Tag: financial planning

Why I Don’t Hold the All Seasons Portfolio

Why I Don’t Hold the All Seasons Portfolio

The All Seasons PortfolioA group of financial instruments. More reports amazing statistics about its returns.  I’d never heard of the All Seasons PortfolioA group of financial instruments. More, so had to check it out.  As I’ll discuss in more detail, it is an asset allocation 

How to Buy Life Insurance

How to Buy Life Insurance

Choosing the right type of life insurance policy and its death benefitThe amount of money a life insurer pays you if you die during the policy term. More can be confusing. Not too long ago, I published a guest post from Baruch Silverman of The 

The Canada Pension Plan And Your Retirement

The Canada Pension Plan And Your Retirement

Note from Susie Q:  When I published my post on Social Security, I promised my Canadian readers a similar post about the Canada Pension Plan.  It took a while, but here it is!  Graeme Hughes, the Money Geek, was kind enough to write it for me.

The Canada Pension Plan (CPP) is a foundational part of all Canadians’ retirement plans, as it represents, for many, the single largest government benefit they will receive during retirement. Over the years, opinions on the plan have varied widely, with many suggesting that younger Canadians shouldn’t count on receiving CPP benefits in retirement.

As it stands today, is this a realistic opinion, or is the reality something different? How does the CPP work, and can it be relied upon to deliver a meaningful amount of pension income to future retirees?

How The Canada Pension Plan Differs From Old Age Security

There are two core retirement benefits that the vast majority of Canadians are eligible to receive: the Canada Pension Plan and the Old Age Security (OAS) benefit.

OAS is a benefit that is funded from tax revenue. Both eligibility and the benefit amount paid are based on the number of years an individual has been resident in Canada prior to his or her 65th birthday. Benefits may be reduced for high-income seniors.

The CPP, on the other hand, is a true contributory pension plan. This means that benefits are available only to those who have contributed, and the amount you receive is directly linked to the amount paid into the plan over your working life. CPP contributions are held separate and apart from other government revenue, and CPP benefits are not income-tested.

A Brief History of The Canada Pension Plan

The CPP has had more than 50 years of success in providing pension benefits to Canadian seniors. But a lot has changed along the way:

  • The CPP started in 1966 as a pay-as-you-go plan. In short, it was expected that contributions from workers each year would fully cover the benefits paid to retirees in the same year. The contribution rate for the first couple of decades was just 3.6% of a worker’s pay, which is a very modest amount, indeed.
  • In the mid-1980’s, it started to become clear to the federal government that this model would not be sustainable in the face of a large wave of baby boomers that would be retiring in future years, so changes had to be made. These involved increases to the contribution amounts, reductions in some benefits, as well as changes to the management of the plan itself.
  • These changes culminated in 1997 with the formation of the Canada Pension Plan Investment Board (CPPIB), an entity at arm’s-length from the government that would be entirely responsible for investing CPP assets and funding the distribution of CPP benefits going forward. This effectively removed the government from the management of the pension plan, and the new board was given one overriding mandate above all – to maximize the returns on invested assets while managing risk.
  • As of September 30, 2019, the CPPIB had $409.5 billion in assets under management.

Is the Canada Pension Plan Sustainable?

Many pension plans, both public and private, have been struggling with sustainability over the last many years given demographic changes (the retiring boomers) combined with very low yields on fixed-income investments which often form the backbone of pension assets.

Fortunately, the CPPIB has an oversight regime that continues to account for such changes. Canada’s Office of the Superintendent of Financial Institutions appoints a Chief Actuary, who has as one of their responsibilities a review of the sustainability of the CPP. This review is conducted every three years.

The last reported review, in 2016, concluded that the CPP would be able to fully meet its commitments for at least the next 75 years (the length of time covered in the review), as long as a target rate of return of 4% in excess of inflation was maintained.

In the CPPIB’s 2019 annual report, it was able to boast an average annual return over the preceding 10 years of 11.1% (net nominal). Portfolio investments include public equities, private equity, real assets and fixed-income instruments. The portfolio has widespread geographic diversification, with only 15.5% of assets invested in Canada.

The chart below, from the 2019 annual report, highlights the sustainability of the plan as reflected in the historical and forecast growth in assets:

Actual and projected assets of the Canadian Pension Plan

Clearly, the CPP is in great shape to serve the needs of Canada’s current and future retirees. Even if this should change at some point in the future, the Chief Actuary has the authority to adjust contribution rates to maintain sustainability, should that be necessary at a later point in time.

How Are CPP Contributions Calculated?

CPP contributions are based on an individual’s income, and split equally between employer and employee. Contributions are calculated on the amount of annual income earned that is between $3,500 (the lower cutoff) and $57,400 (the 2019 upper cutoff). Up until 2019, the contribution rate on these amounts had been 9.9%, but a new CPP enhancement that started in 2019 raised that to 10.2%.

As an example, an individual who earned $50,000 in 2019 would have a total CPP contribution of $4,743.00 ($50,000 – $3,500 = $46,500 x 10.2%). Half this amount would be paid by the employee and half by their employer. Of course, self-employed individuals are responsible for the full amount.

It’s important to note that, while the lower cutoff amount is fixed, the upper cutoff is adjusted each January to reflect changes in average Canadian wages. Remember too, that the contribution rate of 9.9% had been in place until last year, with the CPP “enhancement” starting in 2019. The impact of the enhancement will be looked at later in this article.

What Benefits Can I Expect from the CPP?

The “base” calculation for CPP benefits assumes an individual applies for benefits at the normal retirement age of 65. In 2019, the maximum benefit for new retirees under this base scenario is a CPP payment of $1,154.58 per month. All CPP benefits are adjusted each January to account for changes in the Consumer Price Index.

However, most Canadians do not receive that maximum benefit. The amount you actually receive is based on the contributions made to the plan from the age of 18 until the date you apply for CPP benefits. If your total contributions during those years averaged, say, 70% of the maximum contributions permitted, your CPP benefit at age 65 would be approximately 70% of the maximum amount payable.

In short, the higher your working wage, the more you will have paid into the plan, and the more you will receive in benefits, up to the applicable maximums.

There are also a variety of adjustments made to the calculation of your CPP entitlement. For instance, you are allowed to drop your 8 lowest-earning years from the calculation. There are also adjustments for years spent rearing children under the age of 7, for periods of disability and for other circumstances. For these reasons, calculating your potential future benefit at any point in time is virtually impossible to do on your own. Fortunately, the good folks at Service Canada are happy to do the work for you, and an estimate of your individual benefit can be obtained by phone, or online through your My Service Canada Account.

As of October 2019, the average CPP benefit Canadians were receiving amounted to just $672.87, or about 58% of the maximum.

Lastly, CPP benefits paid are fully taxable as regular income.

When Should I Apply for the Pension?

Although the “base” calculation for CPP benefits assumes retirement at age 65, in reality, you have the option of applying for benefits anytime between the ages of 60 and 70. However, the amount of benefit you receive will be adjusted accordingly:

  • If you decide to take your pension early, your pension will be reduced by 0.6% for every month prior to your 65th birthday that benefits begin. So, if you decide to start payments as early as possible, on your 60th birthday, you will receive a 36% total reduction in your entitlement (0.6% x 60 months).
  • Conversely, if you decide to delay the start of benefits, you will receive an extra 0.7% for every month after your 65th birthday that you delay taking benefits. So, delaying benefits all the way to your 70th birthday increases your monthly amount by 42% (0.7% x 60 months).

The chart below outlines the change in monthly benefit given the age at which benefits commence, assuming an individual was eligible for $1,000 per month at age 65:

Canadian Pension Plan benefits by age

As seen above, the difference between taking your Canada Pension at age 70 versus age 60 is significant. You’ll receive over double the monthly amount. But the decision as to when to apply depends on a number of factors.

A big factor is, of course, your views on life expectancy. If you enter your early 60’s in poor health, or with a family history of shorter life expectancy, you may want to take the CPP as soon as you are eligible. If the opposite is true, you may want to wait until age 70 to ensure you receive the maximum amount of this inflation-adjusted and government-guaranteed benefit, to protect against the risk of running short of savings and income later in life.

Of course, the amount and structure of your own savings, the amount and source of other retirement income, along with your actual date of retirement, will all weigh on your decision. If in doubt, consult a qualified financial planner to assess the merits of different options.

2019 Changes – The Canada Pension Plan Enhancement

Up until 2019, the CPP was designed to replace about ¼ of a person’s average employment earnings once they retire. The current government has decided that should be enhanced such that the CPP will eventually cover about ⅓ of pre-retirement earnings.

To accomplish this, and to ensure that the newly enhanced benefits are self-funding, the CPP enhancement is being operated almost like an add-on benefit to the existing CPP.  CPP contributions for employers and employees are being increased above the previous 9.9% rate, over time, as follows:

Canadian Pension Plan tax rates

In addition to the increased premiums noted above, the maximum annual earnings for CPP contributions will have an additional, “second ceiling” amount that will allow higher-income earners to contribute proportionately more to the CPP, starting in 2024.

The extent to which this CPP enhancement will increase your retirement benefits is dependent entirely on how much you individually contribute to the enhanced portion prior to retirement, both as regards the increased premium amount, as well as within the elevated earnings cap. However, those who end up contributing to the enhanced amount for a full 40 years could see their CPP benefits increase up to 50%.

Of course, if you are retiring in the next few years, you won’t have enough credit toward the enhanced amounts to make much of a difference to your benefits. These changes are really designed to have the most impact on younger workers who are in the earlier stages of their careers. Given the added complexity this new benefit adds to benefit calculations, it makes more sense than ever to keep track of your entitlement by obtaining occasional estimates from Service Canada.

More information on the CPP enhancement can be found here.

CPP And Your Financial Planning

In this article we have looked exclusively at the CPP as it pertains to retirement benefits. In addition, there are survivor, disability, and other benefits to consider as part of a well-rounded approach to managing personal finances. More comprehensive information on the Canada Pension Plan can be found on the pension benefits section of the Government of Canada’s website.

Remember that a good retirement plan is holistic and accounts for all sources of income, whether from government pension and benefits, employer-sponsored plans, personal savings or business ventures. Ideally, the information above will help with your planning and give you confidence that the CPP will indeed be there for you, regardless of your retirement date.

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 budgetA plan showing targets for income and expenses over a fixed time period, such as a month or a year. More.  Here is the start of it, to read the 

Annual Retirement Savings Targets

Annual Retirement Savings Targets

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 riskThe possibility 

The Best Ways to Pay Off Your Debt

The Best Ways to Pay Off Your Debt

The best way to pay off your short-term and revolving debt depends on your priorities and what motivates you.  Two of the common approaches for determining the order in which to re-pay your loans discussed in financial literacy circles are the Debt Snowball and Debt Avalanche approaches.

Both of these methods apply when you have more than one debt that needs to be re-paid.  If you have only one debt to re-pay, the best strategy is to pay it down as quickly as possible, making the minimum payments as often as you can to avoid finance charges which will be added to your principal in addition to the interest charges on any portion of your balance you don’t pay.

In this post, I’ll describe how the two debt-repayment methods work using some illustrations.  I will then help you understand which approach might be better for you.  For more information about the fundamentals of debt, check out my posts on loans and credit cards.

What’s Included and What’s Not

The debts covered by this post include credit cards (one kind of revolving debt), personal loans, car loans and other bills that are overdue. While longer-term loans, such as mortgages, are referenced in the budgeting process, I haven’t included them in the debt re-payment examples. If you have unpaid short-term debt, you’ll want to keep up with the payments on these longer-term loans first, but don’t need to pre-pay them. For this discussion, I will assume that you intend to re-pay all of your debts to your current debtholders. That is, you haven’t dug a hole so deep you need to declare bankruptcy and you don’t feel you’ll benefit from transferring some or all of your high-interest rate loan balances to one with a lower interest (i.e., debt consolidation).

Debt Snowball

Dave Ramsay, a well-known author on financial literacy topics, proposed the Debt Snowball method for paying off your debts.  Under this method, you do the following:

  1. Identify all of your debts, including the amounts of the minimum payments.
  2. Make a budget. (See this post for more on budgeting generally or this one for the first of a step-by-step series on budgeting including a helpful spreadsheet.) Your budget should include all of your expenses excluding your short-term and revolving debts but including the payments you plan to make on your longer-term debts (e.g., car loans and mortgages).
  3. Determine the total amount left in your budget available to re-pay your debts, remembering that you need to be able to pay for the total cost of all of your current purchases before you start paying off the balances on your existing debt. If the amount available to re-pay debts is less than the total of your minimum payments, you may need to look into your options to consolidate or re-structure your debts, get them forgiven or declare bankruptcy.
  4. Otherwise, make the minimum payment on all of your debts except the smallest one.
  5. Take everything left over in your budget from step (3) and reduce it by the sum of the minimum payments in step (4). Use that balance to pay off your smallest debt. After you fully re-pay the smallest debt, you’ll apply the remainder to the next smallest debt and so on.

Debt Avalanche

The Debt Avalanche method is very similar to the Debt Snowball method, except you re-pay your debts in a different order.

The first three steps under the Debt Avalanche method are the same as the first three steps under the Debt Snowball method.  It differs from the Debt Snowball method in that you pay the minimum payment on all of your debts except the one with the highest interest rate at any given time instead of the one with the smallest balance.

Examples

I’ve created the two examples to compare the two methods.  In both examples, I have assumed that you use a different credit card or pay cash for all new purchases until your current credit card balances are re-paid.  That is, to make progress on getting out of debt, you need to not only make extra payments on your existing debts, but also not create additional debt by borrowing to pay for new purchases.  It’s tough!

Example 1

In this example, you have two debts with the balances due, interest rates and minimum payments shown in the table below.

Example 1Balance DueInterest RateMinimum Payment
Debt 1$1,50020%$30
Debt 250010%10

You have determined you have  $100 available to pay off these two debts.  The minimum payments total $40 in this example, so you have $60 available to pay off more of the principal on your debts.

Example 1: Debt Snowball

Under the Debt Snowball method, you will use the additional $60 a month you have to pay off Debt 2 first, as it has the smaller balance.  That is, you will pay the minimum payment of $30 a month on Debt 1 and $70 a month on Debt 2 for 8 months, at which point Debt 2 will be fully re-paid.  You will then apply the full $100 a month to Debt 1 for the next 17 months until it is fully re-paid

Under this approach, you will have fully re-paid both debts in 25 months and will pay $428 in interest charges.

Example 1:  Debt Avalanche

In Example 1, you will use the additional $60 a month you have to pay off Debt 1 first under the Debt Avalanche method, as it has the higher interest rate, whereas you used the additional amount to pay off Debt 2 first under the Debt Snowball method.  That is, you will pay the minimum balance of $10 a month on Debt 2 and $90 a month on Debt 1 for 20 months, at which point Debt 1 will be fully re-paid.  You will then apply the full $100 a month to Debt 2 for the next 4 months until it is fully re-paid

Under this approach, you will have fully re-paid both debts in 24 months and will pay $352 in interest charges.

Example 2

In this example, you have five debts with the balances due, interest rates and minimum payments shown in the table below.

Example 2Balance DueInterest RateMinimum Payment
Debt 1$1,00010%$40
Debt 25000%25
Debt 310,00020%100
Debt 43,00015%75
Debt 57505%30

You have $500 available to pay off these debts.  In this example, the minimum payments total $270, so you have $230 available to pay off the principal on your debts in addition to the principal included in the minimum payments.

Example 2: Debt Snowball

Example 2 is a bit more complicated because there are more debts.  As a reminder, under this approach, you apply all of your extra payments ($230 in this example) to the smallest debt at each point in time.  In this example, you will make the additional payments on your debts in the following order:

Debt 2

Debt 5

Debt 1

Debt 4

Debt 3

It takes only two months to pay off Debt 2 and another four months to pay off Debt 4.  As such, you will have fully re-paid two of your debts in six months.  In total, it will take 43 months to re-pay all of your loans and you will pay $5,800 in interest.

Example 2:  Debt Avalanche

In this example, you will make the additional payments on your debts in the following order:

Debt 3

Debt 4

Debt 1

Debt 5

Debt 2

It turns out that Debt 2 is fully re-paid in 20 months even just making the minimum payments.  Debt 5 is paid off 7 months later again with only minimum payments, followed by Debt 1 2 months later.  As each of these debts is re-paid, the amounts of their minimum payments are added to the payment on Debt 3 until it is fully re-paid after 39 months.  At that point, the full $500 a month is applied towards Debt 4 which then takes only 2 additional months to fully re-pay.  In total, it will take 41 months to re-pay all of your loans and you will pay $5,094 in interest.

Comparison

Dollars and Sense – Two Examples

Looking at the two examples, we can get a sense for how much more interest you will pay if you use the Debt Snowball method instead of the Debt Avalanche method.  The table below compares the two methods under both examples.

Example 1Example 2
Interest PaidMonths of PaymentsInterest PaidMonths of Payments
Snowball$42825$5,80043
Avalanche352245,09441
Difference7417062

In these two examples, you pay more than 10% more interest if you use the Debt Snowball method than the Debt Avalanche method, leading to one or two additional months before your debts are fully re-paid.

Dollars and Sense – In General

The difference in the amount of additional interest depends on whether your debts are similar in size and the differences in the interest rates.  I’ll take that statement apart to help you understand it.

  • If the debt with the lower interest rate is very small, you will pay it off quickly.  As a result, there is only a very short period of time during which you are paying the higher interest on the larger loan under the Debt Snowball method.  As such, there will be very little difference in the total amount of interest paid between the two methods in that case.
  • If the debts all have about the same interest rate, it doesn’t really matter which one you re-pay first, as the interest charges on that first loan will be very similar to the interest charges on your other loans.

Dollars and Sense – Illustration

The graph below illustrates the impact of the differences in interest rates and sizes of two loans on the difference in the total interest paid.  To create this graph, I took different variations of Example 1.  That is, you have two loans with outstanding balances totaling $2,000 and the interest rate on the larger debt is 20%.

 

Interest saved using debt avalanche as compared to debt snowball

How to Read the Axes

The interest rate on the smaller loan was calculated as 20% minus the increment shown on the axis labeled on the right.  That is, the interest rate on the smaller loan for scenarios near the “front” of the graph was 18% or 2 percentage points lower than the 20% interest rate on the larger loan.  Near the “back” of the graph, the interest rate on the smaller loan is 0% or 20 percentage points lower than the interest rate on the larger loan.

The loan balance on the smaller loan divided by the total debt amount of $2,000 is shown on the axis that goes from left to right.  The small loan is $40 (2% of $2,000) at the far left of the graph and increases as you move to the right to $960 (48% of $2,000) on the far right.  Note that, if the small loan exceeded $1,000, it would have become the bigger loan!

The Green Curve

The green curve corresponds to the total interest paid using the Debt Snowball method minus the total interest paid using the Debt Avalanche method.  For example, at the front left, corresponding to the small loan being $40 with an 18% (=20% – 2%) interest rate, there is a $2 difference in the amount of interest paid.  At the other extreme, in the back right of the graph (0% interest rate on a small loan with a balance of $960), you will pay $167 more in interest ($308 versus $140 or more than twice as much) if you use the Debt Snowball method rather than the Debt Avalanche method.

What It Means

Interestingly, moving along only one axis – that is, only decreasing the interest rate on the small loan or only increasing the size of the smaller loan – doesn’t make very much difference.  In the back left and front right, the interest rate differences are only $15 and $22, respectively.  The savings from the Debt Avalanche method becomes most important when there is a large difference in the interest rates on the loans and the outstanding balances on the loans are similar in size.

Sense of Accomplishment

For many people, debt is an emotional or “mental-state” issue rather than a financial problem.  In those situations, it is more important to gain a sense of accomplishment than it is to save money on interest.  If you are one of those people  and have one or more small debts that you can fully re-pay fairly quickly (such as Debts 2 and 5 in Example 2 both of which were paid off in six months under the Debt Snowball method), using the Debt Snowball method is likely to be much more successful.

Key Points

Here are the key points from this post:

  • A budget will help you figure out how much you can afford to apply to your debts each month.
  • If you can’t cover your minimum payments, you’ll need to consider some form of consolidation, re-financing or even bankruptcy, none of which are covered in this post.
  • If you have only one debt to re-pay, the best strategy is to pay it down as quickly as possible, but making the minimum payments as often as you can to avoid finance charges.
  • You will always pay at least as much, and often more, interest when you use the Debt Snowball method as compared to the Debt Avalanche method.
  • Unless you have two or more debts that are all about the same size and have widely varying interest rates, the total interest you will pay is essentially the same regardless of the order in which you re-pay them.  As such, if the sense of accomplishment you get from paying off a few debts will help keep you motivated, using the Debt Snowball method may be the right choice for you.
  • If you have two or more debts that are all about the same size and have disparate interest rates, you will want to use the Debt Avalanche Approach.  Because the balances are all about the same, it will take about the same amount of time to re-pay the first loan regardless of which loan you choose to re-pay first!  As such, it is better to focus on the interest you will save by using the Debt Avalanche approach.

 

Tax-Efficient Investing Strategies – Canada

Tax-Efficient Investing Strategies – 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 assetsThe value of things the company owns and amounts it is owed More in the “best” account from a tax perspective. You 

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.  With Kate’s permission and approval, I’ve interspersed some comments and numerical examples in 

Tax-Efficient Investing Strategies – USA

Tax-Efficient Investing Strategies – 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 xx
Mutual Funds xxx
ETFsx
Bondsx 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 Step 9 – Monitoring your Budget

You may have thought you were done when you created and balanced your budgetA plan showing targets for income and expenses over a fixed time period, such as a month or a year. More.  However, there is one very important step left in the budgeting