Financial independence is a goal for many people. Financial independence is when work becomes optional. It’s when your investments are large enough to support your annual spending indefinitely, without the need for employment income. Reaching financial independence frees you from the typical work/money/time equation. When you reach financial independence you no longer have to trade your time for money.
How much you need to reach financial independence is different for everyone, but the quick and most common metric is 25 times your annual spending. Once you reach this level of savings and investments (not including your home) you can withdraw 4% of your portfolio indefinitely. With the right portfolio your investments will grow enough each year to pay you 4% of the original principal and still keep up with inflation.
Taxes are obviously a big consideration when growing your investments. Tax free growth allows your investments to grow faster and lets you hit your goals earlier.
In Canada we have two main accounts that provide tax free growth, the TFSA and RRSP. With the TFSA you pay tax now but don’t pay tax later. With the RRSP you don’t pay tax now, but you do pay tax later. Regardless of when you pay the tax, the investment growth within an RRSP or a TFSA is tax free. Using your TFSA and your RRSP to its full potential means you can hit financial independence much faster.
Both TFSA and RRSP are great, but they’re also different. These tax-advantaged accounts each have their own pro’s and con’s.
If you only have a set amount to invest each month, it’s important to pick the “right” account.
The “right” account can change over time as your income and personal circumstances change.
Each account, TFSA vs RRSP, deals with taxes differently. Choosing the right account will help you save $100,000+ in tax over your lifetime. Who would say no to $100,000?!?
By choosing the right tax-advantaged account, you can actually save less each month and still achieve all your financial goals.
Tax-Free Savings Accounts (TFSAs) are relatively new. They were introduced in just 2009. Even though they’ve only been around for a short time they’re already the most used out of the major tax-sheltered accounts. There are over 5.5 million households in Canada that have an active TFSA account.
(Authors Note: I love it when people use their tax-sheltered accounts. Good tax planning is a key component of any financial plan and can add $100,000’s to your net worth)
The average usage rate for the TFSA is pretty impressive at 40.4%. This is relatively consistent across both age and income. The highest usage rate is in Ontario where over 45% of the households are using a TFSA. The median contribution to a TFSA in 2016 was $5,765.
All-in-all these are impressive numbers for a new tax-sheltered account.
Given the high usage rate the TFSA must be pretty great, right?!?!
In this post we’ll cover exactly how a TFSAs works, the benefits of a TFSA, as well as some of the drawbacks of a TFSA.
RRSPs are one of the three major tax shelters available to Canadians. They were created in 1957 and since then RRSPs have been a key way to delay and avoid taxes. There are many benefits to an RRSP but also a few drawbacks.
In general Canadians aren’t taking full advantage of this tax shelter. As of 2015 there was over $1 trillion of unused contribution room. That’s an average of $41,560 per tax payer!
Each year the unused contribution room continues to grow. Over the last 5 years unused contribution room has grown by $1,900 per person per year.
This begs the question….
Why aren’t we using the RRSP to its full advantage?
Out of all tax payers only 22.9% used an RRSP last year. While this might seem low it’s important to note that RRSPs aren’t for everyone. There are drawbacks to using an RRSP and it’s because of these drawbacks that some people choose a different tax shelter instead, like a TFSA.
Still, there is a huge potential for tax savings out there. Even at the lowest federal tax rate the potential tax rebate is about $150 million or roughly $6,000 per person. Who wouldn’t like to get a $6,000 tax refund?!?
In this post we’ll cover how RRSPs work. We’ll also cover both the benefits and drawbacks of an RRSP.
When you think “tax shelters” you probably picture some Caribbean island. But did you know that the average Canadian has access to 2-3 tax shelters of their very own?!?!
The average Canadian family can shelter 32% of their gross income every year! They can do this in accounts that either defer or avoid taxes.
What is a tax shelter? In the broadest sense….
“A tax shelter is a financial arrangement made to avoid or minimize taxes.”
But let’s clarify something for a second, avoiding taxes is completely legal and it’s an important financial planning strategy.
What isn’t legal is tax evasion. Tax evasion is the illegal underpayment of your taxes. Tax evasion is basically when you ignore tax rules and use some tax-saving scheme. This is done through shady accounting practices or stashing money in offshore accounts in tax-havens like the Caribbean.
Every Canadian has access to a few different tax-sheltered accounts to help them legally minimize their taxes.
Tax-sheltered accounts are extremely useful because they help you delay, reduce or even avoid paying taxes all together. Using these accounts in the right way can help you avoid paying thousands of dollars in taxes and can even help you boost your government benefits!
Reducing taxes is an important component of any financial plan. Unfortunately, most Canadians don’t maximize their tax-sheltered accounts.
The average Canadian family can shelter 32% of their income each year in accounts that either defer or avoid taxes*. In this post we cover the three common tax-sheltered accounts of which every Canadian should be aware.
Did you know? Your marginal effective tax rate could be as high as 60-70%?!?
You might be thinking….
What is a “Marginal Effective Tax Rate” anyway, and why is it so high?!?
Well….. let’s start with a term you might be more familiar with, your marginal tax rate (no effective).
You marginal tax rate is how much tax you pay on the next dollar you earn. For high income earners this can be above 53%. For the next $100 they earn, $53 goes to taxes and only $47 goes in their pocket.
Thankfully, with our progressive tax system, low and moderate income earners pay a much lower rate, typically in the 20% to 40% range depending on their income. This means a low or moderate income household will only lose $20 to $40 of the next $100 they earn to income tax.
Your marginal effective tax rate is your marginal tax rate plus the claw back from government programs. These claw backs are based on your net income and work much the same way that income tax does, the more you earn, the more of your government benefits get clawed back.
This is a very important consideration when planning your finances. For some low and moderate income households these government claw backs can exceed 30%. This can push Marginal Effective Tax Rate (METR) over 60%. That means $60 of the next $100 they earn will be lost to taxes and claw backs!!!
For example, a family with two children (my situation) who is earning ~$50,000 per year will lose 32.5% of the next dollar to claw backs and 29.7% to income taxes. Their combined marginal effective tax rate is 62.2%!
A family of four earning $50,000 can easily have a marginal effective tax rate that is higher than a single person earning $220,000+.
Two things greatly affect METRs, marital status and children. These two factors affect government benefits the most so in this post I’ll look at how different family situations can affect your METR and I’ll show you in detail how I calculated the METR for my family, including the income level where each government benefit gets clawed back.