Why I Don’t Hold the All Seasons Portfolio

The All Seasons Portfolio reports amazing statistics about its returns.  I’d never heard of the All Seasons Portfolio, so had to check it out.  As I’ll discuss in more detail, it is an asset allocation strategy with more than 50% of the portfolio allocated to US government bonds.  In this current environment of low interest rates, one of my followers asked my opinion of the portfolio as an investment strategy for the near future.  The answer is, as is almost always the case, it depends.  However, after studying the portfolio and relevant data, I won’t be aligning my portfolio with the All Seasons Portfolio.

In this post, I’ll define the All Season Portfolio, talk about when each of the components of the portfolio is expected to perform well and provide a wide variety of statistics regarding its historical performance.  I’ll also talk about the need to re-balance assets to stay aligned with the portfolio and the impact of income taxes on your investment returns.  I’ll close with how I’ve changed my portfolio based on this analysis.

All Seasons Portfolio

Ray Dalio is an extremely successful hedge fund manager.  If you have more than $5 billion in investable assets, he might consider accepting you as a client.  His fund is famous for the All Weather investment strategy.  According to Tony Robbins, in his book MONEY Master the Game, the annual returns on the All Weather portfolio exceed 21%![1]

Composition of Portfolio

In an interview with Robbins, Dalio described a much simpler version of the All Weather portfolio for the rest of us.  This asset allocation is called the All Seasons portfolio.  The allocation in the All Season portfolio[2] is:

  • 40% in Long-Term US Bonds (20+ years), using the iShares Barclays 20+ Year Treasury Bond fund (ticker symbol TLT)
  • 15% in Intermediate US Bonds (7-10 years), using the iShares Barclays 7-10 Year Treasury Bond fund (ticker symbol IEF)
  • 5% in Gold, using the SPDR Gold Trust (ticker symbol GLD)
  • 5% in Commodities, using the PowerShares DB Commodity Index Tracking fund (ticker symbol DBC)
  • 30% in the S&P 500

This allocation is illustrated in the pie chart below.

Economic Indicators

The portfolio’s name, All Seasons, refers not to the four seasons of the calendar year but to four indicators of the economic cycle.  These four indicators are:

  1. Higher than expected growth (often measured using gross domestic product or GDP)
  2. Lower than expected growth
  3. Higher than expected inflation (often measured using the consumer price index or CPI)
  4. Lower than expected inflation

I note that there is overlap between the first pair of characteristics and the second pair.  That is, a period of higher than expected growth can have either higher or lower than expected inflation.

The chart below shows which of the five components of the portfolio are expected to perform well in each part of the economic cycle, according to Robbins.[3]

GrowthInflation
Rising

Stocks

Commodities

Gold

Commodities

Gold

FallingTreasury Bonds

Treasury Bonds

Stocks

Historical Performance

According to Robbins[4], the All Seasons portfolio had a compounded annual average return of 9.7%, net of fees, from 1984 to 2013.  By comparison, I calculate the corresponding value for the S&P 500 to be 8.4%.  In addition, the All Seasons portfolio had much lower volatility, with a standard deviation of 7.6%, as compared to the S&P 500 which had a standard deviation of 17%.  So, at first glance, the All Seasons portfolio seems to be a terrific option – higher return for lower risk.

My Estimate of Returns

There are many challenges to calculating the returns on the All Seasons portfolio.[5]  I made many assumptions to better understand the returns, so do not consider the statistics I’ve calculated as accurate, but I think they are close enough to be informative.

The chart below shows the annual returns on the S&P 500 and my approximation of the returns on the All Seasons portfolio from 1963 to 2019.

From this graph, it appears that the biggest benefit of the All Seasons portfolio is that the non-S&P 500 asset classes diversify away a substantial portion of the significant negative returns on the S&P 500.  For example, in the three years in which the S&P 500 had returns worse than -20%, I approximated that the All Seasons portfolio lost an average of only 0.1%!

Returns by Asset Class

I wasn’t able to get a long enough history of Commodity price data, but was able to calculate the average return on the three other asset classes during those same years (1974, 2002 & 2008), as shown in the table below.

Asset ClassAverage Return in Years when S&P 500 Return was < -20%
S&P 500-30.5%
7-10 Year US Treasury Bonds8.0%
20 Year US Treasury Bonds15.2%
Gold33.5%

As can be seen, all three asset classes had positive returns in those three years, with Gold having the most significant increase.

My Investing Goals

I retired a little over two years ago, so have changed my investing goals to make sure I can meet my cash needs as I don’t have any earned income to cover my expenses.  Specifically, now that I’ve switched from the accumulation phase to the spending phase, I have less tolerance for volatility.

Goals While Accumulating

While I was accumulating assets, I wanted my invested asset portfolio to produce returns that were at least as high as the overall market.  I use the S&P 500 as my metric for market performance.  During that time, I was quite willing to tolerate the ups and downs of the market because I was diversifying my risk over time.  As a confirmation of my risk tolerance, I point out that I did not sell any assets during any of the market “crashes.”

My first market crash was October 19, 1987.  I can still remember being in the office that day.  The internet was not available to the general public, so our news came from TV and radio.  One of the senior people in the office had a TV in his office, though I suspect it had just the over-the-air channels as very few people had cable TV then either.  He told everyone what was happening in the market.  I asked him whether he was going to move his 401(k) money out of the market into a safer fund.  His advice was that it was already too late and that I should just hang on for the ride.  That was one of the best pieces of investing advice I’ve ever gotten.  I didn’t sell during that crash and haven’t sold during any of the crashes since.

Goals While Retired

Now that I’m retired, I am drawing down my assets.  I’ve made two changes to my asset mix to reflect the fact that I now need to spend my assets rather than add to them.

  1. Instead of having a six-month emergency fund in cash, I now have several years of expenses in cash.
  2. I’ve added a few individual corporate bonds (to be clear, not a bond fund) that mature in 3 to 5 years to my portfolio. When these bonds mature, they will add to my cash balance to cover my expenses in those years.

For the rest of my invested asset portfolio, I’ve maintained the same goal – meet or beat the S&P 500.

By having several years of expenses in cash, I know I won’t have to sell any assets during any market turmoil, such as we are experiencing now.  As discussed in my post on reacting to the most recent crash, the market has historically recovered in less than five years (excluding the crash of 1929) and has higher than average returns during the recovery phase.  As such, I don’t want to have to sell stocks when markets are down.

How I Evaluate the All Seasons Portfolio

As I said, my goal is to earn a return close to or higher than the return on the S&P 500.  I would be willing to take a small reduction in return for less risk, but not much given the other aspects of my strategy.  Therefore, I will look at the components of the All Seasons portfolio relative to what I can earn if I just invest in the S&P 500.

In particular, I am interested to see how these asset classes perform when interest rates are low, as they currently are.

Bonds

Returns on bonds (unless held to maturity) and bond funds have the following characteristics:

  • The total return is equal to the interest rate on the bond plus the change in market value from changes in interest rate levels.
  • Returns are higher when interest rates are high or are going down.
  • The total return is similar to the interest rate itself when interest rates stay fairly stable.
  • Returns are lower when interest rates are low or are increasing.

Bond Returns vs. Interest Rate Changes

This relationship can be seen in the chart below which compares the change in the 10-year US Treasury bond interest rate (yield) with the change in the market value of iShares Barclays 7-10 Year Treasury Bond fund (ticker symbol IEF) in each year from 2003 through 2019.

What Can Happen from Here

We are currently in the last situation listed above.  Interest rates are currently quite low by historical standards.  The chart below which shows the yield on the 10-year US Treasury bond from 1962 to 2020.  The last point on the chart is the interest rate on July 8, 2020 of 0.65%.  It is lower than the interest rate at the end of any year since 1962.

For all intents and purposes, interest rates can do one of two things from their current levels – stay about the same or go up.  If they stay the same, the return on bonds funds will be about the same as the interest rate on the bonds – currently less than 1% for 10-Year US Treasury bonds and less than 1.5% for 30-Year US Treasury bonds.  If interest rates go up, the market value of the bonds will go down and returns will be even lower.

As such, I don’t believe the returns on bonds or bond funds in the near term will be high enough to be consistent with my investing objectives.  I will continue to buy individual corporate bonds that mature in the next few years to ensure that I have cash available to meet my expenses.  But, I do not plan to add any bond funds to the investment portion of my portfolio.   If I were younger and the time until I needed to draw down my investments to cover my expenses was longer, I wouldn’t invest in bonds at all in the current environment.

Gold

I am particularly interested in how gold has behaved, as it isn’t something I’ve studied much.  For the current environment, I’m interested in how gold behaves when interest rates are flat or rising.  The chart below shows how I defined historical periods as having interest rates that are either flat or rising.

The line is the same line shown in the 10-Year Treasury Interest Rate chart above.  I have shaded periods in which interest rates have been relatively stable in blue.  The time periods in which interest rates have increased are highlighted in green.

The chart below has the same time periods shaded as the previous chart, but the blue line shows the percentage change in the price of gold between 1971 (when the price of gold was no longer set by the US government) and today[6][7].

Looking back to the 1970s, gold prices were generally up quite significantly when interest rates were either relatively flat and when they increased.  While the increases in price were not as large in the period from 2003 to 2006, another time period when interest rates were flat, as in the 1970s, annual price increases were still generally in the 10% to 30% range, much higher than would be expected on the S&P 500.  Only in the most recent flat period are changes in gold prices not as consistently high.

Gold Funds

Buying gold means that you have to find a way to take delivery of it or pay to have it stored.  One article about the All Seasons fund suggested investing in SPDR Gold Shares[8] (ticker symbol GLD) which is an exchange-traded fund (ETF) physically backed by gold.  I compared the changes in prices of this ETF with the changes in the price of gold.  Although they generally track each other, as shown in the chart below, they are not a perfect match.  Nonetheless, this ETF appears to be a much easier alternative for investing in gold than buying gold itself.

Commodities

I wasn’t able to get a long history of returns on commodities, but the table I provide earlier from Robbins’ book indicates that they are expected to behave in a manner similar to gold.

Overall Portfolio Evaluation

The chart below summarizes the annual average returns (on a compounded basis) for each of the asset classes for which I could approximate returns from 1963 to 2019[9].

Over this time period, it appears that Gold has had returns similar to that of the S&P 500, but the returns on US Treasuries have dragged down my estimate of the returns on the All Seasons portfolio.

I am particularly interested in how these asset classes perform when interest rates are either flat or increasing.  The chart below illustrates these returns using the same approximations as above.

In average in both rising and flat interest rate environments, gold has historical outperformed the S&P 500.  By comparison. both categories of bonds have underperformed and, in fact, have had average returns during those periods of roughly 0%.

Re-Balancing

The performance metrics reported by Robbins and others assume that you maintain the target mix in each asset class.  To accomplish that, you need to sell asset classes that have appreciated the most (or depreciated the least) and buy asset classes that have not performed as well.

What is Re-Balancing

Let’s look at an example.  At the beginning of a year, you invest $10,000 using the All Seasons portfolio.  Your portfolio looks like this:

If your one-year returns were similar to those in 2019, your end of year asset allocation (light green) would not be the same as your target (dark green), as shown in the graph below.

To reach the target allocation, you would need to make the following changes.

GoldSell $44
CommoditiesBuy $28
StocksSell $451
Medium Term BondsBuy $399
Long Term BondsBuy $67

To attain the high returns reported by Robbins, I suspect you need to re-balance the portfolio fairly often.  In my calculations, I assumed annual re-balancing on the first of each year.  How often you re-balance the portfolio depends on your personal preference, but should generally be more often when the prices of one or more of the asset classes is changing rapidly and no less often than annually.

Impact of Income Taxes

It is better to own portfolios you need to re-balance regularly in a tax-free or tax-deferred account.  Otherwise, you will need to pay income taxes on the net of your capital gains and capital losses.  401(k)s and IRAs are the most common tax-free and tax-deferred accounts in the US.  The Canadian counterparts are TFSAs and RRSPs.

Continuing the example above, you sell $44 of gold and $451 of stocks for a total of $495.  Without going into the details of the calculation, your cost basis for these two sales combined is $387, for a realized capital gain of $108.  Many Americans have a 10% tax rate on capital gains which corresponds to $11 on the capital gain of $108.  These taxes reduce your total return by 0.1 percentage point.  That might not sound like much, but it can add up.  If you make a $10,000 investment in this portfolio and taxes reduce your return from 10.0% to 9.9%, you will have $5,000 less after 30 years.  That’s half of the amount of your initial investment!

Changes I’ll Make to My Portfolio

The analysis presented in this post has refined my thinking about my portfolio in two ways.

First, I have confirmed my past thinking that I can maintain a substantial cash position, supplemented by some individual bonds held to maturity, as a hedge against the risk that the stock market will have a significant downturn.  Although holding several years of expenses in cash lowers the return on my total assets, I find it a much easier and less risky strategy than introducing bond funds into my portfolio.  That is, although the return on money market funds where I hold my cash is low, it isn’t much lower than the current returns on US treasury or even high-quality corporate bonds.  With the significant potential that the market price of bonds will go down, I am more comfortable with my cash position.

Second, I have invested in the SPDR Gold Trust (ticker symbol GLD).  I don’t plan to immediately move as much as the 7.5% of my portfolio into gold as suggested by the All Seasons portfolio (15% if I use gold as a substitute for commodities, too).   Rather, I plan to initially invest 1% to 2% of my portfolio in gold and add to that position as I gain more comfort and experience investing in it.

Footnotes

[1] Robbins, Tony, MONEY Master the Game, Simon & Schuster Paperbacks, 2014, p. 391-392.

[2] “Robbins’ All-Seasons Portfolio.” TuringTrader.com, https://www.turingtrader.com/robbins-all-seasons/.  Accessed July 5, 2020.

[3] Robbins, op. cit., p. 390

[4] Robbins, op. cit., p. 395.

[5] There are many components of the calculation of returns, including assumptions regarding frequency of reinvestment and fees and the choice sources of data used to calculate the returns of the components of the portfolio.  As such, I am not able to replicate his calculations.  In fact, I found another source for returns on the All Seasons portfolio that, in the single year for which details were provided both sources, shows a return that was 3 percentage points higher than reported by Robbins.

[6] “Historical Gold Prices.” CMI Gold & Silver, Inc, https://onlygold.com/gold-prices/historical-gold-prices/, Accessed July 7, 2020.

[7] “Gold Prices.” World Gold Council, https://www.gold.org/goldhub/data/gold-prices, Accessed July 8, 2020

[8] “Bringing the gold market to investors.” State Street Global Advisors, https://www.spdrgoldshares.com/.  Accessed July 8, 2020.

[9] As indicated above, the returns I calculated for the All Seasons portfolio are not as high as were calculated by Robbins.

How to Buy Life Insurance

How to buy life insurance

Choosing the right type of life insurance policy and its death benefit can be confusing. Not too long ago, I published a guest post from Baruch Silverman of The Smart Investor on the different types of life insurance. In this post, you’ll learn how to buy life insurance.  Specifically, I’ll help you evaluate which, if any, of those types of policies fit your situation and how to select your death benefit.

Why are You Buying It?

The first thing you want to consider is why you are buying life insurance. Three common purposes are:

  • the death benefit.
  • the investment returns.
  • sheltering gifts to your heirs from income taxes.

Death Benefit

If your primary purpose for purchasing life insurance is the death benefit, you’ll want to focus on term and whole life insurance.

Investment Portfolio

Some people use life insurance similar to other financial securities (such as stocks and bonds). Variable life and universal life have investment components to them. In simplified terms, the total amount you pay as premium for these types of life insurance is split between the amount to cover the cost of a whole life policy and the excess which can be invested. As such, the life insurer doesn’t invest the portion of premium related to the death benefit.  Further, the life insurer reduces the excess to cover its expenses, a risk charge and its profit margin before investing it.

Variable and universal life policies include the cost of whole life insurance.  Thus, only people who want the coverage provided by whole life insurance might consider using life insurance as part of their investment portfolio. Even then, the returns may not be as high as other investment vehicles with similar risk because of the additional costs charged by the life insurer.

Tax Shelter

Sheltering gifts to your heirs from income taxes only applies to the very wealthy (those who have more than $11 million in assets). I’m assuming that the vast majority of my readers aren’t in this situation, so won’t address it here.

Other Considerations

All types of life insurance can have an indirect impact on your investment portfolio. If you purchase life insurance in an amount that will cover your dependents’ basic living expenses, it allows you the option to invest your portfolio in riskier assets in anticipation of getting higher returns. That is, the death benefit itself could be considered a low-risk investment.  It reduces your overall portfolio risk when added to the other assets you own.

Do I Need Life Insurance?

Some people don’t need the death benefit from life insurance. In that case, it doesn’t make sense to buy life insurance as an investment security either. In the last section of this post, I provide the details of estimating your target death benefit. People whose target death benefit is zero are those who don’t need life insurance.   Briefly, characteristics of people who have a target death benefit of zero are:

  • Their available assets are more than their debts. Available assets exclude any illiquid assets (such as any real estate or personal property they own), savings for their dependents’ retirement (but not their retirement as they don’t need retirement savings after you die), emergency savings and any savings designated for large purchases.
  • They have enough money to cover their dependents’ education expenses.
  • Their dependents can support themselves on their existing income plus your available assets, including being able to make debt payments as they are due or after using available assets to pay off any debts.
  • They have enough money to pay any end-of-life expenses related to their death.

If you aren’t sure if you meet these criteria, keep reading!

Term vs. Whole

If  you’ve decided that you are buying life insurance for the death benefit, you need to decide whether term life or whole life insurance will better meet your needs. The primary differences between the two options are the length of time you need the insurance and the cost.

Term Life

If you think you will need life insurance for a limited period of time, term life insurance is likely better for you. For example, you might have dependents who aren’t currently able to cover their living expenses and the cost of any debt.  In that case, you might want to buy life insurance that will pay off your debts and support your dependents until they are independent.  If your needs change, many insurers will let you convert a term life insurance policy to a whole life policy without having to provide medical information or have a physical, one or both of which are often pre-requisites for purchasing whole life insurance.

Term life premiums are constant over the term of any policy you purchase. However, if you buy a policy when you are older, the premium will be higher than if you buy the same policy when you are younger.

Whole Life

If you think you will need life insurance for your entire life, whole life insurance is likely better for you. For example, if you have a spouse or disabled children who will never be able to support themselves, whole life insurance could supplement your savings to help make sure they are able to live more comfortably, regardless of when you die.

In addition to the death benefit, whole life insurance gives you the option to borrow money. As you pay premium, life insurers designate a portion of your premium as the cash value. The cash value is always owned by the insurance company, but you are able to borrow an amount up to the cash value at any time without prior approval, any collateral or impact on your credit score. The interest rates on cash-value loans are less than many other sources, particularly credit cards. If you die before the loan is re-paid, the amount of the loan will be deducted from your death benefit.

Cost Comparison

Whole life insurance is much more expensive than term life when you are young, but eventually becomes less expensive.

Probability of Dying

The graph below provides some initial insights into the difference in cost between whole life and term life, as it shows the probability that you will die at each age. I calculated the values based on 2016 data from the Social Security web site.

Not surprisingly, the probability you will die increases at each age. If you buy whole life insurance, it will cover the entire portion of the graph from your current age until you die. As such, there is a 100% probability that the life insurer will pay your death benefit (assuming you continue to pay your premiums). It is just a question of when.

If you buy a 20-year term policy and you are 30 years old, only the deaths that occur in the portion of the graph below highlighted in green would be covered. That is, you will receive the death benefit if you die between ages 30 and 50 and will get nothing if you die after age 50.

The probability you will die is much smaller in this narrow window than the 100% probability you will die at some point.

Present Value of the Death Benefit

There are many factors that determine the premium for term life and whole life insurance policies, but the most important component relates to the death benefit. Actuaries (who help price life insurance) usually base the portion of premium related to the death benefit as the present value of the death benefit expected to be paid, on average, in each year.

One-Year Term Policy

The chart below shows the present value for $1 of death benefit for several sample policies. For illustration only, I have calculated the present values using a 3% interest rate and the probabilities of dying from the charts above.

The easiest way to see the impact of the increasing probability of dying is to look at the present value of the death benefit for a 1-Year Term Life policy. You can see it increases from almost zero (actually $0.0015 per dollar of death benefit) at age 25 to $0.042 per dollar of death benefit at age 70 which corresponds exactly to the increase in the probability of dying at each age.

Policies with Longer Terms

There are also increases in the present value of the death benefit for the Whole Life and 20-Year Term Life policies as the age you first start buying the policy increases.

You can also see that the present value of the death benefit at age 25 for the Whole Life policy is much, much larger than the present value for either of the two term life policies. This relationship corresponds to the graphs above which compared the probability of dying in a 20-year period as compared to the 100% probability that you will die at some point.

The difference between the Whole Life and 20-Year Term Life policies is fairly small at age 70, because there is a high probability that you will die between age 70 and 90 – the period covered by the 20-Year Term Life policy. In fact, almost 80% of people age 70 will die during the 20-Year Term Life policy period.  As such, the present value of the death benefit for a 20-Year Term Life policy at age 70 is very roughly 80% of the present value of the death benefit for a Whole Life policy.

Annual Premium

The insurance company collects premium over the full life of the insurance policy to cover the present value of the death benefit. That is, you don’t pay all of your premium to the insurance company in one lump sum, but rather on an annual or monthly basis.

Unless you die during the policy term of the Term Life policy, you will pay premium for more years under a Whole Life policy than under a Term Life policy. Therefore, the differences you see above are larger than the differences in premium payments.

Illustration

The chart below shows the annualized amount of the loss costs. That is, I divided the present values of the death benefits by the average number of years an insured is expected to pay their premium. For example, for the 20-Year Term Life policy, the denominator was calculated as the sum of the probabilities that the insured would be alive in each of the 20 years and therefore able to pay his or her premium.

Post 49 Estimated Premium

Although these relationships are not precise, they are roughly representative of the differences in annual premium you might pay for the different types of policies at different ages. At age 25, the annual cost of a Whole Life policy in this illustration is roughly three times the cost of either of the Term Life policies. By age 70, the annual cost of a Whole Life policy is less than the cost of 20-Year Term Life policy because, while the present value of the death benefit isn’t all that different between the two policies, people who buy Whole Life policies make more premium payments, on average.

Reality vs. Illustration

It is important to understand that I prepared these examples as illustrations to help you understand the differences between Whole Life and Term Life insurance premiums. In practice, life insurers use different tables showing the probability of dying and different interest rates than I used for illustration, as well as using more sophisticated methods for calculating the present value of the death benefit and including provisions for expenses, risk and profit.

In practice, I’ve seen estimates that Whole Life annual premiums are anywhere from three to fifteen times more than Term Life premium at young ages. As you are looking at your options, you’ll want to get several premium quotes, as they vary widely depending on your age, location, gender, health and many other factors.

How Much to Buy

As with any financial decision, there are two conflicting factors that will influence the amount of the death benefit you buy on a life insurance policy – your budget and your financial needs. In the section, I will talk about how to estimate the best (i.e., target) death benefit for your situation. Once you’ve selected an amount, you can get quotes from several insurers to see whether the premium for that death benefit will fit in your budget or whether you will need to find the best balance between premium affordability and death benefit for you.

Rules of Thumb

Not surprisingly, there are some rules of thumb for guiding your selection of a death benefit. Some of the ones I’ve heard are:

  • Three to five times your salary
  • Ten times your total earned income (i.e., salary, value of benefits and bonus)
  • Ten times your total earned income plus $100,000 per child for college

Rules of thumb like these can provide some insights, but they, by definition, can’t take into account your personal circumstances.

Tailored Approach

A better approach for selecting a death benefit is to analyze your own finances and goals for buying life insurance.   I suggest calculating your target death benefit as the total of the amounts needed to meet your goals, considering the following components.

Debt

If you have debt, you’ll want to consider whether your dependents will be able to continue to make the payments on the debt out of their own income. For example, if your spouse’s earned income is high enough to continue to make your mortgage payments, along with all of the other expenses he or she will need to cover if you die, then you might not need to include the remaining principal on your mortgage as a component of your target death benefit. On the other hand, if you are concerned about your dependents’ ability to continue payments on any debt, you’ll want to include the outstanding principal on those debts as a component of your target death benefit. I’ll define this amount as “Debt Principal to be Pre-Paid.”

Final Expenses

When you die, your dependents will incur some one-time expenses. These expenses can include your funeral or memorial costs and professional expenses to settle your estate. I’ll call the amount of these expenses, “Final Expenses.”

Net Future Living Expenses

The next component of your target death benefit calculation is the amount you need to cover your dependents’ future living expenses.

Current Expenses

Start with your household’s total expenses from your budget. This amount will include monthly expenses for everyone in your household, the amounts you are setting aside each month for your designated savings and any amounts you are setting aside for your spouse’s retirement. To be clear, it will exclude any amounts you are saving for your own retirement.

You can eliminate any monthly expenses or amounts for designated savings for things that are only for your benefit. For example, if you spend enough money on clothes for your job to include it in your budget, you can eliminate those expenses. Similarly, you can also eliminate any expenses related to a vehicle that only you drive or designated savings to replace it.

Earned Income

You then need to calculate your dependents’ monthly earned income. This amount may be calculated in two parts – current monthly earned income and future monthly earned income. For example, your spouse may currently work part time as you are relying primarily on your income for support. If you die, your spouse may be able to work full time to increase his or her earned income. Alternately, your spouse may need some education (discussed below) to get the qualifications needed for his or her desired profession.

Extra Expenses

Next, you’ll need to calculate the amount of any expenses that your household will have because of any changes in your spouse’s availability to provide household services. For example, your spouse may work part-time while your children are in school and provide childcare after school. If your spouse starts working full time after your death, you will need to add after-school care expenses to your budget.

Time Periods

The last factor that goes into this calculation is the length of time until you think your dependents will become self-sufficient. For children, you might assume that they will become independent after they turn 18 or graduate from college. The ability of your spouse to become self-sufficient will be a function of his or her skills, education and/or need for more education and household responsibilities (e.g., childcare or elder care).

I suggest splitting the calculation of this component of your death benefit into three time periods – short-term, medium-term and long-term. For each time period, you’ll calculate your net living expenses as expenses minus income. For any periods for which income is more than expenses, set the difference to zero.

  1. Short term – During this time period, you’ll use your current monthly expenses, excluding your personal expenses, and your dependents’ current monthly earned income.
  2. Medium term – During this time period, you’ll use your current monthly expenses with adjustments for extra expenses for services currently provided by your spouse and your dependents’ future monthly earned income.
  3. Long term – During this time period, you’ll assume that your children (other than those who will always be dependent on you for care) are self-sufficient, so can eliminate all expenses related to children and their care from your expenses. You’ll use your spouse’s future monthly earned income. In many households, income in this period will exceed expenses so there may not be a need for death benefits to cover expenses in this period.

You also need to estimate how many months each of these three time periods will last.

Net Future Living Expenses

Your Net Future Living Expense amount for each time period is calculated as the number of months it will last multiplied by monthly net living expense amount. You can then calculate your total Net Future Living Expenses as the sum of the three amounts you calculated for the three time periods.

For those of you who like to see formulas instead of words, you will calculate:

  1. Short-term Net Expenses = Greater of 0 and Current Expenses – Current Income
  2. Medium-term Net Expenses = Greater of 0 and Current Expenses + Extra Expenses – Future Income
  3. Long-term Net Expenses = Greater of 0 and Future Expenses – Future Income
  4. Net Future Living Expenses = (number of months in short-term period x Short-term Net Expenses) + (number of months in medium-term period x Medium-term Net Expenses) + (number of months in long-term period x Long-term Net Expenses)

You could refine this amount by considering inflation and investment returns. Depending on your investment strategy and the time until the funds are used, your investment returns, on average, can be more than inflation. As a conservative first approximation, I suggest using the total without adjustment for inflation and investment returns.

Education

There are two types of education expenses that you might want to include in your target death benefit calculation:

  1. The portion of the cost of education for your children that you want to provide. Some people suggest $100,000 per child for college. This amount may or may not be the right amount depending on how much you expect your children to contribute to their educations, how many years of college education you want to support and what type of school they attend. Prestigious colleges can cost as much as $75,000 to $80,000 a year currently (2020), while in-state tuition (assuming your children live at home while attending college) can cost as little as $15,000 a year in some states. Other children may not go to college or may attend a trade school.
  2. The cost of any education your spouse needs or wants to allow him or her to work in a profession he or she enjoys and allows him or her to earn enough money to increase his or her independence.

Target Death Benefit Calculation

You can now calculate your target death benefit as follows:

Debt Principal to be Pre-Paid

Plus        Final Expenses

Plus        Net Future Living Expenses

Minus   Savings in excess of your real estate and personal property assets, emergency fund, designated savings and spouse’s retirement savings

Plus        Education Expenses

Minus   Amounts in existing college funds

Minus   Any amounts included in your Net Future Living Expenses designated for college

If you are single with no debt, this amount could be zero indicating that you might not need to buy life insurance. If you are married with no children, don’t have a lot of debt and have a spouse who can increase income or decrease expenses to be self-sufficient fairly quickly, you may need only a small death benefit. At the other extreme, if you have several children and a spouse who won’t be able to be financially independent for many years or ever, your target death benefit could exceed $1 million.   As you can see, the specifics of your financial situation are very important to setting a target death benefit and a rule of thumb may not work for you.

The Canada Pension Plan And Your Retirement

Canadian-Pension-Plans

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.

Graeme Hughes is an accredited Financial Planner with 23 years of experience in the financial services industry. During the course of his career he completed hundreds of financial plans and recommended and sold hundreds of millions of dollars of investment products. He believes that financial independence is a goal anyone can aspire to, and is passionate about helping others to live life on their own terms.

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:

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:

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:

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

I recently 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

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 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.

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.

 

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%.

 

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-Effective-Investing-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

Slay-Student-Debt

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-Effective-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

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