Getting the Most of Your Investment Dollar pt. 1

Remember that commercial with the jingle "Hands in my pocket?" Well, that is the investment world. Everybody wants your dollar and they are spending lots to get it. Between mutual fund companies, insurance companies, and the banks, thousands are spent on one purpose: the privilege of managing your money and they will show you the numbers to back this up.

With so much out there, even the best professionals have a tough time choosing what is right for their clients. It is easy for people to make the wrong choices and worse, pay a financial advisor to do that for them. Moreover, most people do not know what is being done with their money and why.

As I type this I look at the TSX to see that there has been a recoup of some of the downfall that we saw over the summer. Many investors read the headlines and see their falling investments and ask themselves the question: "Where is the best place for my money?" It is a worthy question, but I would like to follow that up with "How can every individual get the most out of every dollar they have invested?"

Let's start with the trusty GIC. A dependable safe haven for volatile times. In times of historically low interest rates we also see a reflection in GIC rates. Billions of Canadian dollars are held with the banks in a GIC at this very moment receiving a low return, but on the other hand this is "low risk."

Let's define risk in terms of investing. I think we would all agree that risk to investors can be associated with the loss of capital. Studies have shown that after inflation (the reduction in the value of your dollar) and taxes your real return is actually in the negative with GICs. This means that at the end of the day, let's say in 5 years, the actual value of your dollar is less than when you started. Now that study is from 2004 but I have not seen a dramatic increase in GIC rates and one would argue that life has gotten more expensive.

In the meantime the bank has benefited from 5 years worth of leveraging and making a lot of profit from your money. Not only that, but if you choose to access your money within the stated period of time the bank will charge you a fee or penalty.

This defines risk to me and not necessarily getting the most from my invested money.

I use the idea of building a solid foundation in your portfolio like you would with a building. Once that core has been established you have a lot more freedom to take a more aggressive approach. However, with any investment time always reduces risk. For example, take a core quality balanced mutual fund that holds not only equity but also bonds and other fixed income vehicles. With quality management you will often see a decent real return based on five years (8-10%). I see that as a conservative core to build for yourself.

However, this opens up a big can of worms: Mutual Funds. Here's a crash course on how mutual funds work.

Do mutual funds fit the average Canadian? Are you better to invest in mutual funds vs. index funds? What about the fees associated with investing in funds? What about returns? What about loads? What am I investing in with my mutual fund?

All valid questions.....pt. 2 Mutual Funds

RRSP Contributions vs. Extra Mortgage Payments

I don't want to come off as critical of the RRSP. In my previous post I wrote that I feel that this is one of the only things that gets a lot of Canadians saving and it is one of the only legitimate tax savings vehicles for salaried employees. However, when asked what is good money management and the secrets to building wealth I will always tell people the same thing:

Do what you can to save as much tax as possible and do what you can to reduce the amount of money you are paying to institutions.

This all comes back to cash flow. Keep more of what you earn in your pocket. What you do with it at that point is a whole different story. My personal belief is that the average Canadian today is stretched to the limit with cash flow and doesn't have a lot left at the end of the day for savings or RRSP contributions. This can be attributed to things like high mortgages, compounding debts, and costs related to everyday life.

I was recently reading an article talking about pre-tax dollars and where is the best place to put them: RRSPs, non registered investments, or extra contributions towards a mortgage. This takes into account that an investment in a non-registered investment or an extra contribution to a mortgage would be done with after tax dollars. When that is taken into account the RRSP argument is going to win every time. Not only on the benefits of the contribution itself, but also on the tax end, even though the RRSP is the worst form of taxation you will have. This study was done on the basis that some investors feel that the loss of the dividend tax credit and/or capital gains/losses can be an upside to investing outside of an RRSP. The numbers prove it and once again the RRSP comes out on top.

You can have a look at the article here.

However, something I stumbled upon years ago was The Smith Maneuvre. I have been interested in the ins and outs of the Smith Maneuvre since 2003. What Fraser Smith preaches is the benefits of the tax deductible mortgage. He is right that there are many benefits to changing your payments to generate more tax savings. However, the by product of what Smith promotes is a reduction in the ammortization period of the mortgage itself. In my opinion that is a more attractive result to the average Canadian than just the tax savings. What Smith has done is incorporated the use of 'good debt' to fuel this strategy.

Smith was not the first to use this strategy. However he was the first to market it well. He did it so well that he actually tied his name to it. Talbot Stevens actually wrote about the same strategy in the book 'Dispelling the Myths of Borrowing to Invest' Stevens is a promoter of the use of conservative leverage on many fronts and he does it well. In fact, many of the strategies that I employ come from Stevens in one way or another.

The point that I am trying to make by referring to these two pioneers of the use of leveraged investing is that they are restructuring the use of this tool to use the tax benefits to apply to mortgages. The reason is is that for every dollar that is spent on interest used towards an eligible investment is 100% tax deductible. Each dollar is treated the exact same way as any dollar that is put into an RRSP.

The benefit here, in relation to my previous points, is that when these tax deductions are applied to a non-registered asset that is subject to dividends and/or capital gains the non-registered investment will come out on top every time in terms of money in your pocket. That is because the money being used is no longer after tax dollars like in the article I noted above. Not only that, but when you use leveraged investing you will usually have a larger sum of money working for you sooner, thus taking advantage of time. The end result is the same tax savings with a larger investment subject to less tax.

Back to the RRSP contributions vs. extra mortgage payments. My argument is if you can use tax deductible dollars to apply a leverage strategy towards a tax efficient income stream (which is a whole other entry) and apply that towards extra contributions on your mortgage you will be ahead for many reasons. I will list a few.

1) Every person who has accelerated their mortgage in one form or another knows the thousands that can be saved in non-tax deductible interest going to institutions

2) The freedom of being mortgage free sooner can provide for more time to take advantage of compounding. Not only that but you will have more cash flow to contribute to a plan through dollar cost averaging.

3) The continuation of leverage use on a conservative, educated, and long term method can not only provide for a compounding tax savings over the years but also a dramatic increase in wealth.

4) No mortgage, a house, and a tax efficient investment portfolio beats no mortgage and a house.

Again, I am not saying that RRSPs are not a valuable tool for the average Canadian. I am just saying this is my recommended solution to a common question. These are areas that need to be explored when talking to average Canadians today.

Living in Canada

Today we get to see where our city ranks in terms of living. Money Sense has released the best places to live in Canada for the year 2007. Ottawa/Gatineau has ranked number 1.....and for good reason?

I moved to Ottawa a year ago from London (no.8) and have taken the time to learn about my new local demographic. Aside from financial reasons (highest average income, strong job stability, stable real estate values) you also get a beautiful city to go along with it. One thing to consider is that all the Canadian tax dollars go to Ottawa. Therefore it isn't surprising that many places you might go to are postcard worthy. Not only that, but in any direction you can be quickly out of the city and to somewhere beautiful where one can enjoy the landscape.

For the most part the largest employer is the government. Some of the features that government employees benefit from are above average incomes, job stability, and a nice pension to look forward to. Commonly you may see a household with two income earners in this position. In 2005 the average Canadian income for a household of two income earners or more was in the area of $65,000 per year. A place like Ottawa obviously has many people living above that standard.

A household like that would obviously be paying a lot of tax and likely they would be using RRSP contributions as a vehicle to offset this. This got me thinking about an article that I read a few years ago titled 'Cashing Out RRSP Might Make Sense' that I found in the Toronto Star.

The article applied more to a middle income earner that would not have a pension in retirement saying that RRSPs may not be advisable to a contributor that will be receiving a pension due to the fact that they would be subject to clawbacks of the Guaranteed Income Supplement and/or Old Age Security. The article stated that it might be wise to 'cash out' RRSPs prior to 65.

This leads one to think about the purposes of the RRSP.

For many Canadians this is the one forced savings plan that they have. Some Canadians would never have saved a dime if it were not for this vehicle. The incentive: tax deductions for every dollar that is put into the plan. Not only that but to sweeten the deal the contributions can grow on a tax deferred basis until the money is withdrawn.

For savvy Canadian investors this is elementary.

However, are RRSPs for everyone? It is a good question and it leads me to analyze the negatives that surround Canada's most prominent savings vehicle.

RRSPs have no collateral value. In the bank's eyes an RRSP is not an asset for the purpose of net worth. Therefore you can rarely borrow against the value of an RRSP. RRSPs have limits. You are capped on the amount that you can deposit each year. This poses a problem for the higher income earners.

The Toronto Star article highlights a big point. Every dollar that is taken out of an RRSP is taken into account when calculating income. Income is treated the poorest for the purpose of tax. Not only that, but it can increase your retirement income to higher tax brackets and/or clawbacks.

So, are RRSPs for everyone? Yes, in a way. All Canadians want to save tax and are limited in manner by which they can. Also, it provides the discipline that many may not have in order to save on a year to year basis. However, Canadians need to be aware of proper exit strategies.

This leads me back to Ottawa government employees. With such high pensions does it make sense for these Canadians to invest in RRSPs. My answer is yes. It promotes savings and it saves tax. However, exit strategies need to be examined prior to retirement. Cashing out RRSPs does make sense for some.

You just have to know how to do it right.