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

 

Education is always the first step in bettering yourself. 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 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 6 months of normal expenses, keeping in mind you can collect Employment Insurance if you’re laid off and you’ll probably stop buying expensive things. A high interest savings account is the best place to keep your emergency fund. 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:


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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.

Yoink!

-The Government, every payday

Luckily the government encourages you to save and invest whatever is leftover. The RRSP and TFSA are meant to reduce or eliminate taxation on your investment gains(sort of). I believe 90% of Canadians should use these two accounts, but they aren’t the only tax sheltered accounts. If you have children you can open Registered Education Savings Plan (RESP) to save for their education. If you have a disabled relative you can open them a Registered Disability Savings Plan (RDSP). More info at the Canada Revenue Agency Website.

 

The Quick on the RRSP

That last paragraph was a misleading lie, sorry. With an RRSP, the money goes in BEFORE tax. Or to put it another way, contributing to it will give you a tax credit, and reduce your total taxable income for that year. But there’s no such thing as a free lunch. 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 (which you almost certainly should be) you’ll ultimately pay less tax on it.

Compare that to a taxable investment 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!

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 need the money!” So you contribute the bare minimum to get your employer match. Ignoring this is like flushing money down the toilet.

 

The Quick on the TFSA

The TFSA uses AFTER tax money and all investment income is 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 basically a mirror image of the RRSP. It all comes down to the time of taxation. Image earning $200 at a tax rate of 30%, and investing half in a TFSA and the other half in an RRSP, both earning a 10% return:

TFSA RRSP
1. $100 Earned employment income $100 Earned employment income
2. $70 Income tax (-$30), put leftover $70 in TFSA $100 Contribute to RRSP untaxed
3. $77 Earn 10% investment income (+$7) $110 Earn 10% investment income (+$10)
4. $77 Withdraw, tax free $77 Withdraw, 30% tax taken here (-$33)

 

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

NOTE: these accounts are not actually 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 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 don’t even fill their TFSA. 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.

The most common non-registered account is a margin account. I own one and basically it’s just a cash account with the option to borrow extra money directly from the brokerage. Don’t worry about complexities, in most cases you shouldn’t be borrowing money to invest in the stock market. If you do your own taxes you’ll need to report almost everything that happens in this account so the goverment knows how much to tax you. But your brokerage should issue you a T3 that shows at least some of your investment income. Different investments are taxed in different ways so make sure to do your research before diving into buying and selling in a taxable 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.

Everyone needs somewhere to live, but for most people their home is not an “investment” when compared to renting. Between taxes, maintenance costs, mortgage costs, buying and selling costs, and all the other unexpected expenses involved in property ownership it can take years before you break even. Homeownership should be a personal choice. But 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, both of which can be can be an excellent investments.

If you’ve read this far you should have a basic grasp of investing accounts. 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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