Hear me now! Your TFSA should be for investing. Don’t use it as a savings account for your emergency fund or as a sinking fun for stuff.
In 2024, the contribution room for the TFSA will go up to $7,000. Please don’t tell me that you can’t afford to save $7,000. What can you afford to save? Whatever that amount is, that’s the amount I want you to contribute. Then I want you to squeeze your budget a wee bit more and add in a little extra. The more that’s invested, the happier you’ll be.
Let’s say you can afford to save $1,000 per year. That’s a little less than $20 per week. If you invest that $1,000 each year in your saving account, you might earn 3% each year on your money. After 30 years, you’ll have saved $30,000. At a return of 3% per year, this nifty little Future Value calculator says that you’ll have $49,002.68 in the bank. In other words, you’ll have gained $19,002.68 over 3 decades. This is a bad return on investment.
You could do way better.
If you invest that same $1,000 each year into the stock market and earn an average return of 8% over that time frame, you’ll have $122,345.87. Over the same 30 years, you’ll gain $92,2345.87 – more than 3 times what you invested.
Do you see why you should use your TFSA to hold the investments that are going to give you a bigger return over a long period of time? You’ll have way more money in your kitty at the end of your working life and that money will not be taxed once you start withdrawing it to fund your retirement.
Play around with the values in the calculator. If you can squirrel away $2000 every year – or $40/wk – so much the better. Don’t worry that you can only invest smaller amounts right now. Over time, you’ll be able to invest more. Also, your investments will be generating dividends and capital gains. Re-invest those and think of them as contributions to your future. Compounding is slow at first but it starts to get very sexy and very interesting once a few years have passed.
Do not take money out of your TFSA unless it is the direst of emergencies. You should have a separate emergency fund. Keep that money in the bank. You’re not trying to invest your emergency fund. It has to be there when you need it so accept the 3% return that your bank is offering you. The money that’s in your TFSA should be invested in a broadly-diversified, equity-based exchange traded fund. Or you can invest in a broadly-diversified, equity based index fund. These types of ETFs and index funds invest your money in the stock market.
Notice how I said that your investments in the stock market will likely earn an average of 8% over a 3-decade time span? It’s an average because the stock market is volatile. Some years, the stock market will be down but other years it will be up. However, over 3 decades, the stock market will definitely be higher than it is today.
So invest in the stock market and leave it alone. Set up an automatic transfer so that you’re investing from every paycheque. Once you’ve done that, you go about your merry way and let time in the market work its magic on your money.
It’s expensive out there. Staying at home with a cup of homemade coffee, snuggled under my favourite throw, and reading a long-anticipated book is a cheaper use of my time. And it’s just as satisfying to me as anything I pay for outside my home.
I don’t know about you but it’s expensive to leave my house. Yesterday, it was gassing up my vehicle. Today, it was groceries. Tomorrow, it’s Halloween so there might be last minute run to the grocery store for candy. Later on this week, it’s dinner with a dear friend. Next weekend… sigh… I think you catch my drift.
In terms of problems, this one really doesn’t count. Over the years, I’ve built up some very good habits for my money. I use automatic transfers to fund my emergency accounts and to invest for retirement. Several years ago, I established sinking funds for annual, un-sexy expenses like insurance premiums and property taxes. And lest you think that I don’t have any fun, there’s even a sinking account for travel, gardening, birthday presents, and theatre subscriptions.
So when I say that leaving my house is synonymous with money leaving my wallet, please know that I’m taking care of my priorities before spending on the day-to-day stuff that crops up.
You see, I think it’s the same for everyone. Leaving the house usually means spending money. The world is literally designed for us to spend money everywhere. Vending machines. Coffee shops. Grocery stores. Restaurants. Drive-through windows. Retailers of every stripe. Parking lots & parking meters. It’s hard to get through the day outside of the home without spending a little something somewhere.
Priorities First
Based on my own observation, the trick is to do your saving and investing first. It’s the timeless principle to pay yourself first. You may have heard of it as living below your means. When you get paid, transfer some of your net income – ideally 20% or more – into your saving/emergency/investing account. Once that money is tucked away, you can spend the remaining amount however you want so long as you don’t go into debt.
At the tender age of 16, I got my first part-time job as a cashier in a grocery store. Every two weeks, I took home just over $130. I picked $50 as my “savings amount” and transferred it into a separate account. By the time I bought my first car 5 years later, I had socked away $8,000. (Living with parents who paid for everything helped tremendously.)
If I knew then what I know now, I would’ve embraced public transit sooner and that money would’ve gone into equity investments in the stock market. Oh, well… too late smart.
Bottom line is that I started my first habit – saving a chunk of my paycheque every time I was paid – at a tender age. When I bought my first condo, I really had to figure out where my money was going. It was the first time I realized how badly I needed an emergency fund. If I had to pay for a condo assessment, then I needed to have money set aside or else I would have to go into further debt to cover my portion of the assessment. And when I moved from a condo to a house, I learned that furnaces and hot water tanks and roofs are exactly cheap. Again, my emergency fund got some loving attention.
Tune Up Your Finances
Speaking of your emergency fund, how’s it doing? Do you have atleast 3 months of expenses in there yet? If not, get to work. If yes, then consider beefing it up. Inflation is still something of a concern. I don’t know what’s happening in your corner of the world, but things aren’t getting any less expensive as far as I can tell.
Once your emergency fund is nice and fat, focus on filing your TFSA and your RRSP. Ideally, you’ll max out your contributions every single year. Realistically, that’s not likely to happen. Do what you can to put in as much as you can. Invest your money for long-term growth. When you’re too old to send your body out to work, your TFSA and RRSP will provide the cash you need to live.
And if you’re fortunate enough to be able to max out those two accounts, then open a non-registered account and invest your money. Unlike the TFSA and the RRSP, there is no limit to how much you can invest in your non-registered account. Take advantage of that to earn dividends and capital gains, two forms of income that are taxed less lightly than your paycheque.
I speak from personal experience. It took me years to fine-tune my system, but it’s now running like a well-oiled machine. Between my automatic transfers and my sinking funds, I’m able to fill my TFSA and my RRSP every year. I’m able to send money to my non-registered account from each paycheque. And my emergency fund is nearly fully funded because it takes a very long time to save up a year’s worth of expenses. (Yes – in my view, a fully funded emergency fund is one that will keep me going for a year. You may feel otherwise.)
You Can Do This
So long as you’re investing 20% of your income, or whatever you can realistically afford, then it doesn’t really matter that you spend money every time you leave your home. Just don’t go into debt! If you’re going into debt, then you need to stop. Debt is corrosive to your ability to secure your future. Money that’s going to your creditors is money that it not going towards your financial future.
And I know that 20% is a big chunk of money. You may not be able to save that much right away. Guess what? I don’t care. You start where you are and you work your way up. Ruthlessly cut out whatever you don’t need so that you can save and invest for Future You. No one else is responsible for ensuring that you have the kind of retirement you want for yourself.
So, yes – going out is going to be a hit to your wallet, more often than not. However, if you take care of yourself by investing off the top and by keeping your emergency fund healthy, then those hits won’t matter. The money that’s working for Future You will keep doing its job, regardless of the day to day expenditures.
Starting on January 1, 2023, the contribution room to the Tax Free Savings Account will increase from $6,000 to $6,500. If you’re fortunate enough to have any money to invest, take advantage of tax-free growth and invest it under the TFSA umbrella. It should be obvious but I’ll say it anyway. Investments grow faster when Canada Revenue Agency doesn’t tax them.
And if you can’t afford to contribute the full $6,500 in 2023, don’t sweat it! Starting today, invest what you can. That might be $10/day or $25/week. The amount doesn’t matter so much as the actual fact of contributing your money. Set up an automatic transfer so that the money goes into your TFSA. The sooner it’s invested, the sooner you reap the benefits of tax-free compound growth.
Once the money is in your TFSA, invest it in well-diversified, equity-based securities like index funds, exchange-traded funds, or mutual funds. If you like real estate, you can buy REITS. And if you’re into picking individual stocks, you can do that too. When you hold your income-generating investments within your TFSA, the CRA will not tax them. You can reap the dividends, capitals gains, and interest without having to share any of it with the TaxMan.
I wish this account had been called the Tax Free Investment Account. Too many people think that it can only be home to a savings account. This is completely and utterly wrong! You can open a TFSA account at your preferred brokerage, and you should. Ideally, you’re investing for the long-term. Over the long-term, the stock market’s average returns are way higher than the interest paid of your saving account. It’s better to earn higher returns and benefit from tax-free compound growth.
If you were 18 or older in 2009, then your lifetime contribution to the TFSA will be $88,000 starting in 2023. Don’t fret too, too much if you haven’t been able to maximize your contributions each year. Start where you are and do what you can. Inflation is taking an added bite out of everyone’s wallets, so finding the money to fund the Care and Feeding of Future You might not be easy. Regardless of whether it’s easy or hard, you have to do it. When you’re ready to quit working, you’re going to need money to replace your current income. Without solid investments, it’s unlikely that you’ll be able to maintain or improve the lifestyle that you already enjoy.
If you invest wisely and your investments perform very well, you can withdraw each year’s earnings and live off the cashflow. The principal can remain within the TFSA to generate even more tax-free money the following year. Your TFSA has the potential to become a money-making machine for you. The tax-free earnings could supplement your other retirement income if you wanted. Of course, this machine won’t exist if you don’t start investing today.
The TFSA contribution amount for 2022 is $6,000. And the very best day to make that contribution is January 3, 2022, so that your money is invested as soon as possible. The sooner you contribute to your TFSA, the better since tax-free growth only starts once the money is deposited.
What’s that, you say? You don’t have $6,000 lying around, waiting to be invested? Your money tree isn’t casting off riches in the dead of winter?
No worries, my dear Reader. You start where you are and you do what you can. Right now, many of us are in the thick of holiday activities. After last year’s lockdown, there’s a good chance you’re itching to see family and friends in person. (And if you do, please be very, very careful and follow guidelines for not spreading COVID-19 as you go about your merry-making!) There might be some shopping or baking or carolling in your plans. Perhaps, you’re walking around to see the festive light displays of neighbours and town centres.
I can certainly understand that you probably have other things on your mind at this time of year. I myself still have a number of things to cross off my To-Do list before Santa Claus makes his appearance in two weeks. At the top of that list is remember to be nice instead of naughty… tough to do when we’re all a bit stressed and crazed by the madness that seems inherent in holiday preparations.
Be that as it may, believe me when I say the following. You still have to do what you can to achieve your dreams. Let’s be honest here – no one else cares about your dreams as much as you do. They’re too busy working on their own dreams, aren’t they? The reality is that you have to know yourself in order to prioritize that which is most important to you and to direct your money accordingly.
Dreams cost money. Coming up with $6,000 at the drop of a hat isn’t easy for the vast majority of us. No argument there! Yet, it’s likely that you could find $5 a week – maybe even $20? Start with that. Set up an automatic transfer from your chequing account to your TFSA and get in the habit of contributing regularly. As your budget allows, increase the transfer amount. Your goal is to stuff your TFSA without going over the current contribution limits. Unless you have a lot of disposable income, contributing the maximum amount will not be super-easy. Don’t feel bad that it might take you longer than someone else to get the money into your TFSA. At the end of the day, the most important element of this whole endeavour is to get the money into your TFSA. The speed with which you do so is secondary.
As you pay off debts, increase your contribution amount. Truthfully, $6,000 per year is $115 per week. That’s a good chunk of money, so work up to it. Did you get a raise? Great! Save half and spend the rest. Did you pay off your car loan? Awesome! Re-direct 75% of your former payment to your TFSA. Student loans finally gone? Let the good times roll… but first make sure that two-thirds of your former payment are re-directed to your TFSA. Money from Santa? I think you know what to do – save a good chunk and enjoy the rest!
Hey! I’m not going to quibble over the precise amount. You’re more familiar with your own numbers better than I am. My suggestion is based on personal observation. Money that isn’t immediately re-directed from a former payment to an investment of some sort inevitably get absorbed into the costs of daily living. I don’t always know how it happens, just that it does.
One of the best things about the TFSA is also one of its worst features. Your contribution room rolls over to the following year if you don’t use it. That means, if you don’t put money in today, then you can put it tomorrow. I strongly urge you to no delay your contributions. Money that isn’t invested will never benefit from tax-free growth!!!
Yes – that’s right. I said tax-free growth. TFSA is an acronym for Tax Free Savings Account. It still confounds me that the Powers That Be didn’t call it a Tax Free Investment Account. Your TFSA need not be limited to savings accounts. Considering that inflation is decimating the rate that you’re earning in a savings account, you need to have your TFSA invested in an equity ETF. Over the long term, equity investments outpace both savings accounts and inflation. It can be a bumpy ride but your odds of seeing growth in your portfolio go up tremendously with investments in equity.
The TFSA is too amazing of a tool for you to ignore. Find a way to get your money invested within your TFSA as soon as possible. If you can’t make the maximum annual contribution, don’t fret. Just do what you can!
In 4 short weeks, the new year will have arrived. Hooray! Happy, happy, joy, joy! Kiss kiss to everyone!
I don’t know about you but I don’t believe in new year’s resolutions. If I think changes to my life are going to make it better, then I’m going to implement those changes as soon as possible instead of delaying them to some arbitrary day in the future.
That said, I do set financial goals each year. These goals help me to prioritize my sinking funds. Even though I might want all the things, my wallet only stretches so far so I can only get some of the things. Retirement is very, very important to me so I’ve got money set aside to fund my TFSA. And the plan is to start saving for 2023’s TFSA contribution with my very first paycheque of the new year. After all, next holiday season is hardly the time to start looking for $6500 – fingers crossed! – to contribute in January of 2023. Am I right?
Pre-pandemic, another huge financial goal of mine was paying for travel before going on any trips. I was very fortunate as I’d been able to take atleast one great trip every year before COVID-19 arrived. I’m fervently wishing that vaccination rates increase quickly around the globe so that I can get back into the routine of traveling.
Then there are the minor details of running a household and being a grown-up. You know, things like property taxes and insurance premiums. While not sexy, I do take pains to pay for these expenses in annual lump sums every year. I really hate automatic withdrawals, so I work hard to avoid them. My practice is to look at last year’s amount for these bills and then increase them by 10%. If I’m lucky, I’ll have saved a little bit over the prior year’s amount.
Don’t think I forget about fun! Not a chance! Pre-pandemic, it was easier to budget for my contributions to the arts. I love going to the theater. I’ve had a subscription to Broadway Across Canada for years. These past two seasons, I’ve sorely missed seeing my scheduled productions. I cannot stress this enough – vaccinations are the key to me being able to fully enjoy this aspect of my life.
Making my home a little cozier will take money. I plan to age in place, so I want make changes to my home that I’ll enjoy for a long time. The goal next year is to pay cash for new blinds in several rooms of my home. I might also have the frames around my windows replaced. Who knows? This might even be the year that I get my home repainted. I’ve never been a fan of the current wall colour, but I’ve also been so busy gallivanting that I haven’t had extra money to hire a painter. See what I did there? Travel was a bigger priority than paint colours, so the money went to travel and my walls stayed meh.
Now that I’m keeping travel on hiatus, money can go towards goals that used to be a bit lower on the priority list.
Is there any way that you would consider planning out your money on an annual basis? Obviously, your priorities are going to be very different than mine. In my very humble opinion, the very best way for you to maximize the odds of you achieving your priorities is to structure your money to pay for them. Maybe you want to adopt a pet? Start a business? Take some courses? Move to another city or country? Upgrade your Christmas tree decorations?
Okay… so maybe we do share that last goal. While decorating my Christmas tree this year, I decided that I’d like a few more blue ornaments. I’ve already started checking out the sale prices on ornaments at various stores. Since I’m a huge fan of buying Christmas decorations after the holidays, I’ve tucked away a little bit of money to do so. I’ve found what I want. It’s already 33% off. Now, I just have to decide if I want to gamble on the price dropping considerably more before the ornaments I want are all sold out.
The fact is that 52 weeks goes by very, very quickly. And there will be multiple opportunities for you to spend money that you might not have intended to spend. Having a plan in place, along with the automatic transfers and sinking funds, means that your most important priorities are funded first. Then you can spend the rest however you wish.
Maybe you’re the sort who needs to write down their goals? That’s okay. Today, I learned about the YearCompass. I’m going to try their system and see if it helps me to finesse my current process. One of the reasons I decided to try YearPass is that it helps people create goals in all areas of their life. This would be good for me. Check it out. Maybe it’s a tool that you would also find useful. Maybe, it’s not. You won’t know until you give it a look-see.
Again, there’s no need to wait until January 1 to craft your financial goals for 2022. I know that most of us want to visit with family and friends. Many of us lost the opportunity to do so last year, so we feel a need to make up for lost time. I’m urging you to take a few minutes to figure out what you want in the new year, and to think about how you’ll fund your goals. After all, the best use of your money is to spend it in ways to create the life that you truly want.
One of the cruel ironies of money is as follows: the less you have the more you need it.
Take two people – Joe & Morty. Both of them have monthly expenses of $2,750 – rent, food, utilities, car payment, gasoline, and various other stuff. Joe has $500 to pay his bills this month. (His employer went bankrupt and isn’t paying anyone, whether those people are employees or creditors.) Morty has $7,000 to pay his bills this month. (He won the 50/50 draw at the hockey game.) Who has a more acute need for more money?
Obviously, Joe needs it more. Joe’s need is more acute because he doesn’t have enough money to pay his bills. Morty has sufficient money to pay his bills this month, so he doesn’t need more.
I bring this up because it’s a fact of life that’s rarely discussed. Let’s face it. The AdMan has no interest in telling you to think about these things. His job is to get you to spend whatever you have in your pocket right now. And he can’t do his job if he’s also whispering to you that it might be a good idea to keep a little something set aside just in case something goes wrong.
And the Creditor will seduce you with the lie that credit is as good as cash. That’s not true. Cash will never charge you interest, penalties or fees. Cash sits there, waiting to be deployed. Once it’s gone, it’g gone and there’s no obligation to repay anyone. Also, cash is its own cushion of comfort. The more of it you have, the more comfortable you are.
So where does inflation come in?
Inflation erodes the purchasing power of your money. That’s a fancy way of saying things get more expensive over time. If $200 buys you 7 bags of groceries today, then that same $200 will buy you 6.8 bags of groceries tomorrow. And with each passing year, that same $200 will buy you fewer and fewer groceries. The reason for this is that the purchasing power is being reduced due to inflation.
The corrosive power of inflation on your hard-earned dollars is the reason why you ought not to keep your retirement funds in a savings account. If the bank is paying you 0.05% annually, and inflation is running at 1.2% per year, then you’re losing money on your savings account.
Here’s the math:
$1,000 in the bank earning 0.05% is $1,000 x 0.0005 = $0.50. (Yes, that’s right. Money in your savings account earned you $0.50 in one year. For the purposes of this example, I’m going to ignore the effect of taxes on that earned interest. However, rest assured that you will be required to pay taxes on interest earned in your savings account.)
The purchasing power of your $1,000 decreased by 1.2% thanks to inflation.
$1,000 x (1- 0.012) = $1,000 x 0.988 = $988
After one year, the purchasing power of your $1,000 has been reduced to $988. Add to that the $0.50 in interest that you earned. Your new purchasing power is now $988.50… this is the reduction in purchasing power after only one year. Imagine what happens after 5 years? 10 years? Longer?
Maintain Your Purchasing Power
The way to stay ahead of inflation is to earn a return on your money that is higher than the inflation rate. (Strictly speaking, the return has to exceed inflation and the impact of taxes. I am not a tax expert so please consult a tax expert to get advice on tax matters.)
When inflation is running at 1.2%, then you need to earn 1.3% to stay ahead of it. The wider the gap between inflation and the rate of return, the better it is for you.
Your results may vary, but the best thing I’ve done to ensure that my money earns a return higher than inflation has been to invest in the stock market via exchange traded funds. I used to invest in mutuals funds, then I learned about index funds and exchange traded funds. For the sake of transparency, my money is invested with Vanguard Canada. I used to invest with iShares (now known as BlackRock), and I would’ve stayed with iShares if their management expense ratios had been as low as Vanguard Canada’s.
The bottom line is this. You need to guard against allowing inflation to erode your money’s purchasing power. You do this by investing your money in ways that ensure your rate of return exceeds the inflation rate.
A new year is right around the corner. In a few short days, we will usher in 2021 and 2020 will be in the history books! Can I get an “Amen”?
I don’t know many who would argue that this year has not been trying for the vast majority of us, and on so many fronts. The one good thing to come out of this year is the announcement that the Tax Free Savings Account contribution limit for 2021 is going to be $6,000.
That’s right – it’s TFSA time again! Hooray!
If you’re one to make New Year’s resolutions, you should definitely put one or two money-related items on that list. Toward that end, consider adding some money to your TFSA. This is a financial tool worthy of your time and attention. If you have a TFSA, any money sheltered therein is allowed to grow tax-free. This is a tremendous benefit that should not be squandered!
I’ve said this before so please indulge me as I repeat myself… I do so wish this tax-shelter had been properly named the Tax Free Investment Account. Contrary to its egregiously-mislead moniker,this particular financial tool is not limited to savings accounts. Yes, if you absolutely must, you can have a savings account in your TFSA. There’s nothing preventing you from pursuing that option.
Consider the following… a savings account is not the best use of the tax-free feature of this tool. An investment account is a far more beneficial way to use the tax-free feature of the TFSA. At the time of this post, savings account pay less than 1%. A so-called “high interest savings account” pays less than 2%.
Does 2% sounds like a “high” interest rate to you?
Here’s another question for you. Would you rather earn less than 1% without paying taxes or earn 7% without paying taxes?
It’s not a trick question… You’re not an idiot. You’d rather earn 7% without paying taxes. How do you do that? Simple, not easy. You consistently contribute money to an investment account held in your TFSA where your money is invested in a low-cost equity index fund over a long period of time. On average, the stock market has averaged a return of 7% or better. This means that some years, the stock market’s return will be less than 7% and in some years, its return will be higher than 7%. Over the long-term, the average return will be 7%.
Without taxes to cannibalize your returns, an investment account held in a TFSA can grow to a very nice size over a very long period of time.
Again, for the cheap seats in the back, savings accounts are currently paying less than inflation. In other words, inflation is eroding the purchasing power of your money faster than you’re earning interest. Take a look at your financial situation. If you’re only early a pittance in interest each month in your savings account, yet your grocery bill is going up by $20 each time you re-stock your pantry, then you’re hooped. Your savings account money is not working for you – it is losing value every single day! A savings account is not where you want to keep your money if you’re looking for it to be invested for long-term growth. Savings accounts are best used as short-term sinking funds. For example, a savings account is a great place to hold your money while you’re saving up for a vacation, a family celebration, or a major renovation.
Your tax-free (TFSA) and tax-deferred (RRSP) money shelters are for the money that’s meant to grow faster than the rate of inflation. Do not waste the very precious room in these shelters by keeping your money in a savings account. The ability to grow your month without paying taxes is a financial super-power. Use that power to the best of your ability by investing your money for long-term, tax-free growth.
Contribute as much as you can!
The TFSA was first introduced in 2009. Since then, the following annual contribution limits have been in place. Whatever contribution room is not used in one year is carried over to the next year.
For 2009, 2010, 2011, and 2012
$5,000
For 2013 and 2014
$5,500
For 2015
$10,000
For 2016, 2017, and 2018
$5,500
For 2019, 2020, and 2021
$6,000
Lifetime Total Contribution on January 1, 2021
$75,500
Roughly six weeks before the end of each year, the Canadian government tells people how much money can be contributed to their TFSA. In 2021, people aged 18 and over will be permitted to contribute $6,000 to this magnificent tax shelter. This latest contribution amount is in addition to any contribution room that you have carried over from prior years.
Carry-over room is not something to strive for, since you want your investments to start working for you as soon as possible. The reality is that it’s not always possible to max out your contribution ever year. Fair enough. Contribute as much as you can, as soon as you can.
The quick and dirty of contributions for 2021 are as follows:
If you’ve never made a contribution to your TFSA, then your lifetime contribution room on January 1, 2021 will be $75,500.
If you’ve already contributed $X to your over the years TFSA, then you’ll have $75,500 minus $X worth of contribution room.
And should you be in the very fortunate position of having made full contributions to your TFSA over the years, then you will have $6,000 of contribution room when 2021 finally arrives.
Stay healthy. Wear a mask. Wash your hands. Socially distance if it’s essential for you to be out and about. And invest as much of your hard-earned money as you possibly can for long-term, tax-free growth inside your TFSA.
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Weekly Tip: Pay off your mortgage before you retire. It’s never wise to give up a paycheque while you have debt. For many people, retirement means living on a fixed income. As such, that fixed income should not be paying for debt payment. Make a plan and pay off your mortgage before you retire.
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.
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!
Blue Lobster, I’ve got a question for you… I’ve saved up some money. Where do I invest it for long-term future growth?
Great question! And one that I’d love to answer… but first things first. I have to state the following:
I am not a financial advisor nor am I in any way certified or qualified to give tax advice. The following post is based solely on my life’s experiences. I can tell you what I did, but I’ve made mistakes over the years. My choices were based on my particular circumstances which means that my choices might not be right for you. If you want professional advice, then I’m going to strongly recommend that you find a professional person to give it to you. I’m not a professional financial advisor so you rely on my opinion at your own risk.
Now, with that out of the way, let’s get back to your question. I like to call the following my Order of Investing Money.
First Things First
In my opinion, the best place to first put your money is into a Tax Free Savings Account (TFSA). The TFSA was created in 2009. If you’ve never contributed any money to your TFSA, then your cumulative contribution room as of January 1, 2020 is $69,500.
The TFSA does not generate a tax deduction. The money that goes into the TFSA is after-tax money. Whether you’re in the highest tax bracket or the lowest tax bracket, your money goes into the TFSA after you’ve paid taxes on it. If you invest it in equity products and you earn outsized returns, then all of the initial contribution and the growth generated can be withdrawn without any kind of tax penalty.
Allow me to be repetitive so that the following point is not lost on anyone reading this post. All money that goes into a TFSA grows tax-free. When you take it out of the TFSA, the money is not taxed by the government.
Whatever you take out of your TFSA can be contributed back into your TFSA in the following calendar year. This rule is applicable even if your withdrawn amount is higher than the amount that you’ve contributed over the years. In other words, you can withdraw both your initial contributions and the growth that has accrued, then you can contribute those amounts back to your TFSA the following calendar year.
So if you’ve invested the maximum to your TFSA, i.e. $65,000, and it’s grown to $110,000, then you can withdraw the full $110,000 whenever you want. You simply can’t put any of that money back into your TFSA until January 1, 2021.
Should I put my money anywhere else?
The next best place to save your money, in my humble opinion, is in your Registered Retirement Savings Plan (RRSP). However, there are a few major differences between the RRSP and the TFSA that you need to know about.
Unlike the TFSA, money inside your RRSP will grow on a tax-deferred basis for as long as it stays inside the RRSP. The taxes that are owed on the money that accumulates in your RRPS are deferred. You don’t pay those taxes now – instead, you will pay those taxes later. To be precise, you will pay taxes on that money when you withdraw it from your RRSP.
Contributions to your RRSP are tax-deductible. If you put money into your RRSP, then the Canada Revenue Agency will refund you the taxes that you paid on that money when you earned it. This is great!
If you’re in a high tax bracket when you contribute to your RRSP and in a lower tax bracket when you withdraw from your RRSP, then you’ll save money on taxes when you withdraw it.
If you’re in a low tax bracket at contribution and then a higher tax bracket at withdrawal, then you’ll pay more in taxes. This sounds bad but keep in mind that you’ll have had years of tax-deferred growth within your RRSP if you’ve seen good returns on your investments.
Paying taxes on money is far, far better than having nothing set aside for retirement.
And if I’ve maxed out my TFSA and my RRSP?
Gentle Reader, you’ve done me proud! If you’re in the very fortunate position of having maxed out both your TFSA and your RRSP, then I salute you. Reach over and give yourself a pat on the bat. You’ve done well!
Your next step is to open a brokerage account, aka: an investment account, and start investing your money. You’ll be contributing after tax dollars to this account. Your growth will be taxed as you earn it, but you’ll be investing your money instead of squandering it on frivolities that don’t add to your life.
Throughout this entire order of investment priorities, you should be taking care of your present and future financial needs by practicing the 4-step process for financing your dream life: save-invest-learn-repeat.
You’re going to have to take some time to learn about TFSAs, RRSPs, brokerage accounts, and the various investment options available to you.
Do not let analysis-paralysis stop you from starting. Similarly, it mustn’t prevent you from making investment decisions. You won’t make perfect decisions, but console yourself with the truth that no one does. This is why learning is such an integral part of the 4-step process.
Maxing out my accounts is impossible!
Stop fretting! No one said you have to max out all your accounts.
If you can, then great.
If you can’t max out all your accounts in one shot, then contribute as much as your budget will allow and get on with the rest of your life. The only “bad” contribution amount is $0. Anything over and above $0 is progress. Find ways to cut expenses or find ways to increase your income. The option is yours, but so is your obligation to yourself to contribute as much as you can towards the Care & Feeding of Future You.
As you learn more, you’ll earn more. And when you earn more, you’ll contribute more. It’s that simple.
Please do keep in mind that simple isn’t the same as easy. I’ve yet to find that “easy” way to earn money to contribute towards my investments. Every dollar has been hard-earned.
My advice is to start with first things first. Begin by fully funding your TFSA. Once you’ve done that, max out your RRSP. When that task is done, set up an automatic transfer to fund your brokerage account. And if you decide to not follow this Order of Investing Money, then I beseech you to continue learning about money so that you’re confidently investing for your future in a whatever manner that best suits you.
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Weekly Tip: Open an online savings account. Get one that pays higher interest than what the brick-and-mortar banks are offering. Consider EQ Bank. (I’m not being paid for mentioning this bank.) This savings account should be separate from your daily chequeing account. Set up an automatic transfer of money from your paycheque to your online savings account. This transfer should fund – in order of priorities – your emergency fund, annual bills, short-term goals, and luxuries for yourself.
I’ve been reading many articles about how people in their 60s, 70s and even in their 80s are still working because they can’t afford to retire.
Invariably, the statement is made that the government pension is not enough to retire on and to have a comfortable life.
For the record, I want it known that I believe retirement is a function of money and not a function of age. Once employers transferred the obligation of saving for retirement into workers, it became necessary for workers to realize that retirement wasn’t guaranteed with the passage of a particular birthday.
In order to maximize your chances of retiring comfortably when you want to, you must do the following things.
First, live below your means so that you can fully fund all of your registered accounts. These would be the Tax Free Savings Account (TFSA) and the Registered Retirement Savings Plan (RRSP) in Canada. You can contribute up to $26,500 to your RRSP for the 2019 tax year. As for the TFSA, the 2019 contribution limit is $6,000. These might be huge amounts for you, or they might be pocket change. Either way, contribute as much as you can as soon as you can. I promise you that you will need money in your dotage. These two accounts allow you to set aside money and to have that money grow without being taxed. Tax-free growth is awesome!
Second, continue to live below your means so that you can invest in you non-registered investment accounts. If you’ve got the money after fully funding your registered accounts, then don’t blow it on things that don’t bring you joy. Instead, put some of it away for your future. Non-registered investment accounts are also called brokerage accounts. Some people say to save 15% of your income. I advocate for saving until it hurts. The more you save, the longer your money has to compound and grow.
Third, stay out of debt to the greatest extent possible. Debt is a financial cancer. It puts a claim in your future income. Debt stops you from investing your money towards your own goals. Think about your debt as a claim on your time. More debt means staying in the workforce longer in order to pay off your creditors. Do what you have to do to eliminate debt from your life to the greatest extent possible. Make sure that debt doesn’t accompany you into retirement!
Fourth, get rid of your TV. The entire purpose of commercials is to get you to buy stuff. Every ad is designed to make you believe your life would be better if you opened your wallet. This is not true. Stop exposing yourself to so many damn ads! Bury your nose in a book. Go for a walk. Find a volunteer activity. A new year is about to start. Consider a resolution to eliminate television from your life, whether it be cable, Netflix, Crave, Hulu, whatever. Maybe the idea of going cold turkey on TV makes your heart race? Could you pick one day of the week to give up the consumption of commercials? Even seeing 1/7th fewer exhortations to spend will give your wallet some relief.
The size of your retirement kitty is dependent on how soon you plant and water your money tree. Save-invest-learn-repeat. Unless you’re living on 30% of your income, it’s going to take a good long time to save up a decent-sized retirement kitty. Start saving today!
You’re the one with the power to invest your money for long-term growth. You have the ability to learn about various options for your money. It’s on Today You to prepare as best you can for the arrival of Tomorrow You. Save yourself from the struggle of living on a government pension. The maximum pension payment in Canada today is less than $1200 per month. And you’re only entitled to that if you’ve worked for 40 years!!!
Even if you’re one of the fortunate ones who love their job situation, you must still think about having enough money to retire in your own terms. Ask yourself if you’d still love your job if certain conditions changes. A new boss? A longer commute? Fewer resources to do more work? A change in duties? Do you want to have the option to leave the world of work without financial worries if the job you love were to morph into one you despised?
Retirement is a function of money, not age. When you have enough money, you can retire whenever you want. Try to think about this every time you go to spend. Is your intended purchase worth another day at work?
