all costs were subject to the same inflation rate.
To avoid the risk that you won’t have enough money to pay for the second used car, I will assume that you can earn 3% in an essentially riskfree investment for the first 10 years (until you replace your new car for the first time). In the current interest rate environment, you can earn close to 3% on CDs, corporate bonds or highyield savings accounts. After that, you have enough savings built up from buying two used cars instead of two new cars that you can afford to take on the risk of investing in the stock market.
I have used the annual returns on the S&P 500 from 1950 through 2018 to model the amounts you will have accumulated by selecting the less expensive strategies.
For the first comparison, I will look at the example discussed above – buy a new car every 10 years or a used car every 7 years. In this comparison, I calculated how much you would have at the end of 40 years if you invested the difference between the new car costs and the used car costs. For the first 10 years, I assumed you would earn 3%. For the remaining 30 years, I used the time series of 30 years of S&P 500 returns starting in each of 1950 through 1968 (for a total of 39 time series). To reiterate, this comparison assumes that you invest the difference in a taxadvantaged account and don’t spend it on something else.
If you buy used F150s instead of new ones, the historical stock market returns indicate that you will have an average of $390,000 more in retirement savings at the end of 40 years with a range of $200,000 to $800,000. For the Subaru, the average is $160,000 in a range of $75,000 to $350,000.
This analysis indicates that, if you prefer to drive fairly expensive cars that depreciate quickly when they are new, you can accumulate a substantial amount of money if you buy used cars for 40 years. For less expensive cars that don’t depreciate as quickly, the additional savings amount isn’t as large but is still significant.
You can get almost as much additional retirement savings if you buy a less expensive new car and own it for 10 years as you can if you buy the used F150 instead of a new one and more than if you buy a used Subaru instead of a new one. For example, if you buy the Fusion (currently about $15,300 new) instead of the Subaru Impreza (currently about $26,000 new according to Edmunds) every 10 years, you would have an average of about $300,000 more in retirement savings. That additional money comes from:
This analysis shows that you can save more by buying a less expensive new sedan (the Fusion) every 10 years than by buying a threeyear old Subaru every seven years. That is, if instead of buying new Subarus you buy new Fusions, you will have an average of $300,000 in additional retirement savings, but only $160,000 if you buy used Subarus.
You can also accumulate savings by buying cars less often. For this comparison, I looked at comparison of buying new Subarus and F150s every five years and every 15 years. If you replace the Subaru every 15 years, you will accumulate an average of $300,000 of additional retirement savings in 40 years as compared to replacing it every five years. With the faster depreciation and higher cost of the F150, the average additional savings in 40 years is about $600,000.
The box and whisker plot below (discussed in more detail in my post on risk) compares the amount of additional retirement savings you will have under the options above. Briefly, the boxes represent the range between the 25^{th} and 75^{th} percentiles, while the whiskers (lines sticking out of the boxes) represent the range between the 5^{th} and 95^{th} percentiles. Recall that the only source of variation in these results is the different time periods used for stock returns – the 39 30year periods starting in each of 1950 through 1988.
The first three boxes relate to the purchase of fairly modest sedans – the Subaru and Fusion. The graph shows how much more retirement savings you will have if you either buy new Fusions instead of new Subarus (second box) or replace your new Subaru every 15 years instead of every 5 years (third box) than if you buy threeyearold Subarus instead of new ones (first box).
The last two boxes relate to the purchase of the more expensive F150. Again, you will accumulate much more in your retirement savings if you replace your F150 every 15 years instead of every 5 years (last box) than if you buy threeyearold trucks instead of new ones (second to last box).
Ultimately, you’ll need to buy a car that best fits in your budget and meets your needs. As you make your choice, though, you might want to remember that there are clearly ways you can save money even if you prefer to buy new cars.
The post New vs Used Cars appeared first on Financial IQ by Susie Q.
]]>Continue reading "My Next Car: Pay Cash, Borrow or Lease?"
The post My Next Car: Pay Cash, Borrow or Lease? appeared first on Financial IQ by Susie Q.
]]>I have a post that provides all the basics you need to understand about loans.
There are plenty of resources available to provide you with information about leases, so I won’t repeat that information here. Here are a few resources:
Your credit score is an important driver of the terms you will be offered whether you lease or borrow. When I looked for examples on line, all of the offers were contingent on your credit score being above 800. A credit score of 800 is excellent. I have a post on how you can check and improve your credit score.
Cars are expensive to own. This post will focus on the cost of buying a car under three different options – cash, borrowing and leasing. As you evaluate which of the options works for you, you’ll also want to make sure you are able to afford the other costs of ownership of a car. In addition to the purchase costs discussed below, there are four other categories of expenses:
Your car needs gas, diesel or electricity. As you are selecting a car, you’ll want to consider the type of fuel your car needs, the miles per gallon the car gets and how many miles you are going to drive.
You will need to register your car every year. In the states in which I’ve owned cars, registration is a function of the value of the car – the higher the value, the higher the registration fees. I recall that a car worth $20,000 cost about $300 to $400 a year to register, whereas the minimum charge (for older cars) was about $50 a year in Minnesota, but the amounts vary widely across states. In other states, registration fees are a flat amount regardless of the age or value of your car.
In all states you are required to buy car insurance. This post provides information on insurance you are required to purchase and coverages you might want to purchase. Liability insurance usually doesn’t depend on the value of the car, though can be higher for sportier and faster cars. The premiums for physical damage coverages (comprehensive and collision which protect you against damage to your car) increase with the value of your car.
Cars need regular maintenance – oil changes, replacement brakes and tires, among other things. Some dealers provide regular maintenance at their location for one or more years if you buy a new car, but that is not always the case. In addition to regular maintenance, cars break down and need to be repaired. Repair expenses tend to be higher on older cars. Even on new cars, repairs can be expensive and unexpected.
You’ll want to keep some money in your designated savings for car repairs, as discussed in this post. Another option is to buy an extended warranty to cover repairs to your car. Extended warranties can be quite expensive, but cover the cost of some major repairs if they are needed. I’ll write about extended warranties in another post in the future. If you choose to purchase an extended warranty, you’ll need to include that cost as part of your expenses related to owning the car, along with a provision for repairs not covered by the warranty.
I always find it helpful to define what I want and can afford before I go shopping for anything expensive, cars in particular. My husband does all of the negotiating on price for our cars because that is a skill I never acquired and I don’t like the process so don’t want to acquire it. I figure out what I need, what’s available in our price range that meets those needs and make a very detailed list so he can go to different dealers to negotiate the terms.
As part of your needs, you’ll want to think about the length of time you’d like to own your car. Some people like to drive a new or at least a different car every few years. I was that way when I was young – I bought a different car every 3 years for a bit. I’ve always regretted selling the first one – a 1969 Mustang convertible. Live and learn!
Other people drive cars until they die or become unreliable. Now that I understand the finances of cars better, I have moved to the second category. The most recent two cars I’ve sold (both Honda Preludes) had 250,000 and 150,000 miles on them respectively. The only reason I sold the second one is because I moved to a place with hills and snow, as opposed to flat and snow, and a Honda Prelude just wasn’t going to get me home reliably in the winter.
The second step in the process – figuring out what’s in your price range – can involve several perspectives.
Gap insurance is another expense you may have to pay if you don’t pay cash for your car. In some cases, you’ll want to buy it for your peace of mind. In other cases, the lender or lessor may require it.
Gap insurance protects you against the difference between the value of the car and your outstanding balance at any point in time during the loan or lease. Although it may not be clearly stated in your lease agreement, lessors think of your lease payments as including compensation to them for the reduction in the value of the car as you use it (depreciation) and interest on the value of the car (similar to loan interest). As such, both loans and leases have outstanding balances at all times during their terms.
The chart below compares the outstanding balance on a loan with an estimate of the value of a $23,000 car over the term of an 84month loan. For this illustration, I’ve assumed that the borrower paid $1,000 towards the value of the car as a down payment and the loan has a 3% interest rate. I estimated the value of the car by looking at the clean tradein value of a Ford Fusion from prior model years on the National Automobile Dealers Association (NADA) web site, a common source for lenders to get car values.
For the Ford Fusion, the loan balance is more than the value of the car between 4 and 36 months. If the car is totaled, your car insurer will reimburse you for the value of the car minus your deductible. During that time period, you will owe the lender not only your deductible but the difference between the blue line and the orange line. To protect yourself from having to pay the additional amount, you can buy gap insurance.
You’ll want to investigate the cost and need for gap insurance for the particular make and model you are buying. Cars depreciate at different rates. For example, when I looked at the NADA web site for a Subaru Impreza, the value never went below this illustrative loan balance.
Now that I’ve covered the preliminaries, we can get to the main topic of this post – the details of paying cash, borrowing and leasing.
When you pay cash for a car, there is only one number on which you need to focus. It is the outthedoor cost of buying the car. This amount will include some or all of the following:
Not all of these charges are included in every state or by every dealer. I recently bought a new car in Montana. There is no sales tax in Montana, there wasn’t a delivery charge and you pay the state for title and registration fees directly, so the only things on my invoice were the cost of the car, the cost of the two options I added and a $100 documentation fee. If you are comparing prices from different sources, you’ll want to make sure that they consistently treat all of these possible costs. For example, you should make sure they either all include or all exclude title and registration fees. If not, you’ll need to add them to your analysis of the total amount you can pay for the car.
The finances of leasing involve many important numbers, even more than borrowing. All of these numbers should be available to you in the contract and from the dealer or leasing company.
You’ll want to make sure you know the total amount of the upfront payment, including sales taxes, title and registration fees and the base charges from the dealer and finance company. The upfront payment often includes the first month’s lease payment, but not always, so you’ll want to be sure to know whether it is included for each offer you consider.
The amount that you’ll pay every month.
You pay sales tax on your monthly lease payments.You’ll need to know if the sales tax is included in the monthly payment you’ve been quoted and, if not, what sales tax rate applies.
The term is the number of months you are committed to the lease. It is important to note that my spreadsheet assumes the lease term is 36 months and you will honor your commitment to the lease for its entire term. There can be significant penalties if you choose to return the car before the lease ends.
Every lease contains a maximum number of “free” miles you can drive on average each year.
You can use your actual annual mileage to estimate how much you will have to pay in excess mileage charges to understand the full cost of a least.
If you exceed the total allowed mileage (the allowed annual mileage times the term), you will pay an extra fee when you return the car. To calculate the extra amount, you first take your actual mileage and subtract the total allowed mileage. You then multiply the excess miles by the cost per extra mile. As I’ve looked on line at leases, I’ve seen several that charge 15 cents per extra mile. If, for example, you drive 50,000 in three years on a car with 12,000 miles allowed and a 15 cent per mile charge, you will pay an extra $1,800 when the lease ends.
You may also need to pay a fee if your car experiences more than the normal amount of wear and tear. For example, if you live on a gravel road or a busy street, your car may have many more nicks and dings than someone who lives on a quiet paved culdesac.
If you think you might want to buy the car at the end of the lease, you’ll need to know the residual value.This amount is what you will pay to keep the car.
If you want or need to buy gap insurance, you’ll want to know by how much it costs each month. You can buy gap insurance from your car insurer and, sometimes, the dealer, though I’ve read that buying it through the dealer tends to be more expensive.
The finances of taking out a loan for a car are a bit less complex than leasing. Here are the important numbers you need to know.
Because I just purchased a Subaru Impreza for around $23,000, I use it and two other cars advertised as having similar costs as illustrations.
The table below summarizes the values I found on line and/or created for a Subaru Impreza, a Toyota Camry and a Ford Fusion
Although the cash prices are similar, the Lease and Borrow options have fairly different terms. The amount due at signing and monthly payment are much lower for the Toyota Camry lease than for the other two cars. The interest rates on the loans are very different, even though the monthly payments are all essentially identical. The Subaru has a lower interest rate and shorter term than the other two cars. Because the payments are the same and the interest rate is higher, the amount due at signing must cover more of the cost of the Toyota than for the other two cars.
Not all of these values were clearly identified in the terms I found online. The actual offers could be somewhat to significantly different from the values I’ve shown above. Nonetheless, the differences in the terms help differentiate the total financial cost of these offers.
We will first look at a comparison of the three options for the Subaru Impreza. Before we can do that, you need to determine for how long you want to own the car. For illustration, I’ve looked at two options – own it for the term of the lease (assumed to be 36 months) or own it until it dies (or at least until you’ve made all of your loan payments).
The first row of the table below shows the total of all of the payments you will make under each of the three options over the course of the first three years. For the Cash option, it is your outthedoor cost. For the Borrow and Lease options, it is the sum of the amount due at signing, your monthly payments and the monthly cost of gap insurance. For the Lease option, I added sales tax to the monthly lease payments.
Three Years  Cash  Borrow  Lease 
Upfront Cost + Monthly Payments  $23,691  $14,133  $15,971 
Amount on Sale  12,000  761  1,350 
Net Cost  11,691  13,372  17,321 
The second row shows how much you would get or pay at the end of 36 months. For all three cars, I have assumed you can sell them for $12,000 after three years. For the Cash option, the second row shows the total sales price of the car. For the Borrow option, it is the difference between the $12,000 sales price and the loan balance. For the Lease option, the value is negative meaning it is an amount you have to pay instead of receive. It is the charge for the extra miles put on the car. If you look at the inputs table, you’ll see that there is a 15 cent per mile charge for every mile over 12,000 a year and I have assumed you will drive 15,000 miles a year.
The third row shows the total net cost, calculated as the first row minus the second row. For the offers for the Subaru Impreza, the Cash option is cheapest if you plan to sell after 3 years. If you can’t afford to pay cash up front, the Borrow option is preferred to the Lease option.
Under the Drive Forever option, the sales price of the car is assumed to be essentially zero, so we can look at just the cash outflows. The table below summarizes the total cost of the three options.
Drive Forever  Total Cost 
Cash  $23,691 
Borrow  25,581 
Lease  31,321 
The total cost of the Cash option is the same as in the Three Years table. There are no purchasing costs other than the amount paid at signing under this option. For the Borrow option, the total cost has increased from the Three Years option because it now includes the monthly payments after three years until the loan is fully repaid. For the Lease option, the cost has increased by the residual value of the car, $14,000 in this case. That is, in addition to the upfront and monthly lease payments, you’ll need to pay the $1,350 for the extra miles and $14,000 to buy the car from the lessor.
Using the longer time frame, the Lease option is even more expensive than the Borrow option. Because the interest rate is fairly low, the additional interest paid after three years isn’t a lot so the difference between the Borrow and Cash options doesn’t increase by a large amount from what was observed for the Three Years option.
The relative order of the three options varies depending on the terms of the offer. The graph below compares the net costs of ownership of the three cars if you anticipate selling the car in three year.
The values for the Subaru Impreza are the same as the ones in the third row of the Three Years option table above. As can be seen, leasing isn’t always the worst option as was the case for the Subaru. The Lease option is less expensive than the Borrow option for the Camry and is only slightly more expensive than the Borrow option for the Ford, using the threeyear time frame.
If you are indifferent among the three cars, you could also compare the costs among the cars. For example, let’s say you don’t have enough cash to pay for the car up front, so you are looking at the Lease and Borrow options. The net cost of the Lease option for the Camry is about the same as the Borrow option for the Impreza. The risk of the Lease option is that you will drive even more miles than you’ve estimated adding to the net cost of the Camry Lease option. You would want to offset that risk with the risk that you might not get $12,000 for the Impreza when you sell along with the hassle of having to sell the Impreza.
This comparison highlights the importance of getting all of the detailed terms of every option.
The graph below shows the same comparison for the “Drive Forever” option.
Other than the total costs of ownership being higher (because you are owning the car until it dies instead of having to replace it or selling it in three years), the relationships among the three options for each car are essentially the same. That is, the order and relative costs of the Cash, Borrow and Lease options are the same for each vehicle.
Of the Lease and Borrow options, the Impreza Borrow option is the least expensive in this example. The Camry Borrow and Lease options and Ford Borrow option are all $3,000 to $4,000 higher, so you might choose from one of those if you didn’t like the Impreza. If you have cash to buy the car outright, the Ford Cash option is the least expensive, though the Camry is only a few hundred dollars more.
In addition to comparing different makes and models, you can make similar comparisons among offers you obtain from different dealerships for the same car.
For those of you who read my post about Chris’s mortgage, you know that I suggested he consider paying the minimum payments on his mortgage and investing the rest of his money. You may be wondering why I haven’t talked about the benefits of investing money under the Lease and Borrow options.
There are a few reasons.
To help you create your own comparisons similar to the ones above, I’ve provided you my spreadsheet at the link below.
The flowchart below will help guide you through the financial aspects of the carbuying process. It assumes that you have identified one or more cars that will meet your needs and possibly fit in your budget.
The hexagonal boxes in a flow chart correspond to decision points. The rectangular boxes contain action items.
The first step is to determine whether you can afford to pay cash. If not, you won’t have to negotiate a price for the Cash option for any of the cars you are considering.
Next, take a look at estimates of the upfront and down payments for the Lease and Borrow options. If you can’t afford either of them in addition to the other costs of car ownership, you will need to find a less expensive option – either new or used – and go back to the top of the flowchart.
The next decision point is how long you want to own the car – the term of the lease (which I have assumed will be three years) or a much longer time (at least as long as the term of the loan in the Borrow option). When you are done entering the values, you’ll look at the summary at the top of the Lease Term tab if you plan to own the car for the lease term and the Drive Forever tab if you want to own it longer.
If you want to own the car beyond the end of the lease, you’ll need to be able to afford to pay the residual value at the end of the lease. If not, you’ll want to exclude the Lease option from consideration and focus on the Borrow option.
Once you’ve narrowed down your choices to a few cars and figured out which of the Cash, Lease and Borrow options work for you, you will be ready to talk to dealers and other car sellers. The Inputs tab of the spreadsheet lists all of the information you need for each type of purchase. I defined each of the inputs earlier in this post. For every deal you are offered, be sure to get all of these values. I found that there are some of these values that are consistently unavailable if you look on line. You may need to ask for some of these items specifically. If you aren’t sure you are getting straight answers, you can always ask for the actual contract. It is required to have all of the terms.
Next, enter all of the values into the Inputs tab. Then, go to the tab that corresponds to the time period you plan to own your car – Lease Term or Drive Forever. You can see the total cost of the options for which you entered the data.
If you have deals for more than one car, I suggest making one copy of the spreadsheet for each car. You can then compare not only between the Cash, Lease and/or Borrow options for a single car, but can compare whichever options are available to you across cars.
Your final choice of car and deal could be the least expensive or a different one. It will all depend on your personal financial situation, your qualitative considerations and their relative importance. Buying a car is an important decision, so cost may not be the only factor to influence your decision.
The post My Next Car: Pay Cash, Borrow or Lease? appeared first on Financial IQ by Susie Q.
]]>Continue reading "Savings Accounts for Kids"
The post Savings Accounts for Kids appeared first on Financial IQ by Susie Q.
]]>There are several ways to save for your kids. They range from easy – for example, just open an account in your name with the intention of giving the money to the kids – to quite complicated and possibly expensive – for example, setting up trusts. Besides the ease of the process and the expense, your choice will also depend on when you want your children to be able to access the money and your and your kids’ tax situations.
Starting from simplest to most complex, I will explain the following options here:
Before making gifts to your children, you need know that there are tax rules in the US about gifts themselves as well as any investment returns your children earn.
Information from the Internal Revenue Service (IRS) about gifts can be found at this link. Each individual can give another individual a gift of up to the gift tax limit ($15,000 in 2019) each year without any tax consequences. For example, each of a father and mother could give their daughter a gift of $15,000 for a total of $30,000 in a year and there would be no additional tax reporting or taxes.
If you make a larger gift, the portion in above the gift limit is called an excess gift and needs to be reported to the IRS. According to Schwab’s web site, you do not have to pay gift tax to the IRS as long as the combination of your gifts in excess of the limit and the amount you give to people as part of your estate when you die doesn’t exceed a stated threshold ($11.18 million for 2019 through 2025). I believe that the excess gift and estate tax limit in some states is much, much lower. If you are fortunate enough to be able to make large gifts, I suggest you contact your tax advisor to ensure you understand the tax ramifications.
A child’s unearned income (e.g., interest, dividends and capital gains) exceeds $2,100 may be subject to tax, according to the IRS web site. As outlined at that link, in some cases, parents can report the child’s income on their own tax return. In other cases, the child must file its own tax return.
The 2019 Federal tax rates on child’s taxable income go up very quickly, as shown in the table below. Taxable income includes all earned and unearned income.
Taxable Income  Taxes 
Up to $2,550  10% of taxable income 
$2,550 – $9,150  $255 + 24% of taxable income in excess of $2,550 
$9,150 – $12,500  $1,839 + 35% of taxable income in excess of $9,150 
More than $12,500  $3,011.50 + 37% of taxable income in excess of $12,500 
If you choose to gift large amounts of money to your children, you will want to consider whether you can include your child’s income on your return, the complexity of filing a separate return for your child and the difference in the taxes on your income as compared to your child’s income.
The easiest way to open a savings account for your kids is to open a bank or brokerage account in your name and know “in your mind” that you intend to give the money to you kids. The advantage of this type approach is that you have complete access to the money and can change your mind about giving it to your children. Of course, that defeats the purpose of setting aside money for your kids!
You will report any interest, dividends or capital gains from the account on your tax return, as you own the account. If you use this approach, you’ll want to be careful of the gift tax rules when you transfer it to your child. The value of the account may exceed the gift tax limit when you give the money to your child if you have been contributing to it for many years and/or it has grown through investment returns.
Another form of savings accounts for kids is a joint account at a bank or brokerage account. That is, both your and your child’s name will be on the account. We took this approach for our children to teach them about saving.
Some of these accounts allow your child to deposit or withdraw money at any age, while others allow only you to make transactions on the account. If you choose a truly joint account (which means your child can make withdrawals), you need to be certain you can stand watching them withdraw the money and spend it on their own. I will admit I was surprised at my emotional reactions to watching my children spend money. They were much stronger than I would have guessed.
According to Pocket Sense, if your child doesn’t file a tax return, you will report the income, gains and losses on the account on your tax return – the same as if you open the account on your own. If your child files a tax return, you’ll report all of the income as yours, but you then deduct your child’s share from your return and report it on his or her return. In addition, the amount you deposit into the account is considered a gift to your child in the year it which it is withdrawn.
There are two types of savings accounts for kids that give you a bit more control over the money than a joint account. These accounts are Uniform Transfer to Minors Act (UTMA) and Uniform Gift to Minors Act accounts.
UTMA and UGMA accounts are easy to set up at a bank or brokerage firm. Someone, often the parent or person who opens the account, is identified as the custodian on behalf of the minor (the beneficiary). The money in these accounts can be used by the custodian for the benefit of the minor, though there are fewer restrictions on how money in an UTMA account can be spent than an UGMA account. Broadly, expenses that parents usually pay for their children, such as food, housing and clothes, are considered to be “for the benefit of the minor.” At ages established by each state individually for each type of account, often 18 for UGMA accounts and 21 for UTMA accounts, the beneficiary becomes solely responsible for the account.
These accounts have the benefit that your child can’t access the money until they are at least 18. They have the drawback, relative to a joint account, that you can use the money only for the benefit of your child.
The money you put in an UTMA or UGMA account is considered a gift when you deposit it. Any interest, dividends or capital gains will be reported as the child’s income, so you might have to file a tax return for your child if he or she has enough income.
Another legal structure you can use when you open a savings account for kids is a trust. A trust is a legal entity that requires a trust agreement and gets its own tax ID number. The trustee is the person who oversees the trust until the child receives the money.
We created a trust for each of our children, as they each received an inheritance that stipulated that the money be put in trusts, and had a lawyer draft the trust agreement. I suspect there are books and websites that will help you do it yourself as well, but you’ll want to consider the cost of establishing a trust as you decide it this option is best for you.
Once you have created the trust, you can then open a bank or brokerage account on its behalf. The trust agreement will specify who can withdraw money and for what purposes. One of the advantages of a trust over an UTMA or UGMA account is that you determine the age at which your children receive the money. In some cases, people even release portions of the money to their children at two or three different ages. If you are concerned about your child’s ability to handle money responsibly, a trust will allow you to delay distribution of the money to them until they are more mature.
Trusts always needs to file a tax return separate from you and your child. The 2018 tax rates for trusts are the same as those shown above for children shown earlier in this post. Any deposits into a trust are considered as gifts by the IRS.
This table shows a quick comparison of the four different options I’ve described here.
Account in your name  Joint Account  UTMA/UGMA  Trust  
Who owns the account  You  Both  Child, with custodian oversight  Child, with trustee oversight 
When can child spend money  Only when you transfer it  Anytime  At age established by state  At age established by trust agreement 
Purposes for which you can withdraw money  Anything  Anything  For benefit of child  As specified by trust agreement 
When considered a gift  When you transfer money  When spent by child  When deposited  When deposited 
Who pays taxes  You  50% by you/50% by child  Child  Trust 
For other tips on how to help your kids become financial literate adults, check out my guest post for Grokking Money in honor of Financial Literacy Month.
The post Savings Accounts for Kids appeared first on Financial IQ by Susie Q.
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