All posts by Robb Engen

Which accounts to tap first in Retirement?

Retirees, or those close to retirement, may have several buckets from which to withdraw income in retirement.

There may be assets in RRSPs, taxable or non-registered investment accounts, TFSAs, and possibly corporate or small business assets. At retirement you need to consider which of these accounts to tap into first.

To further complicate matters you might also have income from a workplace pension, not to mention government benefits such as CPP and OAS (and when to apply for these benefits).

The natural inclination, both from a behavioural and a tax planning perspective, is to put off paying taxes for as long as possible. For Canadians, that means leaving assets inside their RRSP(s) until age 71, converting their RRSP into a RRIF, and beginning RRIF withdrawals in the year they turn 72.

Delaying CPP and OAS

Also worth consideration is the incentive for retirees to delay their application for CPP and OAS until age 70. Do this and your CPP benefits will increase by 42 per cent and OAS benefits will rise by 36 per cent versus taking these entitlements at 65.

Tax-Free Savings Accounts (TFSAs) have been around for less than a decade but already play a critical role in retirement planning. Money saved inside a TFSA grows tax-free and you pay no tax on withdrawals. For retirees, an added benefit of TFSAs is that any money withdrawn does not affect means-tested programs such as OAS and GIS, so there’s no chance that a clawback will be triggered by this income.

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Tax Deductions and Tax Credits: What’s the Difference?

Canadian taxpayers have until May 1, 2017 to file their 2016 taxes. However, before the calendar turns over to a new year many Canadians want to know how best to maximize their tax refund or minimize what they owe the government.

The two main ways to reduce taxes owing are through tax deductions and tax credits. What’s the difference between a deduction and a credit? Let’s explore:

Tax Deductions

A deduction reduces your taxable income. The value of a deduction depends on your marginal tax rate. So, if your income is more than $200,000, you are taxed at the federal rate of 33 per cent and a $1,000 deduction would save you $330 in federal tax. On the other hand, if you were earning $30,000, you are taxed at the federal rate of only 15 per cent and a deduction of $1,000 would only save you $150 in federal tax.

An example of a tax deduction is your RRSP contribution.

Deductions checklist

  • RRSP contributions
  • Union or professional dues
  • Child care expenses
  • Moving expenses
  • Support payments
  • Employment expenses (w/ T2200)
  • Carrying charges or interest expense to earn business or investment income

Tax Credits

There are two types of tax credits: refundable and non-refundable. A non-refundable tax credit is applied directly against your tax payable. So if you have tax owing of $500 and get a tax credit of $100, you now only owe $400. If you don’t owe any tax, non-refundable credits are of no benefit. For refundable tax credits such as the GST/HST credit, you will receive the credit even if you have no tax owing.

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Why Robb Engen’s 4-minute RRSP portfolio is tough to beat

I spent a total of four minutes working on my RRSP portfolio last year.

It wasn’t benign neglect:  my two-ETF all-equity portfolio really is that simple! I made four trades, which took about a minute each after determining how much money to invest, in which of the two ETFs to allocate the investment, and how many shares that would buy (plus a few seconds to enter my trading password).

The buying process is easy since I don’t have any bonds in my portfolio. I simply add money to the fund that brings my portfolio closest to its original allocation – 25 per cent VCN and 75 per cent VXC.

I don’t expect my four-minute portfolio to change much this year. I still plan on making four trades this year in my RRSP, and now that I’m contributing regularly to my TFSA again I’ll make an additional four trades in that account. Add 12 monthly contributions to my RESP and that brings my total time spent on investing to just 20 minutes a year.

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Millennials don’t get the Latte Factor

Financial author David Bach introduced the Latte Factor as a metaphor for all the small indulgences we regularly treat ourselves to that add up over time. It wasn’t meant to single out Starbucks as the main culprit for our financial woes, but somehow millennials feel the need to stand up for their beloved coffeehouse and defend their right to buy an obnoxious drink whenever they damn well please.

Helaine Olen (not a millennial) made people feel good about buying lattes again when, in her best selling book, Pound Foolish, she explained how the Latte Factor is a lie and buying coffee every day is not why you’re in debt. No, instead it’s the big things: housing, transportation, health care (in the U.S.) that are more difficult to cut back on.

Related: The worst financial advice ever given to millennials

More recently, this author whined about how millennials were being judged on their spending choices, criticizing a survey that revealed millennials spend more on coffee than on saving for retirement:

“Millennials are continually being accused of wasting money on supposedly frivolous things. In October, an Australian man named Bernard Salt wrote that he had had enough of seeing young people ordering “smashed avocado with crumbled feta on five-grain toasted bread at $22 a pop and more. Twenty-two dollars several times a week could go towards a deposit on a house,” wrote Salt. 

According to my calculation, if millennials were to abstain from their avocado toast three times a week, they’d save around $3,432 per year. Which isn’t all that much, in reality.”

Oh really? And in what reality is $3,432 not that much money? According to the author, life is unfair and millennials should just give up on the idea of owning a home, or saving for retirement, so just let them have their damn latte and $22 toast.

My take on the Latte Factor Continue Reading…

Using Monte Carlo Simulations in your Retirement Planning

 

Wouldn’t it be nice for our retirement planning purposes if stocks consistently gave us eight to 10 per cent returns each year? After all, that’s what stock markets have delivered on average over the very long term.

Indeed, between 1935 and 2016 U.S. stocks returned 11.4 per cent annually, Canadian stocks returned 9.6 per cent annually, and international stocks averaged annual returns of 8.3 per cent.

I have an eight per cent target in mind when projecting investment returns for my own retirement plan.

The trouble is that stock returns are anything but predictable and so while they may average eight to 10 per cent over a 25-or-50-year period, each single year could deliver panic inducing losses, euphoric gains, or something in-between.

Since 1988, the S&P 500 had single-year returns as low as negative 37 per cent (2008) and also gained as much as 37.58 per cent in a single year (1995). Only in three of those 29 years did the S&P 500 deliver annual returns between eight and 11 per cent. The rest of the years are all over the place.

Why does this matter to your retirement planning? Because it’s not enough to just plug “eight per cent” into your retirement projections and call it a day.

What happens if stocks plunge by 35 or 40 per cent in year one of retirement, as they did to those unlucky enough to retire in 2008?

Enter the Monte Carlo Simulation

A Monte Carlo Simulation can reveal a wide variety of potential outcomes by taking into account fluctuating market returns. So instead of basing your retirement calculations on just one average rate of return, a Monte Carlo Simulation might generate 5,000 scenarios of what hypothetically might happen to your portfolio as you draw it down and markets fluctuate.

Let’s look at an example of a 60-year-old who retires with $750,000 invested in a standard balanced portfolio of 60 per cent stocks and 40 per cent bonds. This retiree wants to know how much is safe to withdraw from the portfolio each year and whether it can last 30, 40, or even 50 years.

We can do this with a Monte Carlo Simulation. I used Vanguard’s retirement nest egg calculator. We’ll start with a safe withdrawal rate of 4 per cent per year:

  1. How many years should the portfolio last: 30 years
  2. What is your portfolio balance today: $750,000
  3. How much do you spend from the portfolio each year: $30,000

The results: There’s a 93 per cent probability that this portfolio lasts 30 years.

When I re-run the simulation using a withdrawal rate of 5.3 per cent (spending $40,000 per year) there’s now just a 74 per cent chance the portfolio survives 30 years.

What happens if our retiree lives until 100? We’ll need to make the portfolio last for 40 years instead of 30.

Spending $40,000 each year means the portfolio has only a 62 per cent chance of surviving 40 years. If we go back to our original 4 per cent safe withdrawal rate ($30,000 per year) then our portfolio jumps back up to an 87 per cent survival rate.

In one interesting simulation, I increased the stock allocation to 100 per cent and changed the annual spending to $50,000 (or 6.7 per cent of the portfolio). The $750,000 portfolio has a 50 per cent chance of lasting 40 years. Not something I’d chance to a coin-flip!

How does a Monte Carlo Simulation work? According to Vanguard, they randomly select the returns from one year of the database for each year of each simulation.

Using those values, they calculate what would happen to your portfolio – subtracting your spending, adjusting for inflation, and adding your investment return.

This process is repeated one year at a time until the end of your retirement or until your portfolio runs out of money. After 5,000 independent simulations there’s a broad range of possible scenarios and clear patterns begin to emerge.

Final thoughts

For those of you close to retirement or that have recently retired, I strongly encourage you to speak with your financial advisor about running a Monte Carlo Simulation for your own portfolio using several different inputs that match your goals and projections. DIY investors can find calculators such as Vanguard’s online to run their own simulations.

Err on the side of caution so that you’re comfortable with the outcomes. If there’s only a 50 per cent chance that your portfolio lasts the length of your retirement, that’s not a plan, it’s a gamble.

In addition to running the Boomer & Echo website, Robb Engen is a fee-only financial planner. This article originally ran on his site on January 2nd and is republished here with his permission.