INVESTING FOR BEGINNERS PART 1 – EMERGENCY FUND, TFSA, and RRSP

 



Welcome to the first day of the rest of your life. The information on this page is a culmination of years of research with books, blogs, forums, news articles, speaking with advisors, and my own personal experience. There is no one-size-fits-all answer to personal finance but I have generalized everything for what I believe is applicable to most people.

 

Step 1 – BUILD AN EMERGENCY FUND

An emergency fund is a fat wad of freely available cash for emergencies, such as you getting laid off or your car exploding. It’s up to you how big it should be, a good rule of thumb is 3-6 months of normal expenses. Keep in mind that if you find yourself unemployed you’ll collect Employment Insurance and probably stop buying expensive things. A high interest savings account is the best place to keep your emergency fund. You need easy access to the money but not too easy. Keep it out of your chequing account so you aren’t tempted to spend it, and definitely take it out from under your dirty mattress and put it in a bank where it can get at least 1% interest.

TOOL: Estimate your monthly expenses and write it in the box below. Press enter and I’ll recommend an emergency fund size. (inputs are not saved or recorded in any way) Primary expenses might include:

  • Rent or Mortgage
  • Food
  • Car Payments and insurance
  • Utilities (electricity, water, heat, cell phone, internet)
  • Debt payments
  • Drug money

Total Monthly Expenses:
________
________
________
________

Those are some big numbers! Don’t fret though, one strategy is to commit 1-3% of your monthly income into your savings every month to keep the emergency fund topped up.

 

Step 2 – OPEN TAX-SHELTERED INVESTMENT ACCOUNTS

It’s time to open your Registered Retirement Savings Plan (RRSP) and your Tax Free Savings Account (TFSA). With your emergency fund bulging at the seams, you can begin step 2, which is where the real investing fun begins! If you’ve made any money ever (legally) you’ll know the government takes a hefty cut off the top as income tax.

Yoink!

-The Government, every payday

After reaching their hand out of your wallet they encourage you to save and invest whatever is left. The RRSP and TFSA are meant to reduce or eliminate taxation on your investment gains. Normally if you invest $100 and earn $10 the government will charge you tax on your investment gains of $10. Each tax shelter account works slightly differently:

 

The Quick on the RRSP

With an RRSP, the money goes in BEFORE tax. Or to put it another way, contributions will give you a tax deduction, which reduces your total taxable income by the amount you deposit. This happens automatically if you go through your employer, and if you make your own deposits afterwards you can actively control what your taxable income is for the tax year. Just make sure you have enough contribution room (18% of your taxable income up to ~$26,000 per year, plus any unused contribution room from previous years).

But the RRSP isn’t all tax deductions and employer matching. Any money WITHDRAWN from an RRSP during retirement will be taxed as regular income. The tax is only delayed. The advantage is that you’ll start with more money (because it wasn’t taxed) and the money can continue to grow with tax free investment returns. To sweeten the deal, if you are in a lower tax bracket in retirement (most people are) you’ll ultimately pay less tax on the same money (because you will likely spend less money in retirement and thus require less income to sustain yourself).

“But wait? it’s all taxed anyway so what’s the point?” The RRSP only makes sense in two scenarios:

  1. The alternative to the RRSP is a taxable investment account – Investment gains themselves aren’t taxed in an RRSP. Only withdraws are subject to tax. In a taxable account you’ll start with money that was already subjected to income tax and any investment gains will also be taxed. That’s double tax!
  2. You’ll be in the same or lower tax bracket in retirement – Remember that the RRSP is only DELAYING tax. You can’t avoid the tax, but you can influence how much you’ll pay. If you are currently in the 36% tax bracket you can contribute to your RRSP to shift that tax burden to retirement where you might only be in the 25% bracket, thus reducing income tax by 11%! Keep in mind the opposite could be true, and you may end up paying more tax. Do your best to predict the future.

One more important point, most employers will match a percentage of your contributions. ALWAYS TAKE ADVANTAGE. For every $100 you invest, you instantly earn ANOTHER $100. That’s an INSTANT ONE HUNDRED PERCENT RETURN. You’ll never get anything like that in the stock market! If you are not doing this, stop reading and go talk to payroll (I know you’re reading this on company time you slacker). This is a no-brainer. “But Profitmoose, I am in debt and can’t afford to make contributions!” 3-5% of your income is not much. Eat out less, take the bus a couple days per week, buy cheaper clothes, do what you have to do to contribute the bare minimum to get the employer match. Ignoring this is flushing money down the toilet.

 

The Quick on the TFSA

The TFSA uses AFTER tax money and investment gains are not subject to taxes. You can also withdraw at any time (compared to the RRSP which can only be withdrawn during retirement without penalties). The TFSA is a mirror image of the RRSP where the mirror is the time of taxation. Imagine earning $300 at a tax rate of 30%, and investing $100 each in a TFSA, RRSP, and taxable account all earning a 10% return:

TFSA RRSP Taxable
1. $100 Earned employment income $100 Earned employment income $100 Earned employment income
2. $70 Income tax (-$30), put leftover $70 in TFSA $100 Contribute to RRSP untaxed $70 Income tax (-$30), put leftover $70 in taxable account
3. $77 Earn 10% investment income (+$7) $110 Earn 10% investment income (+$10) $77 Earn 10% investment income (+$7)
4. $77 Withdraw, tax free $77 Withdraw, 30% tax taken here (-$33) $75.95 Withdraw, 15% capital gains tax on $7 gain (-$1.05)

 

You see? Mirror Images. That being said, the TFSA is more flexible as the money can be withdrawn without penalty at any time whereas the RRSP will have penalties if you are younger than 65. Then again your employer doesn’t match contributions to a TFSA… Hmmmm… which account should you use then? The answer is simple. BOTH

COMMON MISCONCEPTION: I often ask people if they have a TFSA and they reply “Yes”, but then I follow up by asking what they invest in and they give me a blank look. It’s important to know these accounts are not inherently investments, they are HOLDING TANKS. Simply depositing money will not do anything. You have to actually buy investments or have someone else buy investments for you within the accounts. Don’t worry though we are getting to that very soon. Just please don’t waste your precious TFSA on a high interest savings account. Are you really concerned with reducing your tax burden on your 1% interest rate?

 

Step 3 – OPEN NON-REGISTERED, TAXABLE ACCOUNTS

The next step is a taxable account (AKA non-registered account). Assuming you’ve picked all the low hanging fruit from your tax sheltered RRSP and TFSA you need to supercharge your investing. Income from non-registered accounts are taxed at the rates set out by the goverment of Canada, in most cases it’s less than normal employment income but this is a beginner page so I won’t go into it here. Congratulations though! You’ll be joining the high rollers with this account since most Canadians aren’t able to fill both their TFSA and RRSP. If you have one of these already you’ve probably been reading one of the good investing blogs, and are just here out of pity. Thanks for the support!

The most common non-registered account is a margin account. Margin means that you can invest more than what you deposit into the account by borrowing money from the brokerage on “margin”. Don’t let that intimidate you, most people don’t invest more than the cash they deposited to the account.

If you do your own taxes you’ll need to report almost everything that happens in this account so the government knows how much to tax you as opposed to the TFSA and RRSP where you don’t report anything about the internal investments. Your brokerage will issue you a T3 that summarizes the activity in the account. Investment gain tax varies based on the investment type. Capital gains, dividends, bonds, and REITs are all taxed at different rates. Keep that in mind as you start investing in a non-registered account.

You can never “max out” a non-registered account so it’s up to you when you want to venture into other ventures. Maybe you don’t want a taxable investment account at all and want to go straight to alternative investments.

 

Step 4 – DO OTHER INVESTMENT STUFF

This category includes real estate, businesses, lottery tickets, or anything else someone tricked you into thinking is a worthy investment. I personally have none of these things, and no this blog doesn’t count as a business.

REAL ESTATE – Everyone needs somewhere to live, but for most people their home should not be though of as an investment. Real estate tax, maintenance costs, mortgage costs, buying and selling costs, and all the other unexpected expenses involved in property ownership need to be considered compared to renting. Are you terrible at saving and investing money? Maybe buying a home can help as it will force you to save money in the form of home equity. Or maybe you can rent out some of your rooms, or maybe you want to buy a rental property. Becoming a landlord comes with its own set of problems, but it’s the best way to turn real estate into an investment. Well, except if you invest in REITs.

I hope the basic investment accounts make more sense now. In the next page I’ll talk about what to put in these accounts.

Link: Part 2 – ETFs, Stocks & Bonds, Mutual Funds

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