November, 2020 - Millionaire on the Prairie

Marginal Tax Rates

Quick! What is your marginal tax rate?

If you answered “I don’t know”, then welcome to the club! Pull up a chair and sit down for a spell. Most of us do not know what our marginal tax rate is… which is really too bad. It’s one of the more useful pieces of information to know when it comes to making informed decisions about our personal finances.

The technical definition of a marginal tax rate is that it is the rate of tax that is paid on an additional dollar of income.

…Um… what does that mean?

Good question, Gentle Reader, very good question.

Federal Tax Rates

Before you can understand a marginal tax rate as it applies to your personal income, you need to know the federal tax rates. Here’s a handy little chart I found online courtesy of the good folks at the Canada Revenue Agency.

Federal Tax Rates in Canada

15% on the first $48,535 of taxable income

20.5% on the portion of taxable income over $48,535 up to $97,069

26% on the portion of taxable income over $97,069 up to $150,473

29% on the portion of taxable income over $150,473 up to $214,368

33% of taxable income over $214,368

Let’s walk through an example together.

*** And we’ll ignore your marginal provincial taxes for now. (What? You thought the provinces didn’t want a slice of your income too?) In real life, you won’t ignore the addition of marginal provincial tax rates on your annual income tax bill. You’ll pay the provincial marginal taxes on top of your federal ones since you’re required to do so by law.

How Marginal Tax Rates Work

Jamie earns $47,000 and pays 15% in federal taxes, which works out to $7050 (= $47,000 x 15%). If Jamie earns another $1, his marginal tax rate is 15% because he stayed in the same tax bracket of 15%. Jamie’s additional $1 of income did not take him over the threshold amount of $48,535.

On the other hand, if Jamie’s side hustle earns him $5,000 in the year, then his marginal tax rate goes up to 20.5% on the amount of income that exceeds $48,535. Between $0 and $48,535, his tax rate is 15%. As soon as he earns his next $1, putting him at $48,536, he moves into the next tax bracket. His marginal tax rate is now 20.5% because that’s the rate of tax he pays on his next dollar of income.

In this case, Jamie’s income for the year is $52,000 (= $47,000 + $5000). Jamie would pay 15% on $48,535 (= $7,280.25). Then he would pay a further 20.5% on $3,465 (= $710.33). In other words, Jamie pays a higher amount of taxes on the dollars earned above the 15% tax threshold of $48,535. In this case, the amount of $3,465 is the difference between his income of $52,000 and the 15% tax threshold of $48,535.

At $52,000, Jamie’s marginal tax rate is 20.5%. More importantly, his marginal tax rate on every dollar earned beyond the first $48,535 remains at this tax rate until he hits $97,069. He owes $7,280.25 + $710.33 = $7,990.58 in federal taxes on his income of $52,000.

Imagine Jamie doubles his income to $104,000 per year…

Good for you, Jamie!

So how much federal tax does Jamie owe on $102,000?

A quick check of our handy-dandy little chart tells us that Jamie’s marginal tax rate is now 26%. Why? Because Jamie has earned more than $97,069, which is tippy-top of the second lowest tax bracket.

Further, we know that he only has to pay 26% on the dollars over and above $97,069.

So let’s get to calculating.

We know Jamie owes 15% on the first $48,535 = $7,280.25.

His next $48,534 will be taxed at 20.5%, because $97,069 – $48,535 = $48,534. So Jamie will pay $9,949.47 (= $48,534 x 20.5%).

Finally, he will pay 26% on any dollar of income over $97,069. In this case, Jamie earned $4,931 beyond $97,069 to get to his income of $102,000. The amount of $4,931 is taxed at his marginal tax rate of 26%. Jamie will owe $1,282.06 on this portion of his income.

Jamie’s total federal tax owing is $7,280.25 + $$9,949.47 + $1,282.06 = $18,511.78.

Tax refunds, anyone?

Here comes the part where things get a little exciting! The more taxes you pay on your income, the more taxes you can get back via contributions to your Registered Retirement Savings Plan. The RRSP is a great tool for saving for your retirement.

Contributions to an RRSP lead to tax refunds, which means the tax paid on that earned income is returned to the person making the contribution. The more tax you pay, the bigger your refund. And why is this so? Because a higher marginal tax rate is used to calculate your tax refund. Sweet!

The 2021 TFSA contribution limit is $6,000. TFSA contributions do not generate tax refunds. Money goes in and it grows tax-free until withdrawn. And those withdrawals are also tax-free. The TFSA is also a great way to save for retirement.

However, contributions to a TFSA are just contributions where the taxes have already been paid on the income earned. This is why contributions to TFSAs are said to be made with after-tax dollars.

Steak…meet sizzle!

Let’s say Leslie earns $250,000. According to our handy-dandy little chart, she’s paying 31% in federal taxes. Ouch!

And then there’s Alex, who earns $48,000. The chart tells us that he’s paying 15% in federal taxes.

Both of them are in a position to contribute $6,000 to their retirement. They have a choice of contributing to their Tax Free Savings Account or to their Registered Retirement Savings Plan. (In an ideal world, they would contribute to both but sometimes that’s not possible.)

Leslie and Alex both decide to contribute to their RRSPs. They like getting taxes back from their government! And both of them have realized that their tax refunds can be used to contribute to their TFSAs. Two birds, one stone – beautiful!

Leslie contributes $6,000 to her RRSP. Her marginal tax rate is 31%. This means that her RRSP contributions results in a tax refund of $1,860 (= $6,000 x 31%). She promptly puts that into her TFSA. Leslie’s $6,000 RRSP contribution has resulted in her ability to set aside $7,860 for her retirement.

Alex contributes $6,000 to his RRSP. Since his marginal tax rate is 15%, his contribution nets a tax refund of $900 (= $6,000 x 15%). He contributes that $900 to his TFSA without delay. Since he’s in a lower tax bracket, he paid less taxes in the first place. Still, he’s managed to save $6,900 for his retirement – not shabby at all!

The morale of this little tale is this. You must know your marginal tax rate so that you can make wiser financial decisions. Had Leslie and Alex simply contributed $6,000 to their TFSAs, they wouldn’t have received tax refunds. Their monies still would have grown tax-free but neither of them would have benefitted from the added little boost of also being able to invest their tax refunds.

Understanding how marginal tax rates work is just another arrow in your personal finance quiver. Knowledge is power.

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Weekly Tip: Never carry a balance on your credit card. It’s a financially disastrous move. Even if the interest paid it small, it plants the seed in your brain that credit card balances are okay. And the most certainly are not!

Student Loans are an Anchor

When I was younger, I was convinced that student loans are an anchor. I believed that the best course of action was to eliminate them as soon as humanly possible. Full stop – no further discussion needed. Paying off student loans ASAP was a sign of being a mature adult. One did not carry debt if one could pay it off early. Being debt-free was the Holy Grail!

Suffice it to say that my views on student loans have become more nuanced as I’ve aged.

Full disclosure. When I graduated from post-secondary, I had student loans of just under $15K. My salary was paid bi-weekly, so I made extra student loan payments from every paycheque. These were on top of my regular monthly payment. I was fortunate enough to receive bonuses at work, so my first two years’ worth of bonuses went towards my student loans. Within 2 years, those loans were gone!

For the most part, I still believe that student loans are an anchor for many folks. If you’ve got a $200, $400, $700 student loan payment every month, that’s a big chunk of money that isn’t being used to build a better future for yourself. It’s not going towards a down payment. The money isn’t being set aside for your “thirsty underwear” years. (Hat tip to Garth Turner at Greater Fool for that descriptive phrase!) Those funds aren’t seed money being deployed in your own business. Depending on your circumstances, it could take you a very long time to pay off your student loan debts. Time that can never be recovered.

Truth be told, I still encourage people to focus on paying off their student loans. After all, it’s good to have less debt. Do what you can to make extra payments. Set up a per diem and have that money sent to your student loans every week. Do it via automatic transfer. If it’s $1/day, then send make an extra payment of $7/week. If you can afford $5/day, then that’s an extra $35/week. And if you can swing $10/day, then you’re looking at extra payments of $70/week… which is a very sweet $3,650 per year. The higher your per diem, the faster the debt goes away. Make this extra weekly payment on top of your regular minimum monthly payment. If you’re fortunate enough to get a raise or income from a side hustle, then use some of that money to pay off your student loans even faster.

When my student loans were gone, I felt very proud of myself. A debt obligation had been lifted from my shoulders! I was one step closer towards being debt-free. Yay, me!

Nuance…

It’s been over 15 years since I paid off my student loans. And I’ve learned a lot about investing in the stock market. Had I paid the minimum monthly payments on my student loans and invested in equities… <sigh> … Well, I’d be the Retired Blue Lobster by now, and my student loans would also be completely paid off. All else being equal, my loans would have been paid off in 9 years and I would have an even larger investment portfolio. My money would have had an extra two years to grow and all those extra payments would’ve been invested for growth.

Make no mistake! I still believe that student loans are an anchor. Yet, I’ve also come to believe that investing the stock market for the long-term is slightly more important than paying off student loan debt ASAP. This is because the weight of that debt burden, i.e. anchor, is reduced in two ways. Firstly, the debt gets smaller each time you make your minimum monthly payment. Secondly, the debt becomes a smaller portion of your net worth as your investments grow over time. Eventually, the debt will be gone and you’ll have a nice cushion of cash in the form of your investments.

If you go hard on your student loans to the exclusion of investing, you’ll be debt-free sooner but there’s no cash-cushion at the end. If you’re fortunate enough, you’ll be able to immediately re-direct your former student loan payments to investing. It seems trite to say this but I will anyways. Focusing solely on paying down debt robs you of the time that your money could have been working hard for you in your investments.

Investing early is a key to building wealth.

I’m not talking about investing money in a single stock and hoping that you’ve managed to get in on the ground floor of the Next Big Thing. From my perspective, that path is simply gambling. If you want to gamble, save your money and go to Vegas – it’s a lot more fun to gamble in Vegas!

The kind of investing that I’m referring to involves holding a broad-based equity exchange-traded fund (ETF) over a very long period time. Regular, consistent contributions to this kind of product gives investors access to the entire stock market and removes the temptation to jump from one promising stock to another.

An ETF offers you the chance to invest in a lot of companies at once. While they’re hardly exciting, ETFs offer regular people the opportunity to invest in some of the biggest companies in the world. You don’t have to be a genius, nor do you have to be lucky. The Next Big Thing will eventually become part of the ETF’s holdings, so you’ll still wind up own a sliver of it. And you’ll have avoided the risk of investing all of your money in one single company.

You should definitely read The Simple Path to Wealth by J.L. Collins. He does an excellent job of explaining why and how this works. Rest assured that I am not being paid for mentioning this book.

Real estate is another way to make long-term investments for the future. To be explicitly clear, this is not my preferred method. I am not an expert in real estate investing. If this interests you, then check out Bigger Pockets. I follow this account on social media and I’ve learned a lot. Again, I’m not being paid for mentioning them.

Some people can’t do both.

Fair enough.

I appreciate that not everyone has this option of to investing while paying down debt. Maybe you don’t have the money to do both. Reality being what it is, money only stretches so far. Or maybe the thought of debt causes you psychological distress. If that’s the case, then pay off your student loans as fast as you can. They are an anchor on your wallet. They prevent you from investing in your future because they force you to pay for your past.

You’ll make the best choices that you can with the information and money that you have available.

However, there are those in my audience who have enough to pay off the minimum student loan bill while also investing. If you’re fortunate enough to be in these circumstances, then I strongly urge you to do both. It may take you years to pay off your student loans. That is time that you can never get back. It makes the most sense to be investing in the stock market or in real estate while also paying down your debts. Your investments should be growing while your debts are decreasing.

Student loans are an anchor. There’s no doubt about it. However, how your handle those student loans will drastically impact your wealth-building goals. I don’t have all the answers because everyone’s situation is different. I just want you to think long and hard about what will work best for you.

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Weekly Tip: If you must finance a car, follow the 20-4-10 rule. Always put down 20% of the car’s purchase price. Make sure the loan is for a maximum of 4 years. Do not let the car loan be more than 10% of your annual salary. When your loan is paid off, keep making the payment to your Next Vehicle Fund so that you can pay cash the next time around.

A Potentially Horrible Boss

This summer, I was lucky enough to have a socially-distanced visit with some friends. As we enjoyed our cheesecake, the host mentioned that he was worried about what would happen when his boss retired. My friend explained that his boss’ child would likely take over the company. This likelihood was causing a good deal of angst since the offspring’s… leadership style… wasn’t particularly inspiring nor admirable. My friend was facing the very serious, very probable situation of working for a potentially horrible boss.

The worst part is that there is very little to be done. My friend has sought other employment, yet that pursuit has not been fruitful. Further, there are bills to be paid. The twin goals of paying off the mortgage and saving for retirement still have to be met. There’s no realistic option of just walking away from the bad situation which is looming. Like a great many people, my friend doesn’t have an income-producing portfolio as a safety net.

I had no words of wisdom for my friend. Instead, all I could do was be supportive and listen. However, that conversation has stuck with me. Perhaps I don’t have a way to fix the situation for my friend. Yet, I’m confident enough to believe that I do have a suggestion for those who aren’t yet in my friend’s circumstances.

Assess Your Situation

If you are very, very lucky, then you’re working for pay doing something that gladdens your heart. You’re satisfied with your work life and it’s a source of contentment for you. Your boss is an asset, rather than a point of stress. Still… you should always be aware that this is a situation that can change on a dime. Lots of things can happen. Maybe your current boss takes a promotion, moves away, retires or gets sick. In any of these situations. you’re suddenly facing the risk of a potentially horrible boss taking her place.

Trite though it might sound, the following statement must be acknowledged. Most of us do not have the financial ability to just walk away from our job. We realize that having a steady paycheque ensures we can feed ourselves and pay the bills. The vast majority of people have to keep working and hope for the best. In other words, a potentially horrible boss is a source of stress and there’s little that many workers can do to avoid it.

You, Gentle Reader, don’t have to be one of those people.

Get Horrible Boss Insurance

This is a form of insurance that insulates you from the risk of working for a potentially horrible boss. Unlike car insurance or house insurance, you don’t pay a premium to a company to acquire it. Nope! This is the kind of insurance that you create for yourself.

How so? By creating your own income-producing portfolio over time. The amount of time is up to you. You can save a little bit over the very long-term. Alternatively, you can save a lot over the short-term and engage in extreme frugality by saving up to 70% of your income. Or you can find a balance that works on a time-table that best suits your personal goals.

How you invest your money is your choice. Save-invest-learn-repeat. This is my mantra. Feel free to adopt it as yours too. You can learn about whatever investment you want. Some people are big fans of real estate investing. This is not my area of expertise but I have been devoting some time to learning about it over the past two years.

If you’ve been here for awhile, you’ll have noticed that I’m a big fan of the stock market and dollar-cost averaging over time. You’ve often heard me suggest that you should invest a portion of each and every one of your paycheque in a broad-based equity product, preferably an exchange-traded fund. The fees for ETFs are lower than the fees for mutual funds. Stock-picking is most likely not your strong suit so I’d advise you to only do it with 10% (or less) of your entire portfolio.

Money in the stock market is going to be invested for the long-haul. That means it is going to be invested in the stock market for decades. To be clear, your stock market investment money is separate and apart from your emergency fund money. It also shouldn’t be co-mingled with money you set aside for short term goals, which are those that are to be funded within a year or two. Oh, and you’re going to want to be very disciplined about ridding yourself of debt as fast as you can.

Money Buys Options

Gosh! That sounds like a lot, doesn’t it? Saving for retirement. Building an emergency fund. Funding short-term goals. Paying off debt! Life is meant to be lived and no one wants to be richest person in the graveyard.

Blah-blah-blah!

Believe you me when I say the following. The day that you have to work for a potentially horrible boss, you will not regret having money in your emergency account. You won’t ever regret having a second, back-up income generated by your portfolio. The Ad Man and the Creditor want you to believe that it’s some monumentally unfair disadvantage to not spend every penny you make. They are lying to you! The most precious thing in the world is time. Ironically, it is one of the few things that money cannot acquire. The second most precious thing in the world is having options. Money most definitely purchases options.

If a potentially horrible boss is on the horizon for you, then I promise you that you will want to have the option of getting away from that person. Having money allows you to do that. You need not work for someone who is going to make your life a living hell for want of money.

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Weekly Tip: Make extra payments towards your debts so that you minimize the interest that you pay to your creditors.

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Well, Gentle Readers, there are currently less than 60 days left in 2020. How are you doing with your financial plans? What needs to be tweaked for next year? Which financial habits will you keep in 2021?

Money in Your Kitchen

I’ve said it before, and I’ll say it again. There is money in your kitchen! The room of your home where you keep your fridge and your stove, your pots and your pans, your cutlery and your crockery is a treasure of stored value.

The way to find this money is to use your kitchen for …(drum roll please!) …COOKING!

Yes, I know this is a novel idea. And yes, cooking results in dirty dishes. I’m even willing to admit that you might not even know how to cook!

I don’t care. I want you to learn to feed yourself, and to save money while you do it.

Gentle Reader, there is nothing quite so satisfying as a delicious meal that has been prepared with your own hands. I say this a person who often socialized with my friends at restaurants in the Before Times. Steak – sushi – Thai – Greek – Italian – chain restaurant – bistros, cafes, and holes-in-the-wall! I loved them all, and I freely spent money on food prepared for me by others.

That said, very few meals – save for everything I ate in Italy – have been as sumptuous as the ones I’ve made for myself. If you eat out a lot, then you’ll understand me when I say the following. After a while, it all starts to taste the same.

Treats are special when they’re rare

We all know this. If you only eat out once every three months, then it’s a treat. It happens 4 times a year! It’s rare and that rarity makes it special. You might get dressed up. Possibly, you turn it into a special occasion. Dining out becomes an event and you anticipate it. You might savour each bite because you know it’ll be another 89 days before you eat out again.

But when you eat out everyday, it becomes part of your routine. It’s as mundane as brushing your teeth but exponentially more costly! When was the last time that you truly and deeply savoured the meal you picked up at the drive-thru window? Or had delivered to your home in an insulated carrier bag?

Get into your kitchen and cook for yourself. Turn those restaurant meals back into a treat! In the process, the money in your kitchen can stay in your wallet.

This week, I was lamenting to my sibling that I needed a new recipe for the extra lean ground beef that I’d taken out for dinner that evening. Trust me when I say that COVID19 has robbed me of my love for my own spaghetti and my homemade hamburgers. I’ve made them too often since the pandemic was declared and I don’t want to make them anymore! Though younger and much taller than me, my sibling is very wise in the ways of the kitchen. My younger relative suggested that I make Korean Beef.

Taking the suggestion to heart, I went to the World Wide Web and typed in the words “Korean beef recipe”. A plethora of results instantly appeared on my screen. I chose the following recipe from Damn Delicious, and I was not at all disappointed. What I love about this website is that so many people leave comments, tips, and insights into how to tweak the recipe. (I readily admit that the recipes can be made as-is and are still very, very tasty!) One such commenter suggested adding julienned carrots to the dish.

At first, I was afraid – I was petrified. I’d never julienned a carrot in my whole entire life!
(Apologies to Gloria Gaynor!)

However, there’s another marvelous invention in our universe called YouTube. It’s almost as good as the local library when it comes to a free resource for learning how to do stuff. I went to YouTube, searched for “how to julienne carrots”, and happily julienned my first carrot a few minutes later.

Another commenter mentioned that his family liked a lot of sauce, so he’d doubled that portion of the recipe. Guess what? I like lots of sauce too! So I followed his lead and doubled the sauce for my dish. No regrets! Doubling the sauce was a simple, easy, foolproof tweak that would increase my enjoyment of my own cooking.

So I made the recipe, doubled the sauce, and added my julienned carrot… and I wound up with this…

Then I added a little extra something….

Together, they produced the following…

And it was delicious! As another very wise friend would describe it, I served myself a meal that was yummy-yummy-in-my-tummy! There were enough leftovers for lunches and dinners the following days.

While I’m quite certain I could’ve ordered a pizza for $9.99 from a well-known chain, I’m equally certain that the pizza would not have tasted nearly as good as my homemade Korean Beef. Yes, I had to do dishes but it was a small price to pay for having a wonderful meal at home. And I received the added benefit of keeping the money I found in my kitchen. :-}

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Weekly Tip: Start an automated transfer to a savings account. The last time I checked, EQ Bank was paying 1.70% on deposits. I’m as un-impressed with that rate of return as you are. The point is to automate your money so that it’s there when you need it. The money siphoned off via automatic transfer is to plump up your emergency fund. If you’ve already got one that’s nice and fat, then use this automated transfer to save up money for your annual expenses: insurance premiums, property taxes, professional dues, etc…

Maybe you like to invest in big chunks. Fine. Set up the automatic transfer. Every time the account hits your pre-determined amount, transfer the money to your investments and then keep your mitts off it until you retire. Automatic transfers reinforce the savings habit so, if you haven’t already done so, set up your automatic transfer today.