We are all trying to save some little money on various loans (mortgage, auto loan, etc.), which is, essentially, very good.
But many of us often neglect the possibility of saving much larger amounts, which could be as much as thousands of dollars, through taxes.
What do I mean?
To simplify, let’s consider the hypothetical situation of two friends:
- Both are 48 years old,
- Each of them earns $60,000 a year,
- They both own a house with a $250,000 mortgage for 25 years at an annual interest rate of 3%.
- After they have paid all their mandatory expenses, there is $5,000 of discretionary income left to each of them every year.
The first one, let’s call him Jack, believes that personal finance is strictly private and fairly simple, so he sees no need for professional advice on this matter.
The second, we’ll call him Peter, believes that the world of money is quite complex, and that finances should be managed by professionals. He is used to working with his financial adviser.
According to Jack’s strategy, the best investment is to pay off his mortgage as quickly as possible. Therefore, he uses his $5000 of discretionary income to reduce his mortgage debt every year.
If Jack repeats this procedure every year, he will pay off his mortgage ahead of schedule i.e. in 17 years.
On paper, it’s very good, to pay off the mortgage 8 years ahead of schedule and to retire at 65 years old and to wake up in a paid-off house. At first glance, that’s satisfying, but let’s look at how much money Jack will really have at the age of 65?
|Jack’s assets (what he owns):||Jack’s liability (what he owes to his creditors)||Net value (following our hypothesis)|
|His house||Mortgage: $0||The market value of his property.|
|His savings: $0||Savings : $0|
Thus, once retired, Jack will set free from the burden of repaying his mortgage. Nevertheless, I think you will agree with me that his mortgage does not represent all his expenses. After all, he will need to pay for other expenses that do not depend on the mortgage and that will always be there: municipal taxes, electricity, food, communications, transportation, travel, medication, etc.
There is a major problem in Jack’s plan, the lack of liquidity, because all his money is invested in his house.
Following his financial adviser’s tips, Peter decided to approach the issue from another side. Peter decided to start to take care of his retirement income now. According to all financial laws, the time factor has a huge impact on one’s investments (thus, you need to start as early as possible). In this regard, it was decided that Peter would invest $5,000 annually in investment funds.
Peter’s income, in our hypothesis, is $60,000 a year. Which means that in one year, about $15,000 of Peter’s income is retained as federal and provincial taxes.
Taking this into account, it was decided to invest the above $5,000 in a Registered Retirement Savings Plan (RRSP), which gives him a right to additional tax returns. At his tax rate, Peter will receive a tax refund of $2,000 per year. This money will also be invested in funds, but in a Tax-Free Savings Account (TFSA) instead.
I will not bore readers with financial mathematics or with compound interest (those for whom it is interesting can contact me individually). I will only say that by investing in a balanced portfolio, with an average annual return of 5% over the same 17 years (until the age of 65 years old), Peter will have accumulated:
The balance of his mortgage will be approximately $100,000.
Peter can pay off this balance using his entire TFSA, which is non-taxable, and a portion of his RRSP that is subject to taxation.
|Peter’s assets||Peter’s liability||Net Value|
|His house||Mortgage: $100,000||The market value of his property.|
|His savings: |
$210,000 in an RRSP and in a TFSA
The difference between these two strategies is $110,000. This amount represents a great source of increase of Peter’s retirement income, which allows him to feel financially safer than Jack.
Let me tell you, dear readers, that this situation is given by way of example and may not be suitable for everyone.
There are situations where it is best not to use the RRSP at all, but there are other cases where if you use it with skills, you could get even more interesting numbers.
Each situation is individual, and the solution must be as well.