Clients often ask me how high of a return can they expect from the portfolios I recommend. While I understand why they are focused on the potential returns, I always start my answer with my favourite rule when it comes to money: It doesn't matter what you make, it matters what you keep.
What is the point of making a big return if you erode your return by half? It is just not efficient investing. One force that will diminish your portfolio, even in spite of strong long-term investment returns, is taxes.
As Canadian residents, we must pay taxes: we pay tax on the income we earn, on items we purchase and on investment growth we make. Through proper planning and guidance with an advisor, you can determine how to become a tax wise investor by making sure that your investments are in the right type of account, depending on your situation.
RRSPs (Registered Retirement Savings Plans) and TFSAs (Tax Free Savings Accounts)
Each of these accounts can hold a broad range of investment vehicles such as stocks, bonds, GICs or mutual funds but each has different characteristics. Particularly important are the rules regarding how deposits and withdrawals are treated at tax time.
Understanding the mechanics of these types of accounts and how they can help you achieve your goals will make a big difference when the time comes to use your investments to finance your retirement -- and we know from the Sun Life Canadian Unretirement Index that the average expected retirement age in Canada is 66.
One popular question: who should be using an RRSP and who should be using a TFSA?
RRSPs are ideal for people who get paid a salary. Business owners, for example, have the opportunity to take income in other, more tax advantaged forms such as dividends. Often, these strategies are more tax efficient in the long run than paying themselves an income and then contributing to an RRSP. As well, RRSPs are well suited for people who earn over a certain amount of income. The specific amount depends on which province you are in.
For example, in 2014, the blended marginal tax rate for Ontario residents is 33 per cent for every dollar that they earn over $43,562 up to the next jump, which is at $87,123. (http://www.cra-arc.gc.ca/tx/ndvdls/fq/txrts-eng.html)
Ontarians who earn more than $43,562 could contribute to an RRSP -- but only dollars over and above this threshold. This is because, with clear planning, the chances are good that when you pull the money out, your marginal tax bracket will be lower than 33 per cent.
The key to making your RRSP work is to put the money in when your marginal tax rate is high and pull the money out when it is low. You may be surprised by how many Canadians do the opposite without realizing it!
TFSAs are ideal for people who are business owners or earn a salary of less than $43,562 (in Ontario) because, as explained above, RRSPs may not be useful vehicles for them. TFSAs are also a great option for people who have maxed out their RRSPs. If you are a high-income earner and have already taken full advantage of the tax breaks offered by RRSPs, a TFSA still provides a great opportunity for tax-free growth.
TFSAs are also great for retirees who are forced to receive more income than they can use in a given year. With CPP (Canada Pension Plan), OAS (Old Age Security), pensions and RRIF (Registered Retirement Income Fund) withdrawals, retirees often receive more money than they can spend in the year that they receive it. For my clients in this situation, I take the excess income and put it into a TFSA for them. This will continue to grow so that they will have access to tax-free money in the later stages of retirement.
Working with an advisor
Ultimately, having a comprehensive financial plan should address portfolio construction and should also project investment growth. The other side of the plan needs to deal with how you are going to access the money when you need it. Consult a professional that you trust to help you with your plan and help you invest in the right types of accounts for your unique situation.
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