Implementing Your Plan

At the beginning of the book I indicated that many people hope to start down the road to financial success by selecting a specific investment. I will reiterate that it should be the last decision that is made.

All of the other pieces need to be put into place first. Financial goals and tolerance to risk need to be identified, a plan put into place and an asset allocation chosen. Tax-free, tax deferred and taxable accounts need to be used to maximum benefit.

Once all of that is put into place, appropriate investments that meet your personal criteria can be chosen.

A Review of the Process 

  • Establish your financial goals.
  • Determine your tolerance to risk.
  • Develop a financial plan to achieve those goals.
  • Choose an appropriate asset allocation.
  • Implement your investment strategy by choosing investments that fit your asset allocation.
  • Manage your portfolio.

Investment selection

The selection of the specific investments within each asset class is a dynamic process because economic conditions can change quickly and dramatically.

Suggesting investments in this book would be foolhardy. Before the ink was dry, many of the recommendations would be out-of-date.

There are those who suggest an approach where you invest in index funds where the content of those funds gives you a diversified portfolio that rarely changes. But applying a blanket (or index) approach does not always create the best results.

Someone has to decide what is in the index and the people who make those decisions are not always infallible.

There are three good examples that contradict the index approach: 

  • Nortel represented about one-third of the value of the S&P/TSX Composite Index in September 2000. Today it is worthless.
  • As of the end of 2012, Canada’s broadest index had no exposure to the REIT sector in Canada. For the past ten years REITs have been one of the best performing sectors of the Canadian market.
  • Gold bullion is virtually ignored by every index but it too has been one of the best performing asset classes at various times in the market cycles.

In these cases, the index held a very large amount of one of the worst possible investments and completely ignored two strong performing asset classes.

Don’t automatically assume that choosing an index is the easy way to make a sound investment decision. Besides, there are hundreds of different indexes from which to choose and deciding which are appropriate is challenging.

Selecting appropriate investments is reliant on ever-changing economic and financial data. The decision should be made when you are ready to make the investment and not beforehand.

Implementing your plan – stage of life considerations

Everyone will be in their own unique situation when they begin the process of investing. Some will be in the early stages of their life, some in their high earning years, some close to retirement and some will already be retired.

Regardless of what stage you are at, it is never too late to develop a plan. Exactly how you implement that plan will depend, in part, on what stage you are at.

Early Adult Period

Many advisors are happy to work with novice investors who are eager and willing to learn about what is required from a planning, investing and administrative point of view. Even novice investors should be diligent about their choice of advisors and using the criteria outlined earlier is a good place to begin.

Taking small steps and learning as you go helps build a base of knowledge that can be helpful later in life when you will probably have significantly more money available for investment. It can be a good time to learn all of this when only small amounts of money are involved. Poor markets or unfortunate decisions won’t affect your long term financial future and lessons learned at this stage can be valuable later in life.

Those who are serious about undertaking even a small investment program and ‘learning the ropes’ should strongly consider an investment dealer that offers a full range of products, including mutual funds, exchange traded products and individual bonds.

The good news is that you can start with a very small account at some firms. At this level, investment choices are limited, but it is still worthwhile to start investing. You will begin accumulating savings and at the same time gain an understanding of the administrative requirements involved in beginning an investment program.

The benefits of starting early should not be underestimated. Take the example of two investors who expect to achieve a return of 6% per year on their investments. One begins their investment program at age 30 and one at age 45. Both have the goal of retiring at age 65 when they will begin to draw on their investments.

The investor who began at age 30 saves $6,000 per year while the investor who began at age 45 saves $18,000 per year. Both accumulate the same total savings by age 65. In 35 years the younger investor has set aside $210,000 ($6,000 x 35 years) while the older investor has had to save $360,000 ($18,000 x 20 years) to accomplish the same result.

In this example, by the time the 30 year old reaches age 45, he will have $12,000 more per year to spend on his lifestyle than the person who waited until 45 to begin his savings program.

While a balance between living for today and saving for tomorrow must be developed, it is clear that starting a savings plan earlier in life can have huge benefits, not only in retirement but in the years leading to retirement.

Begin with mutual funds

The easiest way to get your investment account started is to set up a preauthorized chequing plan (or PAC plan). Each month on a specified date your bank account will be debited and those funds will be credited to your accounts. PAC plans work best with mutual funds; they are cumbersome and expensive if you are trying to buy stocks or ETFs.

You can also make lump sum mutual fund purchases in addition to your monthly pre-authorized chequing plan. Simply make a deposit into your investment account and decide, along with your advisor, which fund you want to purchase. There is no additional paperwork required and in many cases the transaction can be completed with a phone call.

Mutual funds provide access to a variety of asset classes including cash, fixed income, equities, REITs, precious metals and so on.

When getting started, the novice investor should complete the same risk tolerance questionnaire as a larger and more seasoned investor. The investments should then be made following those guidelines.

Accounts

The first thing you should do does not involve opening an account.

You should pay down any debts you may have as quickly as possible. This may include student loans, car loans and making extra payments on your mortgage.

When considering which accounts to use, starting with a TFSA makes a lot of sense. Any growth within the account is tax-free and it can be withdrawn without incurring any tax liabilities. Since the financial situation of those who are in the early stages of their working careers can be volatile, the flexibility of a TFSA holds a lot of appeal.

The next account to consider is an RRSP account. Generally speaking, you will probably be in a lower income tax bracket in the early stages of your life and a higher income tax bracket as your career progresses.

Contributing to an RRSP when your income is low does not generate great tax savings. You can delay those contributions to those years when your income is higher and get a larger tax benefit.

In the meantime, your investments can still grow tax-free in your TFSA and you won’t lose your RRSP contribution room even if you don’t take advantage of it immediately. The exception to this strategy applies to those who are earning a very high income early in their working careers. In that case, RRSP contributions will make sense.

The last account to consider is a taxable investment account. Even those with relatively large incomes may have little left after doubling on mortgage payments, making maximum TFSA contributions and maximizing their RRSP contributions. For those who still have extra funds available, it is a good problem to have and a taxable investment account can be established.

Mid-Life Period

At this stage of your life you should have a greater capacity to save and invest than you did when you were younger. Hopefully, your debt load has decreased and your income has increased.

You will probably want to expand your investments beyond mutual funds to include exchange traded funds and individual investments. It is a good idea to continue with monthly contributions to your various accounts and supplement those with lump sum contributions when the opportunity arises.

You probably already have a TFSA and an RRSP in place. Maximizing your RRSP contributions makes a great deal of sense at this stage. You may be in the highest tax bracket of your working career and you will probably be in a lower tax bracket upon retirement.

The theory is that you create the maximum tax benefit with your RRSP contribution but pay tax at a much lower rate when you begin to withdraw in retirement.

Your available contribution limits are easily found on the Notice of Assessment you receive from the Canada Revenue Agency (CRA). That document usually arrives in May or June after you have filed your tax return. It is a good time to make your RRSP contribution and maximize it if possible.

TFSA Accounts

The program began in 2009 for those who are eighteen years of age or older. As of 2013 the annual contribution limits were increased to $5,500 per year while the maximum lifetime contribution limit stood at $25,500.

Contributions to your TFSA account should be maximized before making any contributions to a taxable investment account. Those who have taxable investment accounts but have not yet contributed to a TFSA should immediately open a TFSA and transfer the maximum amount allowable into that account. In many cases, you can simply transfer existing investments from a taxable account to a TFSA and immediately cease paying taxes on the growth generated.

Your taxable investments

Many Canadians will find it challenging to take full advantage of the contribution limits provided by their RRSP accounts and their TFSA accounts. Those who still have additional funds to invest can consider a taxable investment account.

Because income tax will apply on gains on your investments, it is important to consider how the gains provided by various investments will be taxed.

While interest is the most predictable form of return, it is also taxed at the highest rate. Dividends are less certain than interest but the tax benefits make them worth considering. The least certain form of return is capital gain, but once again, tax considerations and the potential for higher returns can make the pursuit of capital gains attractive.

Pre-retirement and Retirement Period

In retirement your primary focus will shift from growth on your investments to income generated from your investments. RRSP accounts will likely be converted to RRIF accounts so you can begin to draw income from those accounts.

Income can be drawn for your tax-free savings accounts as well as your taxable investment accounts.

If you still do not have a tax-free savings account but have money in taxable investment or savings accounts, you should immediately open a tax-free savings account and contribute as much as is allowed.

The caveat is that if you transfer an asset from a taxable account to a TFSA and that investment has a large unrealized capital gain, you will be liable for the tax on that capital gain. Consult with your financial advisor and/or tax advisor before moving asset from a taxable account to a TFSA.

In subsequent years you should continue to move as much as possible from your taxable investment accounts to your tax-free savings accounts.

Unlike RRSP accounts, there is no age limit for contributions; investors who are in their 90s can still make contributions. The reason behind this strategy is that a larger and larger portion of your investment income will become non-taxable each year.

Another overlooked advantage of TFSAs is that you can name a beneficiary so the proceeds bypass probate. This feature makes TFSAs a useful estate planning tool and reduces the need for segregated funds in estate planning.

Tax considerations

In a taxable investment account dividends can provide a significant advantage over interest. For one thing, dividends are taxed at a lower rate than interest. A 5% return via dividends is much better than a 5% return via interest in a taxable account.

Dividends can actually reduce your taxes, as shown in the following example:

Let’s take the example of a 67 year old Ontario resident who collects $6,000 per year in OAS benefits, $9,000 per year in CPP benefits, withdraws $12,000 from their RIF and earns $8,000 per year in interest income. Their total income would be $35,000 and they would have paid approximately $3,800 in taxes in 2011.

Net income would have been about $31,200.

If that same investor had earned $8,000 in dividends rather than interest, taxes would have dropped to approximately $2,100 and after tax income would have been about $32,900. That represents a savings of about 40% on taxes payable.

You can use the free tax calculator on MoneyPages to estimate the impact of changing your investment income from interest to dividends. The link is http://moneypages.ca/page/17/income-tax-overview

Investments that pay dividends that qualify for the dividend tax credit include high quality common shares of Canadian companies as well as preferred shares of Canadian companies.

NEXT: Managing Your Portfolio

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