Tag Archives: taxes

Reframing the RRSP advantage

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I’ve read a lot of bad takes on RRSP contributions and tax rates over the years. One that stands out is the argument that you should avoid RRSP contributions entirely, and focus instead on investing in your TFSA and (gasp) your non-registered account. This idea tends to come from wealthy retired folks who are upset that their minimum mandatory RRIF withdrawals lead to higher taxes and potential OAS clawbacks. They also seem to forget about the tax deduction generated from their RRSP contributions and the tax-sheltered growth they enjoyed for many years leading up to retirement.

I’m hoping to dispel the notion of an RRSP disadvantage by reframing the way we think about RRSP contributions, RRIF withdrawals, and tax rates. Here’s what I’m thinking:

Most reasonable RRSP versus TFSA comparisons say that it’s best for high income earners to prioritize their RRSP contributions first, while lower income earners should prioritize their TFSA contributions first.

The advantage goes to the RRSP when you can contribute at a higher marginal tax rate and then withdraw at a lower marginal tax rate, while the advantage goes to the TFSA when you contribute at a lower rate and withdraw (tax free) at a higher rate.

If your tax rate in your contribution years is the same as in your withdrawal years then there’s no advantage to prioritizing either account. They’re mirror images of each other.

Related: The next tax bracket myth

This comparison focuses on marginal tax rates. But is this the correct way to frame the discussion?

Marginal Tax Rate vs. Average Tax Rate

Isn’t it fair to say that an RRSP contribution always gives the contributor a tax deduction based on their top marginal tax rate (assuming the deduction is claimed that year)?

But when you look at retirement withdrawals, shouldn’t we focus on the average tax rate and not the marginal tax rate?

An example is Mr. Jones, an Alberta resident with a salary of $97,000 – giving him a marginal tax rate of 30.50% and an average tax rate of 23.59%

Alberta MTR $97k

If Mr. Jones contributes $10,000 to his RRSP he will reduce his taxable income to $87,000 and get tax relief of $3,050 ($10,000 x 30.5%).

RRSP deduction

Fast forward to retirement, where Mr. Jones has taxable income of $60,000 from various income sources, including a defined benefit pension, CPP, OAS, and his $10,000 minimum mandatory RRIF withdrawal.

The range of income in each tax bracket can be quite broad. With $60,000 in taxable income, Mr. Jones is still at a 30.5% marginal tax rate, but his average tax rate is just 19.33%. That’s right, he pays just $11,596 in taxes for the year.

Alberta MTR $60k

Conventional thinking about RRSPs and marginal tax rates would tell us that Mr. Jones should be indifferent about contributing to an RRSP in his working years because he’ll end up in the same marginal tax bracket in retirement.

But when we consider all of our retirement income sources, why do we treat the RRSP/RRIF withdrawals as the last dollars of income taken (at the top marginal rate) instead of, say, income from CPP or OAS or from a defined benefit pension? Why would Mr. Jones’ $10,000 RRIF withdrawal be taxed at 30.5% when it’s his average tax rate that matters? Continue Reading…

Misguided thinking about Dividend Investing

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I’ve received an uptick in emails and comments from investors about dividends and so I thought I’d address some common misconceptions around dividend investing.

One reader in particular wanted to know if he should take the commuted value of his pension ($750,000) and put it all in Enbridge stock because it was yielding around 6.5%. That reminds me of the reader who, several years ago, asked if he should borrow money at 4% to buy Canadian Oil Sands stock that was paying an 8% dividend yield.

Related: How did that leveraged investment work out?

I shouldn’t have to tell you why it’s not sensible to put your entire retirement savings into one stock – dividend payer or not.

Most comments were much more sensible and reflected what I perceive to be some misguided thinking about dividend investing.

Dividends + Price Growth = Magic?

Some companies pay a dividend to shareholders. Some do not. Investors shouldn’t have a preference either way.

Amazon doesn’t pay a dividend, focusing instead on reinvesting their profits back into their business for more growth opportunities.

Apple, on the other hand, is awash in cash thanks to the tremendous success of the iPhone and decided to start paying a dividend in 2012. It likely cannot reinvest or grow fast enough to keep up with its cash flow and so it returns some of that cash to shareholders.

Investors shouldn’t prefer Apple to Amazon just because of Apple’s dividend policy.

But what happens when a dividend is paid? The value of the company decreases by the amount of the dividend. That must be true, since the dividend didn’t just appear out of thin air – it came from the company’s earnings.

Company A and Company B are worth $10 each. Company A pays out a $1 dividend, while Company B does not.

Company A is now worth $9, and its shareholders received $1. Company B is still worth $10 and its shareholders received $0.

But some investors do seem to think the dividend comes from thin air and that it does not reduce the value of the dividend paying company.

Consider this example: Let’s say expected stock returns are 8% per year. The average dividend yield from all stocks (both non-dividend payers and dividend payers) is around 2%. That leaves 6% to come from the increase in share prices or capital gains.

Shopify doesn’t pay a dividend. You could consider its expected annual return to be 8% (ignoring the extreme dispersion of possible outcomes for a single stock), but all 8% would come from increases to its share price.

Enbridge has a dividend yield of 6.5%. Should we expect its price to also increase by 8%? Of course not. It would be more reasonable to expect price growth of 1.5% (again, ignoring the extreme dispersion of possible outcomes).

Here’s a more diversified example featuring Vanguard’s VCN (Canadian equities, represented by the yellow line) versus iShares’ CDZ (Canadian dividend aristocrats, in blue):

VCN vs CDZ

How one Tawcan reader lives on $360,000 a year of dividends almost tax-free

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By Bob Lai, Tawcan

Special to the Financial Independence Hub

Long time readers will know that my wife and I are deploying a hybrid investing strategy – we invest in both dividend paying stocks and index ETFs. It is our goal to have our portfolio generating enough dividend income to cover our expenses. When this happens, we can call ourselves financially independent and live off dividends. By constructing our portfolio and selecting stocks that grow dividends each year organically, we believe our dividend income will continue to grow organically and keep up with inflation so we don’t have to ever touch our principal.

In the past, I have done a few simulations showing that living of dividends is possible and that dividend income is very tax-efficient in Canada. But simulations are full of assumptions and the numbers can change. Wouldn’t it be nice to showcase someone that is living off dividends already?

As luck would have it, Reader B, a fellow Canadian, recently mentioned that he retired in 2004 at age 55 and has been living off dividends since. I was very intrigued by B’s story when he told me that he worked as a civil engineer and his wife worked as an administrator.

I fell off the chair when he told me that he and his wife started investing with $10,000 and have amassed a dividend portfolio that generates over $360,000 in dividends each year! 

That’s $30,000 a month! Holy cow! 

While working, they had above average salary (B made ~$110k and B’s wife made ~$90k in today’s money). The high household income has certainly helped them build the dividend portfolio. But I believe a lot of it is due to B and his wife’s living modestly – not a lavish lifestyle but not penny pinching either.

After a bit of emailing exchanges, he agreed to answer my questions about his experience with living off dividends (it took a bit of convincing haha!). I truly believe B’s knowledge will help a lot of dividend growth investors.

Note: B’s original reply was over 11,000 words not including my comments (our email exchanges were very long too). I went through his answers and edited some parts out. For ease of reading, I have decided to split the post into two posts.

I hope you’ll enjoy this Q&A as much as I did.

Living off dividends – How I’m receiving $360k dividends a year and paying almost no taxes

Q1:  First of all, B, thank you for participating. It’s wonderful to learn that you and your wife have been retired since 2004 and have been dividend investors for over 36 years.

A: Thank you, Bob, for giving me the opportunity to share my 36 plus years of dividend investing experience and results with you and your readers. After following your blog, I realized that we and many others were on the same dividend investing path. The only difference being that I was a few more years along in the investing journey. I felt others might benefit from my experience with dividend investing.

You’re on the right path, Bob, and given your rate of progress to date by the time you reach my age (72) you will certainly attain your dividend income goals and likely well beyond. So I wanted to encourage you to continue along the dividend investing path. It’s a very sound and profitable strategy.

I’m more than happy to share with others a few of my ideas on dividend investing and how it can be done in a tax-effective manner.

Q2:  How long have you been investing in dividend paying stocks?

A: I started investing in stocks in 1985. After the initial period of learning the ropes and finding my way in the investing and stock market world, it was only in 1990 after subscribing to a weekly investing newsletter that I finally saw the investing light and found that dividend investing was right for us.

So I guess you could say I’ve been traveling along the dividend paying stock road for some 31 years now. And we’ve been comfortably supplementing our lifestyle with an ever increasing stream of dividends since we retired in 2004 to the present day.

Diving into the dividend portfolio

Q3:  How much dividend income are you getting each year? Can you provide a detailed breakdown across non-registered and registered accounts? 

A: As of April 30, 2021, my wife and I are receiving $360,000 in combined pre-tax dividend income annually – that’s $30,000 per month – and still growing.

Our combined assets are distributed as follows:

  • RRIFs: 8.2%
  • TFSAs: 1.9%
  • Non-Reg Dividend Income Accounts: 85.5%
  • Other Short-Term Liquid Assets: 4.4%

So the amount we have in registered tax-sheltered plans totals 10.1% and is decreasing annually in compliance with RRIF mandatory withdrawal requirements.

These figures illustrate a problem that can develop gradually over time – a severe imbalance between registered and non-registered  accounts caused by the low contribution limits governing registered savings plans. Allowable contributions to registered plans are capped.

If one’s savings levels exceed the cap limits by a significant amount, then the balance between registered and non-registered accounts can tilt heavily towards the latter. The effect is that registered plans then become less and less significant in the overall account mix. This unbalanced effect means that we now have only 10.1% of our assets in tax sheltered accounts while 85.5% is held in “unsheltered” non-registered accounts.

So that makes it critical to find ways to ensure that holdings in non-registered accounts are as tax efficient as possible. The most optimum way to achieve tax-efficiency under such conditions is to focus on buying and holding Canadian dividend paying stocks in non-registered accounts.

We will continue to shift portions of our “other” assets toward Canadian dividend income as we go forward.

Our non-registered accounts are producing the entire $360K dividend income stream referenced above. The annual yield on market value is 4.2%. The actual yield on cost is much higher than the market yield. Our portfolio has returned nicely over the years.

Our annual mandatory RRIF withdrawals are the minimum required by age and proceeds are immediately re-invested in more dividend stocks and held in our non-registered accounts. We do not touch our TFSAs and contribute the maximum allowable amount each year.

Tawcan: My jaw dropped when you told me about your $360k a year dividend income. That is absolutely amazing! 

At 4.2% yield that means the market value of your portfolio is over $8.5M! Obviously your yield on cost would be much higher than that given you have invested over 30 years. Regardless, I’m betting that the cost basis of your non-registered portfolio is in the multi-million dollars range. It is very impressive considering you and your wife only made around $200k a year in today’s money.  

The Dividend Investing Philosophy

Q4:  Can you give us an idea of your general approach to dividend investing?

A: My dividend investment philosophy can be summed up as: “To buy gradually over time, high-quality Canadian tax-efficient dividend paying stocks and hold them indefinitely.”

I buy stocks gradually in roughly equal amounts and spread the purchases over time. I never invest large lump sums all at once. I’ll take an initial position in a stock, usually in the $10K value range, and then return again at an opportune price point and buy some more (i.e. dollar cost-averaging).

High quality stocks are selected – conservative large cap stocks – most often dividend aristocrats – minimum 2% yield with the odd exception for superior growth stocks or those with growth potential. Great focus is placed on buying dividend aristocrats and stocks in the TSX Composite 60 Index with a nod toward following the Beat the TSX strategy.

Tawcan: Funny B mentioned the BTSX strategy. Check out Matt, the brain behind Beating the TSX strategy, and his family’s amazing story about traveling the world with 4 kids. 

I exclusively buy only Canadian stocks – no USA stocks – none – no exceptions. The only US stocks I would consider are those that have a TSX listing and can be purchased in Canadian dollars for tax efficiency reasons.

Tawcan: It’s interesting that you only hold top Canadian dividend stocks and no US or international dividend paying stocks or ETFs. 

All our stock buys must be held in non-registered accounts – contributions can not be made to RRIFs and our TFSA contribution room is maxed out. My wife and I also invest in REITs and they require special attention (more on that later).

All stocks we buy must pay a dividend. As mentioned, I usually insist on a 2% yield or higher – but not too high. One never wants to over-reach for yield, which is often the warning sign for an impending dividend cut. If a stock does eliminate its dividend, then it’s automatically gone from our portfolios and we move on to another stock that does pay a reliable dividend.

On very rare occasions, it may be advisable/necessary to sell a stock for the following reasons:

  1. When a stock’s prospects have taken a downward turn.
  2. In the event of a takeover bid – friendly or otherwise – one often has little choice but to sell.
  3. For tax-loss selling purposes. We seldom pay any capital gains income tax at all. When we do realize a capital gain from a stock sale, then we’ll sell another stock (or partially sell) to realize an offsetting capital loss. But tax-loss selling is not usually done at year-end along with “the herd.” After waiting the mandatory 30 days and if the stock remains a solid investment, then we will often buy the stock back – hopefully at a lower price.

Under a buy and hold strategy, there is not a lot of opportunity for capital gains. By not selling, no capital gain is realized and so capital gains tax can be deferred indefinitely.

On the other hand, dividend income can be extremely tax efficient when you are income splitting between two people. We’ll get into the specifics a bit later.

Q5:  You mentioned that REITs require special attention. What did you mean by that?

A: Not all REITs are equal in terms of tax efficiency when held in a non-registered account where taxes on REIT distributions can vary from 0% to 53.53% (in Ontario). Therefore, the most tax-efficient place to hold a REIT is in a registered account. Continue Reading…

Tax rates likely to rise: what to do about it

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By Eva Khabas

Special to the Financial Independence Hub 

The Covid pandemic has led to unprecedented government spending with a deficit that has reached record heights.

Sooner or later someone has to pay for this and that usually means the taxpayer. Don’t look now but when you start your tax planning it’s probably best to assume that tax rates are going up in Canada.

However, even before Covid the federal government was talking about increasing the capital gains tax.

Capital gains inclusion rate could go back up to 75%

Currently, only 50% of capital gains are, in fact, taxable but this was not always the case. In fact, from 1990 to 1999 75% of capital gains were subject to tax! It’s logical to assume that tax revenues will be increased through a higher capital gains portion that is taxable, since capital gains are perceived as ‘passive’ income from investments. In theory, this means taxes should be generated by wealthier taxpayers.

Loss of Principal Residence exemption?

Also, the big fear of every Canadian is that government will remove the principal-residency exemption. Currently, taxpayers can sell their primary residence at a gain and not pay any taxes.  Many taxpayers rely on the appreciation in value of their homes as their main source of retirement income. The impact of making gains on principal residency taxable would be devastating to many, if not most, Canadians.

Before discussing what to do about all this, let’s make sure we understand what capital gains are, how they are different from your other income, and when these gains become taxable.

So, what exactly is capital gain? In a nutshell it’s the growth in the value of an asset being held for investment purposes, so that asset is not for resale. A long-term holding period would indicate that the gain is capital. Currently, only half of the capital gain is taxable, while most other income is fully taxed.

In most cases the capital gain is subject to tax when the asset is sold, but there are also times when you may have to report capital gains without an actual sale occurring. For example, at the time of death there is the deemed or assumed sale of all assets, with any capital gains included in the tax return of the deceased. This would, of course, affect beneficiaries.

It’s important to note that increases in personal tax rates will also result in you paying more tax on capital gains. This is because the tax rate on capital gains is applied at the same tax rates in Canada as on employment and other income. In addition, reporting a higher overall total income would also result in more tax because a higher income puts you in the top tax bracket.

Defence # 1: Timing

So, now we see that many tax-reducing strategies primarily revolve around two things – 1) timing, and 2) reducing your taxable income. First, let’s look at timing.

If you have higher overall income from various sources in 2021, and expect lower taxable income for 2022, consider disposing of the asset(s) in 2022 wherever possible so the gain attracts a lower marginal tax rate for you.

You can also use time to advantage by deferring the cash outflow – the tax you pay to the government – and disposing the assets early in the year. Your tax bill is due April 30th of the following year, so if you sell the capital asset in January of 2022 you still have 15 months until tax must be paid on that.

Staggering gains over multiple years

Now, let’s assume you have a large capital gain. How can you stagger that gain over several years? One strategy is to defer cash receipts from the sale over multiple years. The Canadian Income Tax Act allows you to spread that gain over five years (and in some cases over ten years), provided you receive proceeds from the sale over a number of years. For example, if you receive 20% of the proceeds in 2021, you only need to include 20% of the gain in your taxable income as it can be spread over five years.

RRSPs and TFSAs

All these strategies are of a short-term nature. If the assets are disposed of in the long term, consider holding them inside your RRSP. You don’t have to declare those assets as income until you make a withdrawal. Likewise, you can use your TFSA so some of the gains are not subject to tax at all. Either way, your tax advisor can help determine if assets can be transferred to your RRSP or TFSA. Continue Reading…

Setting them up for success: Financial Advice for new parents

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By Veronica Baxter

Special to the Financial Independence Hub

Are there some things that you wish you knew before you became a parent? Parenting comes with lots of financial responsibilities, and it’s a life-changing experience for many. Suddenly, life is about taking care of yourself, but another person solely depends on you for everything.

Preparation is critical to get ready for this exciting and, perhaps, scary new adventure. It is more helpful to be prepared for the many financial alterations to come. It is estimated that a middle-income American parent spends at least $284,570 (US$)  till the child turns 18 years old.

Most people tend to focus more on their finances after a significant life event. Making the necessary financial plans will save you the stress as you embark on this journey.

Here are vital planners to get you started:

1. )  Make a Household Budget

Having a baby can be expensive. A household budget prevents you from being a spendthrift and also saving for the future. Please write down your steady monthly sources of income and compare them to your monthly expenses.

Adjust your expenses to cover the baby’s needs like diapers, furniture, formula, and other unexpected costs that come up. Also, set some spending limits and do your best to stick to them.

2.)   Get a Life and Disability Insurance Policy

Many new parents question the worthiness of buying life insurance. After all, most don’t think of death. Life insurance comes in handy during such situations to protect you during such worst-case scenarios financially. Life insurance has three different choices:

1.   Whole Life Insurance

This one is lifetime guaranteed. It offers a specified benefit given to your spouse or other beneficiaries upon your death. It accumulates cash value over time and provides the opportunity to earn dividends.

2.   Term Life Insurance

This policy provides coverage for a certain number of years, mostly 15, 20, or 30. If you live longer than the plan, no benefits are paid out since the coverage automatically expires. However, most term policies allow for a continuation after the initial term though at higher charges.

3.   Universal Life Insurance

This policy is a hybrid of the two. It also allows you to set your premiums and death benefits.

Disability insurance becomes a significant refuge when one or both parents cannot work during a disabling injury or illness. No specified amount can never be enough for anyone. That’s why it’s essential to consult a financial expert to help you explore the best option that will fit your financial capability and excellent financial standing.

3.) Write A Will

Thinking about writing a will can be pretty uncomfortable. In a case of untimely death, the state decides how and with whom your assets are shared. The state’s decisions may probably go against your preferences. This is why a will comes in handy to name the guardian to your kids and who will manage your asset distribution when they become adults.

Have the hard conversations of when they are allowed to chip in, to make healthcare and financial decisions. An attorney will give a good outlook that will help you set up a financial trust that aligns with your situation and goals.

4.) Adjust your Emergency Fund

An emergency fund is essential to ensure your household runs smoothly in the event of unforeseen financial circumstances. The amount set aside varies from family to family but should start with three to six months of living expenses. Your emergency fund should now reflect the cost of having a child versus what you initially saved for.

5.)   Include your child in your Medical Insurance Cover

Having a baby is a qualifying life event that allows you to adjust your health plan to enroll your child.  Most of these plans require you to add your child within 30-60 days post-delivery. Try and add up your child as fast as possible to prevent those recurring cash expenses during pediatrician visits.

6.)   Don’t rush to make a Home Upgrade

Some couples equate good parenting to owning a home. However, financial planners advise couples to wait until 3-4 years to make a move. It would be best to have a better outlook of what you want the future to be like within that time.

7.)   Tax Breaks

Childcare can be expensive for many parents. The [US] government offers tax breaks to reduce the tax burden on individuals, allowing them to keep more of the money that they have worked for. Tax breaks are awarded either from claiming deductions or excluding income from your tax returns. Continue Reading…