7 Must-Know Stock Market Sell Signals

7 Must-Know Stock Market Sell Signals: How to Avoid Selling a Stock Too Soon or Too Late

Before we talk about the specific indicators that would signify stock market sell signals, we must understand why we bought each stock in the first place. The simple theory of ‘buy low, sell high’ seems practically very easy, but the reality of the situation is much more complex. When investors look to spend their hard earned cash on stock market investments, it is absolutely necessary that they buy stocks when they are relatively undervalued in comparison to the company or market as a whole. What investors need to assume is the fact that you make money at the price you buy at, not the price you sell. It is imperative as an investor that you understand both sides of the coin when it comes to buying and selling stocks. A breadth of knowledge in technical, fundamental, and psychological factors that affect stock prices will give you an edge.

How You Buy a Stock

Many factors can be used to help look for and find buying opportunities. When buying stocks, look for low price-to-earnings or P/E ratios relative to the industry average or a P/E ratio that is near the low of its five-year range. Find companies with strong earnings and ones that have an economic moat that will protect said earnings. Use short-, medium-, and long-term charts to identify if the stock has a history of growth.  You’ll be surprised how many companies don’t make money or make less than before, and the stock chart usually reflects that. Finally look at the business you are interested in from afar. Is it growing? Does it change the world we live in positively? How does its competition look? Utilize everything you can when looking to buy stocks.  Trades should be based on calculated risk. Without that, you are gambling.

Stock Market Sell Signals

Now that we’ve discussed why we would buy a stock, let’s dive into why you should sell a stock. As the market moves, it’s important to keep an eye on how your company looks from a financial standpoint. Below we will discuss in detail some key fundamental metrics that could be used to signal that a stock is overvalued, also known as stock market sell signals.

Price-to-earnings (P/E)

The P/E ratio is used to show how expensive a stock is relative to the money it earns. The first check you can perform on any stock is to compare the stock in question’s P/E with the sector average. If the stock’s P/E is higher than the sector average, then the stock is relatively more expensive than the sector’s average and can be considered a sell signal. Some companies (typically tech companies) carry a high P/E due to the public pricing of future earnings. This is why the next step would be to compare the stocks P/E within a five-year range of its own P/E. If the stock is near the top of the five-year range, then it’s more overvalued than it has been in the last five years, which could be an indication to sell.

Next, with a word of caution we can look at the Forward P/E. I say with a word of caution because this is based on analysts’ expectations and guidance set by the company. Don’t forget these are educated guesses – they can be spot on or miss the mark completely. Typically, when the Forward P/E is higher next year than the current P/E, there is a projection of lower earnings. Most, if not all, investors should invest in companies projected to make more money quarter over quarter and year over year. This too could be used as a signal for when it’s time to sell a stock. With some simple yet advanced tactics, you can even project the stock price in a range for the next year. Want to learn how to do this? Click here: https://launchpadyourlife.com/learn-earn-retire-early-portfolio-builder/

Price-to-Book (P/B) Ratio

The price-to-book (P/B) ratio is a comparison between the market valuation and the book value of the company. A good buy point for any stock is a P/B under 1. But, when a stock’s P/B is higher than the sector average, then it’s relatively expensive. This comparison could be used to signal when to buy or sell depending on what the P/B is at, as well as how to compares to the industry average. Another word of caution – use this as a checkpoint and not a definitive buy/sell signal. Sometimes companies can window dress book value causing the P/B to appear lower than it really is, so again be cautious.

Earnings Per Share (EPS) Growth Next Year and Next 5 Years

Earnings per share (EPS) growth uses projected earnings to give us a glimpse into what may happen next year. This can also be used to understand trends. Is the company constantly growing its earnings? Is it stable, consistent growth? If the answer differs from its history, it could be one of our stock market sell signals. The importance of earnings growth is that the stock price inevitably follows earnings. Some newer companies could have growth based on expected future earnings, but the stock price generally reverts to the mean at some point – all based on the company’s actual earnings.

Debt Load Management

If a stock has a debt load, it is important to assess how management is handling it. Is management letting debt grow or paying it down faster than expected? The answer is important because a building debt load increases the interest expenses the company will have and therefore affect the bottom line.

We want to focus on year-over-year changes in the debt/equity ratio as well as the long-term debt/equity ratio. We want these ratios to either be a low stable number relative to the industry average or we want to see that management is actively paying it down. In doing so, shareholders equity or the value of the shares you currently own will increase. When the opposite is happening, such as erratic or increasing debt loads, we should be concerned and possibly ready to sell. If you want to look at a year-over-year trend of these statistics, Charles Schwab has some great tools that come with its account. Below we can see the five-year trend in graphical form to the left, a definition of the ratio in the middle area, and the current value of the ratio to the right for a sample company.

Debt to Capital Ratios

Do you want to open a Charles Schwab account to access these awesome features? Click this link to sign up, it only takes minutes! http://www.schwab.com/public/schwab/nn/refer-prospect.html?refrid={REFID}

The Big Picture

Sometimes the best way to tell if it is time to sell a stock is to see if the story has changed.

Changes in Business

Before you ever invest in a company, it is imperative that you look at the business from every angle. It is necessary as an investor to know what you are buying and why you are buying it. You would not buy a car without test driving it, would you? Typically, you look at Consumer Reports, talk to people who have owned that car model, and look at safety ratings and mechanical flaws or misnomers. The same can be said for stocks – look for changes in the income statement, balance sheet, and statement of cashflows. When these things begin to change from your initial thesis, it may be a stock market sell signal.

Changes in Management

When management changes, it may be time to sell. Typically, stock prices fall when new management is announced because a different mindset is at the helm of the company. People may have the same goal, but different paths to reach said goal. The story can change on a multitude of levels. Even if the financials are still intact, if the story about who it is as a company or what it does has changed, it may be one of our stock market sell signals.

An example of this is the Chinese company, Lukin Coffee, which, from its financials, was poised to be the next Starbucks. It was later realized that the earnings were not as they seemed and they were forging financial documents. The stock tanked and has since been delisted from the NASDAQ. Sometimes you can see the smoke before the fire and get out of a stock, and sometimes you will have to get out while down to prevent a total loss.  As a caution, though, a decrease in a stock price isn’t always a sell indicator.  In fact, in some cases it may be a chance to buy more of the company’s stock.  So, you’ll want to be sure to understand why the stock price has decreased.

Sector Rotation

The stock market moves in and out of sectors like the tides in the ocean based on the current point of the economic cycle. Understanding where money is moving in and out of could be used as a signal for when to sell a stock. The best way to grasp this concept is to take a step back and look at the overall economy. During times of fear, the best investments tend to be non-cyclical defensive positions like grocery stores and household goods.  In a depression or economic contraction, you may not buy a new iPhone, but you will still buy bread and toothpaste for your family.

Many graphics can be found by googling ‘sector rotation’ to give you a better idea as to what are the best sectors to invest in based on the economic picture at hand. Trying to time the market tends to not be a successful strategy. The old saying goes, ‘time in the market is better than trying to time the market.  Use sector rotation to either sell at right time or buy on the dips when the sectors rotate.

Portfolio Rebalancing/Profit taking

As you build your portfolio, if you invest in great companies, then eventually the underlying stock prices should rise. As those stock prices rise, the overall percentage that it takes up of your portfolio rises as well. For most passive investors, any one stock should not take up more than 3-5% of your overall portfolio to avoid company specific risk.

Closing Thoughts.

Now you have some stock market sell signals!  Remember that you should only invest in what you know.  When things start to change, do whatever you have to in order to protect your money and continue to grow your wealth. Good luck investing!

About the Author

Brandon Smith is the owner of Launchpad Finance – a financial education source for young adults and new investors. Brandon has been studying and trading in the stock market for over 6 years now, and has been interested in the markets since he was 12 years old. After graduating from The University of Houston with a BBA-Finance, he used his passion for the stock market to start Launchpad Finance to fuel others to have a passion for stock trading, as well as grasp of the value financial literacy in one’s own path to financial freedom.

Do I Really Need to Budget

Do I Really Need to Budget?

I wrote a guest post for The Smart Investor about deciding if you need a budget.  Here is the start of it, to read the entire post, click here.

Budgeting is critical to your financial health, especially when you are just getting started handling your own money.  A budget will help you figure out whether you can afford to make big purchases – a car, a home – whether you can afford a nice vacation and whether you need to find a way to make more money.  However, not everyone needs to make and stick to a budget.

In this post, I’ll talk about the characteristics of people who will benefit most and least from making a budget and will provide a questionnaire you can use to help figure out . . . Read More

Investing for Dividends

Investing for Dividends

Investing for dividends is one of many strategies investors use to identify stocks for their portfolios. Among the strategies I identified in my post on what you need to know about stocks, this is not one that I have ever used.  So I reached out to one of my Twitter followers who uses it to get more information, Dividend Diplomats (aka Lanny and Bert) to get some real-life insights. With Lanny’s and Bert’s help, I will:

  • define dividends.
  • talk about the criteria that Lanny and Bert use for selecting companies and why they are important.
  • show some historical returns for dividend-issuing companies.
  • explain the tax implications of dividends on your total return.

What are Dividends?

A dividend is a cash distribution from a company to its shareholders. The amount of the dividend is stated on a per-share basis.  The amount of cash you receive is equal to the number of shares you own times the amount of the dividend. When companies announce that they are going to pay a dividend, they provide two dates.  The first is the date on which share ownership is determined (also known as the ex-dividend date).  The second is the date on which the dividend will be paid. For example, a company might declare a 15₵ dividend to people who own shares on May 1 payable on May 15. Even if you sell your stock between May 1 and May 15, you will get 15₵ for every share you owned on May 1.

When a company earns a profit, it has two choices for what to do with the profit. Under one option, the company can keep the profit and use it to support future operations. For example, the company might buy more equipment to allow it to increase the number of products is makes or might buy another company to expand its operations. Under the second option, the company distributes some or all of its profit to shareholders as dividends. My experience is that companies that are growing rapidly tend to keep their profits, whereas companies that can’t find enough opportunities to reinvest their profits to fund growth tend to issue dividends.

Dividend Diplomats – A Little Background

Lanny and Bert have been blogging for over 5.5 years and have been best friends for 7.  They both are pursuing the same goal of reaching financial freedom and retiring early to break the “9 to 5” chains.  They hope to achieve financial freedom through dividend investing, frugal living, and using as many “personal finance” hacks as possible to keep expenses low and bring in additional income. For more information about the Dividend Diplomats, check out their web site at www.dividenddiplomats.com.

Why Use the Investing for Dividends Strategy

As you’ll see in future posts, I have used several strategies for my stock investments, but have never focused on investing for dividends.

My Preconceived Notions

I have always considered investing for dividends as most appropriate for people who need the cash to pay their living expenses, such as people who are retired. I am retired, but currently have cash and some bonds that I use to cover my living expenses. As I get further into retirement, I will need to start liquidating some of my stocks or start investing for dividends.

Lanny’s & Bert’s Motivation

So, when I started reading about Lanny and Bert, I wondered why people who are still working (and a lot younger than I am) would be interested in investing for dividends.   Here’s what they said.

“There were a few different motivating factors.

Lanny had endured a very difficult childhood, where money was always limited and his family had struggled financially.   Due to this, he personally wanted to never have to worry about money, period.

Bert was not a dividend growth investor until he met Lanny.  Once he talked to Lanny, learned about dividend investing, and saw the math, he was sold and hasn’t looked back since.

Therefore, we are looking to build a growing passive income stream so we can retire early and pursue our passions.  Building a stream of growing, truly passive dividend income has always been a very attractive option to us.  We love the fact that dividend income is truly passive (outside of initial capital, we don’t have to lift a finger) and we are building equity in great, established companies that have paid dividends throughout various economic cycles.

Second, the math just makes sense.  It is crazy how quickly your income stream grows when you are anticipating a dividend growth rate of 6%+ (on average).  Lanny writes an article each quarter showing the impact of dividend increases and we have demonstrated the impact of dividend reinvesting on our site in the past. When you see the math on paper, it is insane. “

Lanny and Bert provided links to a couple of their posts that illustrate the math: Impact of Dividend Increases and Power of Dividend Reinvesting.

Lanny’s & Bert’s Strategy

Lanny and Bert developed a dividend stock screener that helps them identify undervalued dividend growth stocks in which to consider investing.  At a minimum, the companies must pass three metrics to be further considered for investment:

  • Valuation (P/E Ratio) less than the market average.
  • Payout Ratio Less than 60%. (Unless the industry has a higher benchmarked figure. i.e. oil, tobacco, utilities, REITs, etc., then they compare to the industry payout ratio.)
  • History of increasing dividends.

They don’t consider dividend yield until later in the process.  They never advocate chasing dividend yield at the risk of dividend safety. That is, they would rather a dividend that has very low risk of being reduced or eliminated (i.e., safety) than a higher dividend be unsustainable over the long term.

That’s why they don’t look at yield initially.  It allows them to focus on the important metrics that help them gain comfort over the safety of the dividend.  Here is a link to their Dividend Stock Screener.

Payout Ratio

Lanny and Bert mention that that one of their key metrics is a payout ratio. A dividend payout ratio is the annual amount of a company’s dividend divided by its earnings per share.  For more about earnings per share, check out my post on reading financial statements.

A dividend payout ratio of less than 1 means that a company is retaining some of its earnings and distributing the rest. If the ratio is more than 1, it means that the company is earning less money than it is paying out in dividends.

I worked for a company that had a payout ratio of more than 1. When I first started working there, the company had more capital than it could use. The company was returning its excess capital to its shareholders through the high dividend. After several years, the company’s capital approached the amount it needed to support its business. If it had cut its dividend to an amount lower than its earnings, the stock price might have decreased significantly. Instead, the company was sold. Had the company not been sold, its shareholders might have had both a decrease in future dividend payments and a reduction in the value of their stock at the same time.  This double whammy (dividend cut at the same time as a price decrease) is a risk of owning a stock in a dividend-issuing company especially those with high dividend payout ratios.

Performance – Lanny and Bert’s View

Lanny and Bert are not assuming they can do better than management or the market.  As noted above, they tend to focus on companies with a dividend payout ratio less than 60%.  This approach allows for all three of increasing dividends to shareholders, share repurchases, and internal growth for profit.  Also, this approach ensures the company is continuing to invest in itself as well.  You can’t pay a dividend in the future if you can’t grow, or even maintain, your current earnings stream.  Therefore, if revenues are stagnant or shrinking, the safety of the company’s dividend comes into question.  Companies “can” pay out a dividend that is larger than your earnings over the short-to-medium term.  However, it is not sustainable as was the case with the company for which I worked.

Historical Performance

I was curious about how stocks that met Lanny and Bert’s criteria performed. I have a subscription to the ValueLine Analyzer Plus. It contains current and historical financial data and stock prices about hundreds of companies. I looked at two time periods.  I first looked at the most recent year (November 2018 to November 2019).  Because I was curious about how those stocks performed in the 2008 crash, I also looked at the ten-year period from 2003 to 2013. I would have used a shorter period around the 2008 crash and the period thereafter, but didn’t save the data in the right format so had to look at time periods for which I had saved the data in an accessible manner.

How I Measured Performance

For both time periods, I identified all stocks for which the data I needed for the analysis were available at both the beginning and end of the period.  There were 1,505 companies included in the sample in the 2018-2019 period and 952 companies for the 2003 to 2013 period.

I then identified companies (a) whose dividend grew in each of the previous two fiscal years, (b) whose dividend payout ratio was less than 60% and (c) whose P/B ratio was less than the average of all of the companies in the same. That is, I attempted to identify the companies that met Lanny and Bert’s criteria. There were 332 companies in the 2018-2019 period and 109 companies in the 2003-2013 period that met these criteria.

ValueLine ranks companies based on what it calls Timeliness, with companies with Timeliness ratings of 1 having the best expected performance and those having a rating of 5 having the worst expected performance. Because I suspected that Bert and Lanny’s screen would tend to select more companies with favorable Timeliness ratings than those with poorer ones, I looked at both the overall results, as well as the results by Timeliness rating.

November 2018 – November 2019

In the most recent year, the stocks that met Lanny’s and Bert’s criteria had an average total return (dividends plus change in stock price) of 11% as compared to 8.5% for the total sample. That is, in the current market, dividend issuing companies meeting their criteria returned more than the average of all companies.

Interestingly, when I stratified the companies by Timeliness rating, it showed that for companies with good Timeliness ratings (1 and 2), the Lanny’s and Bert’s companies underperformed the group. For companies with two of the three lower Timeliness ratings (3 and 5), though, Lanny’s and Bert’s companies not only did better than the average of all companies in the group, but also did better than even the group of companies with a Timeliness rating of 1! It looks to me as if their approach might identify some gems in what otherwise appear to be poorer performing companies.

The chart below shows these comparisons.

2019 total returns on dividends stocks by ValueLine TImeliness ranking

2003 to 2013

Over the longer time period from 2003 to 2013, the companies meeting Lanny’s and Bert’s criteria didn’t do quite as well as the average of all companies. In this case, the stocks meeting their criteria had a compound annual return of 5% as compared to 7% for all stocks in the sample. Without more data, it is hard to tell whether the difference in return is the sample of dividend-issuing companies is small, because those companies didn’t fare as well during the Great Recession or something else.

I looked at the total returns by Timeliness rating and the results were inconsistent for both the “all stocks” group and the ones that met our criteria. A lot can happen in 10 years! Nonetheless, it was interesting to see that the dividend-yielding stocks that had Timeliness ratings of 5 in 2003 out performed all other subsets of the data. So, while these stocks didn’t have quite as high a total return over the 10-year period in the aggregate, there are clearly some above-average performers within the group.

Tax Ramifications of Dividends

One of the drawbacks of investing in companies with dividends, as opposed to companies that reinvest their earnings for growth, is that you might need to pay taxes on the dividend income as it gets distributed.

Types of Accounts

If you hold your dividend-yielding stocks in a tax-deferred (e.g., Traditional IRA or 401(k) in the US or RRSP in Canada) or tax-free (e.g., Roth IRA or 401(k) in the US or TFSA in Canada), it doesn’t matter whether your returns are in the form of price appreciation or dividends. Your total return in each of those types of accounts gets taxed the same. That is, if you hold the stocks in a tax-deferred account, you will pay tax on your total returns, regardless of whether it is interest, dividends or appreciation, at your ordinary income tax rate. If you hold the stocks in a tax-free account, you won’t pay taxes on any returns.

The only type of account in which it matters whether your return is in the form of price appreciation or dividends is a taxable account. In the US, most people pay 15% Federal income tax plus some additional amount for state income taxes on dividends in the year in which they are issued. They pay taxes at the same rate on capital gains, but only when the stock is sold, not as the price changes from year to year. In Canada, the difference is even greater. Dividends are taxed at your ordinary income tax rate (i.e., they are added to your wages) and capital gains are taxed at 50% of your ordinary income tax rate and only when you sell the stock.

Dividend Reinvestment

When you earn dividends from a company, you often have the option to automatically reinvest the dividends in the same company’s stock. This process is a dividend reinvestment plan. Lanny and Bert take this approach.

Dividend reinvestment plans are terrific ways to make sure you stay invested in companies that you like, as you don’t have to remember to buy more stock when the dividend is reinvested. The drawback of dividend reinvestment plans is that you will owe tax on the amount of the dividend, even if you don’t receive it in cash. If you reinvest 100% of your dividends, you’ll need to have cash from some other source to pay the taxes unless you hold the investments in a tax-free or tax-deferred account.

Illustration

Let’s assume you are a US investor subject to the 15% Federal tax rate and pay no state income tax. You have two companies you are considering. You expect each to have a total return of 8%. One company’s return will be 100% in dividends, while the other company issues no dividends. You plan to own the stock for 10 years. Your initial investment will be $1,000 and you will pay your income taxes out of your dividends, so you reinvest 85% of the dividends you earn each year.

At the end of the 10th year, you will have $1,931 if you buy the company with 8% dividends. If you buy the company with no dividends, your stock will be worth $2,159. After you pay capital gains tax of $174, you will have $1,985 or 2.8% more than if you buy stock in the company that issues 8% dividends.

If you pay Canadian taxes, the difference is even bigger because of the much lower tax rate on capital gains than dividends. Over the full ten-year period, you will end up with almost 11% more if you buy stock in the company with no dividends than if you buy stock in the dividend-issuing company.

As such, you’ll want to put as much of your portfolio of dividend-issuing stocks in a tax-deferred or tax-free account as possible to minimize the impact of taxes on your total return.

Annual Retirement Savings Targets

Retirement Savings: How Much to Save Each Year

Once you know how much you want to save for retirement, you need a plan for building that savings.  Your annual retirement savings target depends on your total savings target, how many years you have until you want to retire and how much risk you are willing to take in your portfolio.  In this post, I’ll provide information you can use to set targets for how much to contribute to your retirement savings each year.

Key Variables

There are several variables that will impact how much you’ll want to target as contributions to your retirement savings each year.  They are:

  • Your total retirement savings target.
  • How much you already have saved.
  • The number of years you are able to contribute to your retirement savings.
  • How much risk you are willing to take in your portfolio.
  • The impact of taxes on investment returns between now and your retirement. That is, what portion of your retirement savings will be in each of taxable accounts, tax-deferred retirement savings accounts and tax-free retirement savings accounts.  For more information on tax-deferred and tax-free retirement savings accounts, check out this post.  I provide a bit more insight on all three types of accounts in these posts on how to choose which assets to buy in which type of account in each of the US and Canada.

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

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.

  • If you have only a few years until you retire, you might want to invest fairly conservatively. By investing conservatively, you might want to invest in money market or high-yield savings accounts that currently have yields in the 1.75% to 2% range.
  • If you have five to ten years until you retire or are somewhat risk averse (i.e., can’t tolerate the ups and downs of the stock market), you might want to invest primarily in bonds (discussed in this post) or bond mutual funds. Depending on the maturity, US government bonds are currently yielding between 1.5% and 2% and high-quality corporate bonds are currently returning between 2.5% and 4%.
  • If you have a longer time period to retire and/or are able to tolerate the volatility of equities (discussed in this post), you might invest in an S&P 500 index fund or an index fund that is even more risky. These funds have average annual returns of 8% or more.

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.

Taxability of Investment Returns

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 Tax-Deferred & Tax-Free 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

Further Refinements to Tax Adjustments

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 US-Taxable 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 re-invest 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.

Calculation of After-Tax Investment Return

From the table above, it is clear that calculating your after-tax 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 after-tax investment return.

Investment Type

Account Type

Percent of PortfolioPre-tax ReturnTax 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:

  • Money markets, bonds or mutual funds in taxable accounts.
  • Equities, equity mutual funds and index funds in taxable accounts.
  • Tax-deferred or tax-free accounts (IRAs, 401(k)s, RRSPs and TFSAs).

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 Pre-Tax 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 after-tax investment return will be the sum of the three values in the last column.

Illustration of Weighted Average Return Calculation

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 tax-deferred and tax-free accounts.  Although not consistent with my post on tax-efficient 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 tax-deferred and tax-free accounts goes in the All Other row.

Investment Type

Account Type

Percent of PortfolioPre-tax ReturnTax 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 pre-tax return on bonds of 3% and equities of 8%.  Because the All Other category is 50/50 stocks and bonds, the average pre-tax 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 after-tax 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.

Annual Savings Targets

By this point, we have talked about how to estimate:

  • Your total retirement savings target
  • The number of years until you retire
  • An after-tax investment return that is consistent with your risk tolerance and the types of accounts in which you plan to put your savings

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.

Annual Savings/Total Target

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 after-tax annual average investment return.

What percentage of your total target you need to save each year

After-tax Return

Years to Retirement
5101520253035

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.

How to Use the Table

First find the percentage in the cell with a row that corresponds to your after-tax 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% after-tax 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 second-year savings amounts for several combinations of years to retirement and total retirement savings targets for someone with a 5% after-tax investment return below.

Years to Retirement

Savings % from Table (5% Row)Total Retirement Savings TargetFirst-Year Savings AmountSecond-Year Savings Amount

5

16.6%$500,000$83,000$85,490

15

3.7%2,000,00074,000

76,220

301.0%500,0005,000

5,150

400.5%1,000,0005,000

5,150

The first-year 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.

Adjusting for Savings You Already Have

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.

After-tax Return

Years to Retirement
5101520253035

40

2%

1.101.221.351.491.641.812.002.21

3%

1.161.341.561.812.092.432.813.26

4%

1.221.481.802.192.673.243.954.80
5%1.281.632.082.653.394.325.52

7.04

6%1.341.792.403.214.295.747.69

10.29

7%1.401.972.763.875.437.6110.68

14.97

8%1.472.163.174.666.8510.0614.79

21.72

Illustration of Adjustment for Existing Savings

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.

Caution

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. You don’t want to be in the situation in which my friend found herself at age 59 starting over financially.

 

Tax-Efficient Investing Strategies – Canada

Tax Effective Investing in Canada

You can increase your savings through tax-efficient investing. Tax-efficient investing is the process of maximizing your after-tax investment returns by buying your invested assets in the “best” account from a tax perspective. You may have savings in a taxable account and/or in one or more types of tax-sheltered retirement accounts. Your investment returns are taxed differently depending on the type of account in which you hold your invested assets. In this post, I’ll provide a quick overview of the taxes applicable to each type of account (since I cover taxes on retirement plans in much greater detail in this post) and provide guidelines for how to invest tax-efficiently.

The strategy for tax-efficient investing differs from one country to the next due to differences in tax laws so I’ll talk about tax-efficient investing strategies in the Canada in this post. For information about tax-efficient investing in the US, check out this post.

Types of Investment Returns

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:InterestDividendsCapital GainsCapital Gain Distributions
High dividend stocksxx
Mutual Fundsxxx
ETFsx
Bondsxx

 

Cash Distributions

Interest and dividends are cash payments that the issuers of financial instruments (i.e., stocks, mutual funds or bonds) make to owners.

Capital Gains

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

Mutual funds are a bit different from stocks and ETFs. They can have the following types of taxable returns.

  • Dividends – A mutual fund dividend is a distribution of some or all of the dividends that the mutual fund manager has received from the issuers of the securities owned by the mutual fund.
  • Capital gain distributions – Capital gain distributions are money the mutual fund manager pays to owners when a mutual fund sells some of its assets.
  • Capital gains – As with other financial instruments, you pay tax on the difference between the amount you receive when you sell a mutual fund and the amount you paid for it.

Tax Rates

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 Tax-Free Savings Account (TFSA).

Accounts other than Retirement Accounts

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 ReturnTax Rates
Interest & DividendsSame as wages
Realized capital gains & capital gain distributions50% 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.

TFSA Retirement Accounts

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%.

RRSP Retirement Accounts

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.

After-Tax Returns by Type of Account

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 pre-tax investment returns.

Annual Pre-tax Investment Return %InterestDividendsCapital Gains
Stocks0%3%5%
ETFs0%0%8%
Mutual Funds0%3%5%
Bonds4%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 IncomeTax Rate
Wages26%
Interest & Dividends26%
Capital Gains13%

One-Year Investment Period

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 after-tax investment returns after one year from your initial $1,000. Note that the pre-tax 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.

One-Year After-tax Investment Returns ($)StocksMutual FundsETFsBonds
Taxable$66$66$70$30
RRSP59595930
TFSA80808040

This table below shows the taxes you paid on your returns during that year.

Taxes PaidStocksMutual FundsETFsBonds
Taxable$14$14$10$10
RRSP21212110
TFSA0000

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.

Comparison Different Financial Instruments Within Each Type of Account

Looking at across the rows, you can see that, for each type of account, stocks and mutual funds have the same one-year returns and tax payments. In this illustration, both stocks and mutual funds have the same split between dividends and appreciation. Your after-tax 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 capital-gain tax rate applies to your returns.

In all accounts, bonds have a lower after-tax 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.

Comparison of Each Financial Instrument in Different Types of Accounts

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 after-tax return if you invest in a taxable account than an RRSP for one year.  For bonds, the taxes and after-tax 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.

Ten-Year Investment Period

I’ve used the same assumptions in the 10-year 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%.

Ten-Year After-Tax Investment Returns ($)StocksMutual FundsETFsBonds
Taxable$917$890$1,008$339
RRSP921921921382
TFSA1,1591,1591,159480

Comparison Different Financial Instruments Within Each Type of Account

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 tax-sheltered 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 after-tax 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 stock-like financial instruments in a taxable account.

Comparison of Each Financial Instrument in Different Types of Accounts

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 after-tax 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 after-tax 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 after-tax return is slightly lower in a taxable account than in an RRSP for the three stock-like investments. The ability to compound your returns on a pre-tax basis more than offsets the higher tax rate you pay in the RRSP.

Illustration of Tax Deferral Benefit

The ability to compound your investment returns on a tax-deferred 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 three-year period.

Returns and Taxes by YearTaxable AccountRRSP
Initial Investment$1,000$1,000
Return – Year 18080
Tax – Year 1210
Balance – Year 11,0591,080
Return – Year 28586
Tax – Year 2220
Balance – Year 21,1221,166
Return – Year 39094
Tax – Year 3230
Balance – Year 31,1881,260

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 tax-deferred account, $260. The total of the taxes for the taxable account is $66. Multiplying the $260 of return in the tax-deferred account by the 26% tax rate gives us $68 of taxes from that account. As such, the after-tax returns after three years are $188 in the taxable account and $192 in the tax-deferred 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 after-tax returns on the tax-deferred account, using the above assumptions, would be almost 10% higher than on the taxable account.

Portfolios Using Tax-Efficient Investing

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:

  • If there is a wide difference in total return, you’ll want to put your highest returning investments in your TFSA.
  • For smaller differences in total return (e.g., less than 2 – 3 percentage points), it is better to put instruments with more distributions in your RRSP and then your TFSA, putting as few of them as possible in your taxable account.
  • Instruments with slightly higher yields, but little to no distributions can be put in your taxable account.
  • You’ll want to hold your lower return, higher distribution financial instruments, such as bonds, in your RRSP. There is a benefit to holding bonds in an RRSP as compared to a taxable account. The same tax rates apply to both accounts, but you don’t have to pay taxes until you withdraw the money from your RRSP, whereas you pay them annually in your taxable account.

Applying Tax-Efficient Investing to Two Portfolios

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.

Portfolio Example 1

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 tax-sheltered 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.

Portfolio Example 2

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 high-yielding 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.

Risks of Tax-Efficient Investing

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 long-term 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 money-losing 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 after-tax 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.

6 Ways to Slay Your Student Debt This Year

6 Ways to Slay Your Student Debt This Year

From Susie Q: I’m not as familiar with student debt as I am with the other topics on which I write, so was pleased to accept this guest post from Kate Underwood.  Kate is a freelance writer and staff writer for Club Thrifty, a website dedicated to helping people dream big, spend less, and travel more.  With Kate’s permission and approval, I’ve interspersed some comments and numerical examples in italics to expand on a few of her points.

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.

Follow A Budget

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 week-by-week 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!

Start Repayment Right Away

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).

Pay Extra Each Month

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 pre-pay 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!

Refinance Your Loans

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! Win-win!

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 re-finance your loan at 3.5% and continue to make the same $237-a-month 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 re-finance 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!

Start A Side Hustle

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 work-from-home 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 to-die-for 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!

Use Employer Benefits

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.

Say Goodbye to Student Loans Fast

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!

 

 

 

Tax-Efficient Investing Strategies – USA

Tax Efficient Investing: USA

You can increase your savings through tax-efficient investing.  Tax-efficient investing is the process of maximizing your after-tax investment returns by buying your invested assets in the “best” account from a tax perspective.  You may have savings in a taxable account and/or in one or more types of tax-sheltered retirement accounts.  Your investment returns are taxed differently depending on the type of account in which you hold your invested assets.  In this post, I’ll provide a quick overview of the taxes applicable to each type of account (since I cover taxes on retirement plans in much greater detail in this post) and provide guidelines for how to invest tax-efficiently.

The strategy for tax-efficient investing differs from one country to the next due to differences in tax laws so I’ll talk about tax-efficient investing strategies in the US in this post and in Canada in this post.

Types of Investment Returns

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 InvestmentInterestDividendsCapital GainsCapital Gain Distributions
High dividend stocks          x         x
Mutual Funds         x         x         x
ETFs         x
Bonds         x         x

Cash Distributions

Interest and dividends are cash payments that the issuers of the financial instrument (i.e., stock, fund or bond) make to owners.

Capital Gains

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

Mutual funds are a bit different from stocks and ETFs.  They can have the following types of taxable returns.

  • Dividends – A mutual fund dividend is a distribution of some or all of the dividends that the mutual fund manager has received from the issuers of the securities owned by the mutual fund.
  • Capital gain distributions – Capital gain distributions are money the mutual fund manager pays to owners when a mutual fund sells some of its assets.
  • Capital gains – As with other financial instruments, you pay tax on the any realized capital gains (the difference between the amount you receive when you sell a mutual fund and the amount you paid for it) when you sell a mutual fund.

Tax Rates

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.

Accounts other than Retirement Accounts

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 ReturnTax Rates
InterestSame 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.

Roth Retirement Accounts

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%.

Traditional Retirement Accounts

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.

After-Tax Returns by Type of Account

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 pre-tax investment returns.

Annual Pre-tax Investment Return %InterestDividendsCapital Gains
Stocks0%3%5%
ETFs0%0%8%
Mutual Funds0%3%5%
Bonds4%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 IncomeTax Rate
Ordinary Income – This Year24%
Dividends15%
Capital Gains15%

One-Year Investment Period

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 after-tax investment returns after one year from your initial $1,000.  Note that the pre-tax 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.

One-Year After-tax Investment Returns ($)StocksMutual FundsETFsBonds
Taxable$68$68$68$30
Traditional61616130
Roth80808040

The table below shows the taxes you paid on your returns during that year.

Taxes PaidStocksMutual FundsETFsBonds
Taxable$12$12$12$10
Traditional19191910
Roth0000

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.

Comparison of Different Financial Instruments in Each Type of Account

Looking across the rows, you can see that, for each type of account, stocks, mutual funds and ETFs have the same one-year 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 after-tax return in a one-year scenario.

In all accounts, bonds have a lower after-tax 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.

Comparison of Each Financial Instrument in Different Types of Accounts

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 after-tax return if you invest in a taxable account than a Traditional account for one year.  For bonds, the taxes and after-tax 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.

Ten-Year Investment Period

I’ve used the same assumptions in the 10-year 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%.

Ten-Year After-Tax Investment Returns ($)StocksMutual FundsETFsBonds
Taxable$964$931$985$349
Traditional904904904375
Roth1,1591,1591,159480

Comparison of Different Financial Instruments in Each Type of Account

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 tax-sheltered 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 after-tax 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 stock-like financial instruments in a taxable account.

Comparison of Each Financial Instrument in Different Types of Accounts

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 after-tax 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 after-tax 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 after-tax return is higher in a taxable account than in a Traditional account for the three stock-like 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.

Illustration of Tax Deferral Benefit

The ability to compound your investment returns on a tax-deferred 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 three-year period.

Returns and Taxes by YearTaxable AccountRetirement Account
Initial Investment$1,000$1,000
Return – Year 18080
Tax – Year 1190
Balance – Year 11,0611,080
Return – Year 28586
Tax – Year 2200
Balance – Year 21,1251,166
Return – Year 39094
Tax – Year 3220
Balance – Year 31,1941,260

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 tax-deferred account, $260.  The total of the taxes for the taxable account is $61.  Multiplying the $260 of return in the tax-deferred account by the 24% tax rate gives us $62 of taxes from that account.  As such, the after-tax returns after three years are $194 in the taxable account and $197 in the tax-deferred 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 after-tax returns on the tax-deferred account, using the above assumptions, would be almost 10% higher than on the taxable account.

Tax-Efficient Investing for Portfolios

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:

  • You’ll maximize your after-tax return if you buy your highest yielding financial instruments in your Roth.  Because they generate the highest returns, you will pay the most taxes on them if you hold them in a taxable or Traditional account.
  • Keep buying your high-yielding financial instruments in descending order of total return in your Roth accounts until you have invested all of the money in your Roth accounts.
  • If two of your financial instruments have the same expected total return, but one has higher annual distributions (such as the mutual fund as compared to the stocks in the example above), you’ll maximize your after-tax return if you put the one with the higher annual distributions in your Roth account.
  • Once you have invested all of the money in your Roth account, you’ll want to invest your next highest yielding financial instruments in your Taxable account.
  • You’ll want to hold your lower return, higher distribution financial instruments, such as bonds or mutual funds, in your Traditional account. There is a benefit to holding bonds in a Traditional account as compared to a taxable account.  The same tax rates apply to both accounts, but you don’t have to pay taxes until you withdraw the money from your Traditional account, whereas you pay them annually in your taxable account.  That is, you get the benefit of pre-tax compounding of the interest in your Traditional account.

Applying the Guidelines to Two Portfolios

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.

Portfolio Example 1

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.

Portfolio Example 2

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 high-yielding 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 low-yielding 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.

Risk

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 long-term 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 money-losing 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 after-tax 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.

How to Budget Step 9 – Monitoring your Budget

How to Budget: Monitoring Your Expenses

You may have thought you were done when you created and balanced your budget.  However, there is one very important step left in the budgeting process – making sure you are living within the guidelines set by your budget, i.e., monitoring your budget.  That is, are you earning as much income as you planned? Are you limiting your expenses to the amounts in your budget?  Did you put aside the savings you included in your budget, whether for expenses you pay infrequently, for retirement or something in between?

In this post, I’ll tell you how to use a new, budget-monitoring worksheet to compare your budget with your actual income and expenses.

Entering Your Budget

Since the purpose of the spreadsheet is to compare your actual expenses with your budget, the first thing to do is to enter your budget.  Most people find it easiest to monitor their budget on a monthly basis, even if they created an annual budget.  If you created an annual budget, you’ll want to divide all of the values in your budget by 12.

Once you have your monthly budget, you’ll enter it on the Budget Monitoring tab of the budget-monitoring spreadsheet at the link below.  Note that this spreadsheet is different from the one you used to track your expenses and create your budget, though many aspects of it will work the same as the budget creation spreadsheet (named Budget Template).

Enter Your Category Names

To enter your budget, enter the names of the categories from your budget in Column A starting in Row 8. Here are three different ways you can input your category names:

  1. Type the names directly into Column A.
  2. Use Excel’s copy and paste features to copy them from your Budget Template spreadsheet.
    1. On the Budget tab in your Budget Template spreadsheet, highlight all of your category names by putting your cursor on cell A11, holding down the shift key and moving the down arrow until all of them are highlighted. Let go of the shift key.
    2. Hold down the Ctrl key while you hit C or hit the copy button if you have one.
    3. Go to the Budget Comparison tab of the monitoring spreadsheet.
    4. Put your cursor in A8.
    5. Hold down the Alt key while you hit E, S and V or hit the paste-values button if you have one. If you just use a regular paste button, you will get errors because the cells from which you are copying have formulas in them.
  3. Link your monitoring spreadsheet to your Budget Template spreadsheet.
    1. Put your cursor in A8 of the Budget Comparison tab of your Budget Monitoring spreadsheet.
    2. Hit the equal sign on your keyboard.
    3. Go to the Budget Template spreadsheet.
    4. Go to the Budget tab.
    5. Put your cursor in A11.
    6. Hit Enter.
    7. Excel should return you to cell A8 of your Budget Monitoring spreadsheet.
    8. Hit the F2 (edit) key.
    9. Hit the F4 key 3 times. Hit Enter. There should now be no $ in the cell reference.
    10. Copy the formula in A8 and paste it in as many cells in Column A as needed until all of your category names appear.

When you enter the category names, make sure that the row with the total amount of income is called “Total Income,” the row with the expense total is called “Total Expenses,” and the difference between those two values is called “Grand Total.”

Enter Your Budget Amounts

Next, enter the monthly budget amounts in Column B next to each of the category names in Column A. You can use any of the three approaches described above for the category names. If you have an annual budget, you’ll need to divided the values by 12 before copying them if you use the second approach or add “/12” (without the quotes) in step (i) before you hit enter if you use the third approach.

Entering Your Actual Income and Expenses

You can enter your actual income and expenses using the same instructions as were used for entering them in the Budget Template spreadsheet.  See my posts on tracking expenses and paychecks and income for more details or review the instructions at the top of each tab.  Be sure to use the same category names as you used in your budget so all of your income and expenses will be included in the Actual column on the Budget Comparison tab.

For monitoring your actual income and expenses, you don’t need to enter the number of times per year you receive each type of income or pay each bill since your goal is compare what you actually received and paid with your budget.

Options for Expenses You Don’t Pay Monthly

Here are three different ways to monitor expenses that you don’t pay monthly:

  1. Enter them in the Monitoring Spreadsheet as you pay them and keep them in mind as known variances from your budget each month. This approach is the easiest to implement but also the least helpful for comparing your actual expenses to your budget.
  2. Adjust the budget amounts to reflect the amount of those expenses you expect to pay in each month. For example, if you pay your car insurance bill four times a year in March, June, September and December, you would
    • take your budget amount
    • adjust it to a full year if you budgeted on a monthly basis by multiplying by 12
    • divide the annual amount by 4
    • include the result in your budget for March, June, September and December
    • put 0 in your budget column in all other months

This approach is a little more complicated to implement, but will make comparing actual expenses with your budget much easier.

  1. Add an expense transaction every month equal to 1/12thof your annual expense on the Bank Transactions, Cash Transactions or Credit Card Transactions tab. In the months in which you actually make the payment, you’ll enter 1/12th of your actual annual expense.  If the total of the amounts you set aside in previous months differs from the amount you actually pay, you’ll need to include this difference in the actual payment amount in the month you make the payment. This approach is equivalent to moving money from your checking account to your savings account in every month you don’t have this expense and moving it back to your checking account in the month in which you pay the expense.

You can also use any one of the above approaches for income you don’t receive monthly.  If you use the third approach, you’ll put 1/12th of your actual annual income on the Income tab.

Monitoring Your Budget – What Happens When Your Actual Isn’t as Good as Your Budget

There are many reasons why your actual income and expenses might look worse than your budget.  You may have been planning to work overtime or get a second job to increase your income.  Those lifestyle changes can be challenging, so you might not have done them.

More likely, you spent more than you budgeted, either due to an emergency, an impulse purchase or difficulty in breaking long-standing habits.  Emergencies happen to everyone.  If possible, you’ll want to include building or re-building your emergency savings (see this post for more on that topic) in your budget. While overspending your budget can be problematic, especially if you do it continuously, don’t be too hard on yourself. Changing your spending habits is really hard.

A Few More Words about Budget

Congratulations!  You made it through the entire budgeting process. As I said in my first post on budgeting, staying on a budget is like being on a diet.  Just as every calorie counts, so does every dollar spent.  Sticking to your budget will increase the likelihood you will meet your financial goals, so do your best!

Download Budgeting Monitoring Spreadsheet Here

How to Budget Step 8 – Refining your Budget

Refining Your Budget

Very few people have a balanced budget on the first try.  This week, I’ll talk about how to refine your preliminary budget if it isn’t in balance.  I have been very fortunate in that it has been a long time since I found it challenging to meet my financial goals.  Also, I don’t know the specifics of any of your budgets, life-styles or financial goals. So, in this post, I will identify the changes you can make to refine your budget at a high level and provide links to articles by other financial literacy bloggers that provide a whole host of ideas on the specifics.  I hope that one or more of those articles will provide you with the ideas you need to successfully balance your budget.

The Bottom Line

The number on which you’ll want to focus is the Grand Total on the Budget tab.  If it is close to zero (i.e., within a percent or two of your total income) and you have incorporated all of your financial goals, you are done.  Otherwise, you’ll want to look at the section below that reflects your situation, i.e., whether the Grand Total is positive or negative, to learn how to refine your budget.

Your Budget Shows a Large Positive Balance

Congratulations!  If the value in the Grand Total line of the Budget tab shows a large positive number, you have more income than you are spending and saving.  You are among the fortunate few.

Before spending your excess income, you might want to review your financial goals.   Questions you could ask yourself include:

  • Do I have emergency savings of three to six months of expenses?
  • Are there other large purchases I’d like to make in the future?
  • Do I have enough savings to take maternity/paternity leave?
  • If you have children, am I saving for their education?
  • Have I studied the full costs of retirement and am I saving enough?
  • Have I contributed the maximum amounts to all of my tax-advantaged retirement savings accounts (IRAs and 401(k)s in the US, RRSPs and TFSAs in Canada)?
  • Do I want to retire sooner (which would require more savings now)?

If you still have a positive balance after your review, you can consider increasing your discretionary expenses (possibly a newer car or a nice vacation or the addition of a regular treat).  Of course, there is never any harm in increasing your savings.

Your Budget Shows a Large Negative Balance

A large negative balance is much more common than a large positive balance.  I wish I could give you a magic answer to resolve this situation, but there are really only three options.

  • Increase your income.
  • Decrease your expenses.
  • Borrow money either from a third party or by drawing down your savings.

Unless absolutely necessary, I suggest avoiding the third option.  If your expenses exceed your income and you make up the difference by borrowing either from your savings or a third party, you are likely to have a worse problem next year.  Unless either your income or expenses change, it can lead to a downward spiral.

Increase Your Income

Increasing your income can be a more effective way to balance your budget.  However, it has its own challenges and often requires a significant investment of your time and/or money.   Examples of ways to increase your income include:

  • Get a part time job, but make sure it won’t jeopardize your primary job.
  • Work overtime if you are eligible.
  • Make sure you are earning a competitive wage by looking at relevant salary surveys. If you aren’t, ask your boss for a raise, such as described in this post, or look for another job in your field that pays more or offers more benefits.
  • Consider getting more education that will provide you with the opportunity to make more money in the future. Some employers will pay for some or all of your tuition if the additional education is related to your job.  This choice is likely to cause more pain in the short term, but can produce large benefits.  As an example, check out this post.
  • Sell things that you don’t need. Here is a  post on this topic.
  • Start your own business. This option is one that I suggest you pursue only very cautiously if you already have a tight budget.  Starting a business can be very expensive, which of course will put further pressure on your budget.  Also, a large percentage of new businesses fail which means the owners lose money. According to Investopedia, 30% of business fail within two years of opening and 50% fail within five years.  Of those that survive, one source indicates that many business don’t make money until the third year.  If you want to start a side business, turning a hobby into a business is one of the most fun ways to do so.  Here is an article with some suggestions on how to do so.
  • There are hundreds of articles about “side hustles.” I’ve provided a few examples. There are lots of pitfalls with side hustles, including many that might end up costing you money rather than making it. So, as with starting your own business, I suggest exercising caution if you decide to proceed with one or more of them.

Decrease Your Expenses

To be blunt, it is hard to decrease your expenses.  Here are some tips on things to consider:

  • Separate your discretionary expenses from your required expenses. Required expenses include the cost of basic housing, a basic car, gas, groceries, medical care, insurance and the like.  Discretionary expenses are things you could live without, even if you don’t want to.  Here are several posts I’ve seen that provide ideas on how to cut back on discretionary expenses.
  • Review the amount you pay for your necessities to see if you can reduce any of these costs. Here are several posts that provide some ideas.
    • 40 Smart Ways to Reduce Your Monthly Bills
    • 5 Ways To Save $532.30 On A Tight Budget
    • This post focuses specifically on your cell phone bill.
    • This post discusses your energy costs.
    • I really like this post as it covers one of my biggest areas of savings – cooking at home instead of in restaurants. Here is another variation on the same theme.
    • Figure out how much you are spending to pay off your debts, particularly if you have a lot of credit card debt. Research ways to re-finance your debt to reduce interest rate or, if necessary, lengthen time to payment.  For example, if you have something you can use as collateral, a collateralized loan will have a much lower interest rate than your credit cards. See my post on loans to understand the factors that affect the interest rate on a loan and the sensitivity of your monthly payments to changes in interest rates and term.  This post has a lot of great information on re-paying student loans. I also like this post which talks about refinancing student loans – are you ready for it and some options.
    • There are dozens (hunderds?) of blogs on FIRE (Financial Independence, Retire Early). These bloggers tend to post their personal stories about how they are living very frugally so they can retire very early.  Although many of their approaches seem almost draconian, reading one of more of their posts might give you some ideas how you can cut back on your expenses.

There are a few other expenses you can adjust to balance your budget, but I suggest you do them only after you have fine-tuned your budget and looked into re-financing your debt.

  • Reduce the amount you set aside for savings. Clearly, covering the basics, such as food and shelter, take priority over meeting your longer-term financial goals.   Once you have covered those expenses, you’ll need to balance your short-term wants with your long-term goals.  For example, you’ll need to decide whether you want to spend more today on entertainment or put more into your savings so you can have the retirement you desire. The idea of foregoing things today to the benefit of something you will get in the future is called delay of gratification.  It is a difficult concept to implement in practice but is often a key to long-term financial success.
  • Avoid taking on too much more risk. For example, one way to save money on insurance (cars, homeowners/renters or health) is to increase your deductible, lower your limit of liability or, in the case of car insurance, not purchase physical damage coverage.  As I discussed in my post on making financial decisions, these choices reduce your upfront cost, but can have serious consequences in an adverse situation.  If your budget is tight, you may not be able to afford to pay your full share of costs in the case of a serious accident, damage to your home or serious illness.

Closing Thoughts

Working to refine your budget to bring it in balance can be a real challenge. If you can’t do it on the second or third try, be patient with yourself. Learning to be financially responsible is often a long, challenging process.

How to Budget Step 7 – Create your Budget

Creating Your Budget

You made it!  This week your only task will be to create a first draft of your budget.  

Budgeting can be challenging as you try to balance your long-term goals with your short-term needs and wants.  As such, I suggest creating it in two steps. This week I’ll provide guidance on creating the first draft of your budget.  Next week’s post will talk about how to refine it.

Practical Steps

To create your budget, you will enter values in Column D of the Budget tab of your spreadsheet.  As long as you don’t enter values in Column D of any of the “Total” rows, the formulas will automatically calculate those values.

While the spreadsheet was built to be fairly flexible, one of its weaknesses is that it is not easy to add or delete income or expense categories once you have started entering your budget amounts.  So, before you get started, I suggest making a final review of the line items on the Budget tab. If you need to make changes, you can look back at last week’s post for the instructions.

If you find you need to add or delete a line after you have entered budget amounts, here’s what you’ll need to do:

  1. Make a note of the budgeted amounts of all of the line items you’ve entered.  
  2. Add or delete the line item name according the instructions in the last week’s post.
  3. Copy the formula from cell D110 to all of the cells into which you previously typed values.  You can copy a formula by:
    1. Going to cell D110.
    2. Holding down the Ctrl key and hitting C.
    3. Moving your cursor to cell D11.
    4. Holding down the shift key and then hitting the down arrow until all of the cells into which you entered values are highlighted.
    5. Holding down the Ctrl key and hitting V.
  4. Re-enter the budget amounts that you noted.

If you don’t take this approach, some or all of your category names in Column A will change rows, but your budgeted amounts in Column D will stay in the same rows.  You’ll end up with a mismatch between category names and budget amounts.

Budget Amounts

For each line item in your budget, you’ll need to select a budget amount.  These selections will require your informed judgment. Things to consider in making your selection include:

  • How much you’ve recorded in each category over the past several weeks, as shown in Column B.
  • Any changes in your income or expenses you anticipate in the next several months.  
    • Some of these changes might result from life changes – a new job, moving, getting a roommate, getting married, having children or the like.
    • Other changes might result from intentional changes in your habits – fewer meals in restaurants, hiring a cleaning service, newly carpooling, among others.
    • You’ll also have changes from prior expenses if you change your spending or income to better align with your financial goals.
  • If you’ve used the tax approximation, the amounts in Column C for Federal and State/Provincial income taxes.
  • The goals you set as described in my post on setting financial goals.  You might want to increase one or more of your emergency savings, savings for a designated purchase (vacation, house, new car) or long-term or retirement savings.

Final Steps for This Week

Once you have completed your first draft, take a look at the value in Column D of the Grand Total row.  If that value is positive, it means you have more income than expenses and additions to savings. If it is negative, your expenses and savings goals are higher than your income.  In this href=”https://financialiqbysusieq.com/how-to-budget-step-8/”>post, I’ll talk about things you can do so the value is close to zero.