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All members of the Canadian forces who are enrolled before Mar 1, 2012 are facing a impending decision on what to do with their payment in lieu of Canadian Forces Severance Pay (CFSP).  For some it will mean several hundred dollars, for others who have been around a while, it could mean up to over $20,000.

All member should have by now received a letter indicating what their eligible time period is and will have to make a decision on which of the following three options they will be picking between 14 Dec 2012 – 13 Mar 2013.

The choices are :

1. Take the cash now;

2. Take part of the cash now and part of it when you release from the forces; or

3. Take the full amount  when you release.

From the “water cooler” talk most people seem will be picking the “cash now” option.   However, I don’t get the sense that this decision is made with any detailed analysis and that it’s taken because it seems to be the common sense thing to do.

Well being a member of the forces and also a Certified Financial Planner, such hand-wavy approach to money matters will never do.  So I ran some scenarios to see if the accepted wisdom is indeed the right approach.

My conclusion are:

If you are not a Pte, and intent to contribute the funds to your RRSP, then it make sense to take the cash out option.  Otherwise, waiting is a better choice.

Now to to reach the conclusions I made the following assumptions:

1.  I assumed that you will have normal career progression as per pay band – if you are planning to commission, the result maybe different.  You can test that easily by doing your individual analysis.  Email me if you want the spreadsheet that will allow you to do that easily.

2.  I have ignored the effects of inflation because I assume that our pay will increase somewhat in step with inflation and using real returns I made this a non-factor.

If you want to look at the spreadsheet feel free.

Hope this helps you make your decision.

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Over the last few weeks, it seems every article I read is about taxes.  There are articles discussing the merits of the Paul Ryan tax plan; there are articles about President Obama’s Buffet rule tax plan and of course there are the articles about the tax rates of both Mr. Romney and President Obama.

The issue I have with all these discussions about taxes and tax rates is that they never tell you if they are talking about marginal or effective tax rate.  Why does it matter?  It matters because using one versus the other can lead to very different conclusions about what is a reasonable tax rate and how much someone pays at the end of the day. There is a lot of loose talk about marginal tax rates and average tax rates (also called effective tax rates).   The intermingled and often incorrect usage of these two different rates is distorting the numbers bantered about in the tax debate and confusing the whole discussion.

So what is the difference?

  • Your marginal tax rate is the rate of tax you pay on each additional dollar of income you earn.  In most news stories this is the tax rate being discussed  because it requires no calculation.  The top marginal tax rate for federal taxes in 2012 is 35%. So if that is your marginal tax rate and you get a $100 dollar raise, you will pay 35 dollars more in tax than before.
  • Your effective or average tax rate is the rate of tax you actually pay on your whole income.  It is affected by the different brackets of income you have earned and needs to be calculated (see below). The discussion of how much taxes Mr. Romney and President Obama pay is all about their effective tax rate — the rate of tax they actually pay.

Now how can these two different rate distort the tax debate?  Let’s look at an example.

Let’s say you are single and you make $50,000 from a salaried job with no investment income and no deductions; then your marginal federal tax rate is 15%. This means you pay 15% on ‘the next dollar’ after $50,000 and every dollar thereafter.  You will then add your state tax of say 9% and payroll taxes (social security and medicare) of 7.65% (temporarily reduced to 5.56% for 2011 and 2012).  Now, you might think that your effective tax rate is around 32% (15+9+7.65=31.65%). This is wrong but this is exactly the way that the media, clients and writers of comments on news article often talk about taxes. I think this is the basis for a lot of the idea that taxes are too high.

Now, lets look at the actual effective tax rate of our hypothetical tax payer. If we assume for simplicity that you have no deductions, at an income level of $50,000 then your effective federal tax rate is actually 8.96%.  How is that you ask? First, everyone gets the standard deduction and personal exemption which totals to $9,500.  This is an amount you don’t pay taxes on at all.  This means your taxable income is really only $40,500. Next, because the tax code is progressive you actually pay a 10% marginal rate on income under $17,400. You only pay the 15% marginal rate on income above $17,401.  Therefore, once you average all of this out, your effective rate of federal tax is lower than the 15% marginal rate, just 8.96%.

You can use a calculator such as this take-home-pay calculator from calculator.net to find out what your total effective tax rate from earned income will be before deductions including state and payroll taxes. I ran the same state rate as in my marginal tax rate calculations and the effective overall tax rate is 24% (23.6%)  and not 32% derived from using only marginal rate figures.

So without doing anything different in income or rates I have shaved 8% off “your tax.”  This is why it is important to know when people are quoting tax rates which one they are using.  It’s the same reason there are laws to require discussions about interest rates to be done in APR. There are many other ways to discuss interest, but to allow consumers fair comparison among lenders they need to be using the same calculations so you can be sure you are comparing apples to apples.

To allow a fair discussion about tax policy and fairness we all need to be using the same numbers.

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So what should you do with your RRSP if you leave Canada? The simple answer is you can keep your RRSP as is.  However, if you want to access the funds in the future there will be a 25% tax withholding, this amount is considered your tax paid. If you are happy with this you don’t need to do anything further.

If you believe your tax payable should be less than 25%, you can elect to file Canadian taxes and the difference would be refunded.  Keep in mind that for RRSPs the amount you redeem is considered income for that year, which means unless you have a small RRSP and no other sources of income, your income tax payable for the amount is not likely to be less than 25% .  You may also need to report the amount redeemed as part of your income in your new country as per that country’s income declaration requirements.

If you are certain ahead of time that your income tax payable would be less than 25% you can fill out Form NR5, Application by a Non-Resident of Canada for a Reduction in the Amount of Non-Resident Tax Required to be Withheld. This will reduce your withholding before the redemption even occurs.  This process isn’t any easier than filling out taxes, but it only needs to be done every 5 years so it will save you needing to fill out taxes each year if you are doing multiple redemptions.

Another option is to convert your RRSP to a Registered Retirement Income Fund (RRIF) and receive regular payments from the accounts.  The same minimum withdrawal requirements apply for RRIFs as they do with RRSPs and the 25% withholding tax also applies to all payments (unless your country of residence has specific tax treaties).  A reduced tax withholding amount of 15% is possible for US-Canada. This reduction applies if the payment is less than the greater of 10% of fair market value or twice the minimum withdrawal requirement (amount of withdrawal < greater [10% of FMV, 2x RRIF minimum withdrawal]).  A preferential NOTA BENE rate can be acquired but only if redemption is scheduled for regular periods.

As an example, suppose you have a $100,000 RRSP (as of December 31, fair market value) which has now been converted to a RRIF, you are currently 65 years and you want to make withdrawals.

The minimum required for RRIF withdrawal for the year is 4% or $4000.  You would like to withdraw $12,000 a year or $1000/mon.

Under standard non-resident rules you will receive $750/mon with 25% tax withheld.

If you are in the US, to get the reduced rate: 10% of FMV is $10,000  and twice the minimum withdrawal is $8000. The greater of the two is $10,000.  This means the first $10,000 of redemption is tax withheld at 15% and the excess amount is tax withheld at 25%

So for our example, the first 10 months you will received $850/mon and the last two months  you will receive $750/mon.

If you are in the UK such periodic payments should not be subject to any withholding.

If you are thinking of withdrawing from your RRSP I would strongly suggest you research your own country’s tax treaty and discuss it with your institution before proceeding.  They may still want to withhold 25% and let you deal with CRA to claim any amount that was taken in excess.

Of course, you always need to remember that the amount you take in as income may be subject to taxes in your new tax jurisdiction and will need to be reported as per their tax rules.

You may be able to transfer the amount into registered retirement plans, i.e. 401K etc.   The reverse can be done regularly by any large financial institutions in Canada, but I generally find Canadians financial services personnel have more experience dealing with moving money to US than US financial services personnel have in transferring money to Canada.

So in summary – file an NR5 if you really think your tax rates will be less than 25% and see what number they will come up with. Know your tax treaties and use any tax treaty rules in your favour as able, but be prepared to work with your Canadian institution and educate them as required.

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I watched a bit a marathon of “Say Yes To The Dress” from TLC last week.

As a financial planner, my first reaction to the show was wanting to scream “DON’T WATCH THE SHOW!” as it will skew your perception of how much a wedding dress should cost.  I don’t think I saw a budget less than $3000!  And all for what?  One day of make believe and grand delusions?  Ask yourself, do you remember what dress the brides wore at a wedding you have attended 2 years ago?

To be fair, the whole show is not completely without merit.  After a few episodes I started to see how the process of choosing ‘the right’ dress can be a metaphor for making any emotionally charged financial decision.  I see many of the same pitfalls arise every day as a financial planner.  There were :

  • those who want everything but aren’t willing to pay the price
  • those who are looking for the ‘perfect’ dress and so afraid that they will regret their decision that they don’t make any decisions at all
  • those who love everything and can’t decide

The show is set in Klinefield’s, a ‘mass affluent’ bridal store in New York.  In one episode Randy, the fashion consultant, told us his cardinal rules about wedding dress shopping which I think are rules we can follow anytime we are making other large dollar, emotionally charged financial planning decisions in our life:

1. Don’t try on a dress outside of your budget, it will only lead to tears – isn’t that so true?  Our wants will always outpace our needs.  Even in the dream factory that is Klinefield’s the first rule is not to temp yourself.  Life would always be easier if you had more money, but if you don’t have it then why tempt yourself? This is where understanding how much money you have and can spend will keep you grounded.  As I’ve said before, you need to be realistic…and Think Poor. Live in the bliss of ignorance.

2. Don’t keep secrets from your consultant –  Yes, they want to sell you something, but they also want you to be happy, even if for no other reason that you will come back they can sell you something else.  Just remember the advice you get is only as good as the information you provide.  If you tell me you have no debt and want to retire at 65, my advice to you will be very different than if you have lots of debt and you want to retire at 55.  So don’t waste your time and the time of your advisor if you are not going to help them to be successful in helping you.

3. Leave the entourage at home – Don’t be surprised if everyone has a different opinion of how to achieve financial success; too much advice is not necessarily a good thing.  Reading all of the financial blogs and books isn’t necessarily going to help you (except this one of course). It may sound cheesy, but a better way to spend your time is to get to know yourself and what your goals are.  There is always a financial solution out there to get to your goals…just as there is always a dress out there for you. The trick is finding the dress or the financial plan that you can afford and that you can live with.

4. Stop shopping once you found the dress – The fundamentals of financial planning are actually pretty simple and universal.  You will need a tailored plan to suit your needs, but once you have plan, stick with it.  Stop trying to find the ‘better’ plan.  Changing course and second guessing yourself won’t help you and will only cost you more money if you make rash corrections to your plan over the short term.

5. Always wear underwear – Well that goes without saying… you never want to be naked at Klinefield’s or in your finances.  Make sure you always have a rainy day fund that is separate from your other accounts.

I would add one more cardinal rule:

6. Keep some perspective on what is really important – In many ways the rush and excitement of the wedding dress purchase is like the initial stages of your financial planning. Wrapped up in each stock purchase or mutual fund selection are all the hopes and dreams of your whole life, career, family and retirement. The wedding dress encapsulates everything brides dream about their marriage. But the dress itself is for just one moment in time.  It’s a lot of work and done right it can be the foundation of something wonderful but it isn’t the marriage. Try to think of your financial planning as if you are buying that wedding dress and planning for the entire marriage that comes after it. Just like in marriage,  the real return on your investment comes from years of hard work, communication and self-reflection.

So say yes to the dress or to your financial plan, but remember these rules to keep your head out of the clouds.

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In part I of this three part series we found that moving from Vancouver, BC to Corvallis OR hasn’t saved that much money despite moving to the supposedly “low tax” USA.  I have $166.11 less a year having moved here.

In Part II, I will tackle the big ticket costs of housing, car insurance and medical insurance.

First up, housing. Corvallis is a lot more expensive than I had expected.  Before we arrived I did some research and the city website indicated that the average one bedroom apartment was $500/mon, which is a lot cheaper than Vancouver, BC one of the most expensive cities in the world.   Therefore, I thought our total cost of housing would be around $700/mon tops.

Well, was I wrong. Corvallis has rental vacancy rate of under 1% .  The explosive  growth of Oregon State University and lack of corresponding growth in the rental units means that it is actually really hard to find a place to live.  Don’t get me wrong, you can get places cheap.  We saw a ‘bachelor’ unit that was in the basement with uneven walls, no windows and a shower that was in a concrete hallway all for just $400/mon.  There was a small two bedroom for $600/mon but it smelled of mold which was a problem with many of the units I saw.  For a week from my operation centre at the Days Inn through the worst rain storm of the last decade I must have seen every unit available in January and February. We even went to Albany(gasp!).

We eventually settled on a brand new one bedroom unit at this new condo complex which had been converted to an apartment complex.  On top of the rent, renters in Corvallis are expected to pay for everything else… sewage, water and garbage, electricity and even liability insurance.  The breakdown is below.

In Vancouver, we lived in subsidized student housing that included everything .. electricity, wifi, and even cable.   So instead of using our rent, I asked around and I think $1100/mon should get you a one bedroom in reasonable conditions.  Of course renters are required to pay electricity and WIFI.  The breakdown is below:

Canada US
Monthly after taxes and deduction $3,167.19 $3,181.04
Rent $1100.00 $921.00
Sewage/Taxes/Garbage $37.00
Insurance $8.83
Electricity $50.00 $50.00
WIFI $50.00 $50.00
After housing $2,067.19 $2,114.20

So after housing costs, it’s only slightly ($47) cheaper to live in the US.

Next I looked at car insurance.  In British Columbia we have government mandated car insurance through an agency called ICBC.  Their insurance is not cheap.  I qualify for the highest possible discount and annually it costs approximately $1300/year.  In the US my insurance is $606 for the year. So after car insurance I have $1958.86/mon in Canada and $2063.70/mon in the US.  So the US is still cheaper to live in by about $104 a month or around $1258 a year.

But we haven’t talked about health insurance yet.  In Canada we have national health insurance, although in BC we do have pay a premium.  The premium rate depends on the number of members of your family and your income level.  We pay $109 per month in premiums.  This covers all primary and hospital care.  We also pay supplementary health care for dental coverage, prescriptions, massage etc, but I’m going to ignore that and concentrate on primary care. In the US  we have to contend with a private system.  If you have a good employer, your health care is mostly paid for as it is for my husband.  However, if you do not have your own employment coverage or are not covered by your spouse then you have to pay for yourself.  If I get the same coverage as my spouse, our cost will be $306/mon with an annual deductible of $200.  A deductible is the amount you have to pay up front each year and only once you exceed that does your coverage start to pay portions of your care.   I also received independent quotes for healthcare and they ranged from $150 – $250/mon and have deductible $1000 – $2500.  Given that I probably will only go to the doctor twice a year at a cost of $150 per visit I’m likely not to need to take advantage of my plan that much beyond the deductible. So let’s say I take my husband’s work coverage:

Canada US
Monthly after taxes, rent and car insurance $1958.86 $2063.70
MSP premium per month 109
Husband’s monthly health premium 6
My monthly Health Premium 306
Monthly after Health Insurance $1,849.86 $1,751.70

Living in US has all of sudden became more expensive.  I understand now why people would choose to not get insurance. Even if I take the cheapest premium option which leaves me with a deductible of $2500 per year ( which means unless I have a real emergency, I’m paying for my own health care costs) :

Canada US
 MSP premium per month  109
Husband’s monthly health premium  6
My monthly Health Premium 150
 After Cheaper Health Care $1,849.86 $1,907.70
With 2 doctor Visits ea  $400
Money left over for the year $22,198.32 $22,492.40

So US still works out cheaper to live by $294 a year. Next we’ll see if the lack of sales taxes in Oregon makes up for one of the highest state income taxes.

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I’ve been meaning to write a follow up to my recent blog about how to analyze your spending history to help you avoid your spending triggers when I came across this article on shopping habits by Charles Duhigg.  While the article primarily focuses on how your purchase patterns can really betray you;  providing the companies with data that allow them to better target market to you, what I found most useful was the discussion on “habit loops” (on page 8) and how with a little reflection and tracking you can fight your bad habits and foster good ones.

First I think it is important to admit that we all have triggers in our lives that cause us to spend when we shouldn’t.  It may be a sale, a particular store, some particular item i.e purse, shoes, gadget etc., but we all have them.  Triggers tells us that we really need it and we need it now.

A trigger could also be something small like the obligatory 2-3 cups of coffee, lunch everyday, or drink after work.

Regardless what our trigger is,  spending on these “needs” leads us to overspend.  Even if you are not overspending, knowing the details of your habits can help you find more areas for savings.

So how do you start?  First you need to figure out what are the things you are overspending on (reward in the habit loop)  and then what are the triggers (cue)  causing you to want to spend and what routines you can change to break the loop.

So the first step is to identify the bad habits that are causing you to overspend. To just balance your budget you don’t really need to know this information. However, knowing it will allow you to target some specific habits (and break the habit loop) that may be the cause of your overspending.  I like to give the following exercise to many of my clients and the results have always been enlightening:

  1. Draw up what you think you spend in various categories in a month.  You can be broad or very detailed, but your list should at a minimum contain the following:
    • Housing
    • Phone
    • Transportation – including transit, gas, maintenance, insurance
    • Travel
    • Gifts
    • Food – grocery
    • Food – eating out, including alcohol. It may be helpful to breakout lunches and dinners
    • Clothing
    • Child care
    • Household items (sometime grouped with grocery)
    • Pet care
  2. Find your credit card and bank statements from the past year – pick at least 3 consecutive months, I like to use September to November because it doesn’t have too many holidays or vacations which skew your spending pattern.  Based on the categories you have came up in 1, total what you spent in each of the categories and then divide it by 3 to get your average spending per month.  Some credit cards and bank statements now helpfully divide the categories up for you so it won’t be such a chore and should only take about an hour or two to calculate.I suggest using old statements rather than tracking your spending going forward as it gives a real picture of spending, and does not allow your knowledge that the spending will be scrutinized to alter your behavior.

Now look at the difference between what you thought you were spending and what you actually spent.  They are not the same are they?

If you are not currently overspending (i.e spending more than your take home pay) this exercise will highlight areas that may lead to further savings and help you pay down your debt sooner or save more each month.

If you are currently overspending then this exercise will highlight categories where you need to change your habits.  So dig a little deeper.

Digging  Deeper

Are you overspending on small items like coffee?  These items are insiginicant individually but can have large cumulative effects.  $2 spent each day on coffee for the year is $500.  Would you buy $500 of coffee? Can you buy one cup of coffee instead of 2 cups a day?   Why is that you are buying coffee?  Is it a social need, or an excuse to get out of the office?  Dehigg’s article describes a simple exercise you can try to determine if there is another cause for you habit that you may not be aware of.

What about developing a new habit of bringing coffee from home?  Are there things you can do to create a new cue?

In an upcoming post I will list some tricks that I have used and those that my clients have shared with me that may help you develop a new habit and reduce your overall spending.

Put simply, the trick is finding a way to give yourself the reward you actually want just without spending as much and not making yourself feel deprived.

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As a financial planner I am often bemused by the thousands of financial self help books.  Like most self-help books, they simplify complex problems and provide an easy sounding and tempting solution which never quite works.  If any one of the books actually were able to help most people to save more and invest wisely then I hardly think that there will be so many books crowding the financial planning  section of the book store. But while they don’t actually provide the cure that they promise, most are harmless. So as I was recently flipping through “The Total Money Makeover: A Proven Plan” by Dave Ramsey, a few things caught my eye which I really felt I had to comment on. In the section “what this book is not” the author responds to previous challenges to his approach. In fact, if you search for  “Dave Ramsey bad advice” on Google you’ll get over 100,000 hits, so what I have to say may be treading some old ground. In a subsection entitled “This book is NOT going to mislead you on investment returns” he says:

“People seem to think that making a 12% return on your money in a long-term investment is impossible. And that if I state that there is a 12% return available then I have lied to you or misled you. I recommend good growth stock type mutual funds in this book as a long-term investment and dare to state that you should make 12% on your money over time.”

He then goes on to explain how the S&P 500 has averaged 11.67% in the last 80 years and how this indicates that you should therefore be able to get the same returns. Now, you can search for  funds that have averaged 10 year returns over 12% on Morningstar (I found 19).

Morningstar search result where mutual fund's 10 year average return is > 12%

But none of the above funds had the tenure that Ramsey had indicated in the book where he’s citing data from the 1930’s. Ramsey did give return data but slyly did not tell you what funds he’s invested in, rather referring to you to speak to one of the “approved” advisors (I would assume that they pay a fee to be approved by Mr Ramsey who must share his secrets with them).

So a little more digging led me to this list which does seem to be the funds that Mr. Ramsey is talking about in his book.

Hey if there are magical funds out there that are giving you S&P returns over the long term then sign me up (keep in mind this means they have to be beating the returns of the S&P since there are fees involved).  But why aren’t any of the funds that’s recommended by him on my morning star list?

So I dig a little deeper.

I looked at American Funds Invmt Co of America fund. The fund was created on March 31, 1934 just as the country was coming out of The Depression.  Up to Dec 31, 2011 it had an average return of approximately 11.79% annually. Even accounting for inflation which was 3.37% over that time, the returns are still above 8% annually.  So Mr. Ramsey seems to be telling the truth.

But again I ask, why isn’t on my morning star list? It didn’t make it on to my little search list because it’s return for the last 10 years is only 4.42% although it has been out performing S&P by 0.42%.

And that’s the problem that Mr. Ramsey’s critics and myself included have with his assumption of 12% return.  Just because a fund has returned on average 12%,  doesn’t mean that your return will be 12%.  When you invest matters a lot.  If you were smart and got into these funds 3 years ago at the depth of the current downturn, your return on this fund would be over 20% annually.  However if you started to invest 5 years ago (at the top of the market) your return would only be 1% annually.

Mr. Ramsey will of course say that for you to gain the average return, you need to invest in the long term.  As you can see, the 10 year results aren’t 12% but what if we look at 20 years?  The answer is 5.99%.  Only when you go back 30 years – a very long investment horizon for most people – do your numbers start to look better at 11.88%.  The question is will you able to hold the investment for 30 years and ride through all of the 50+% corrections? What if that correction came as you are just about to retire?  These are the questions that many who are nearing retirement are grappling with.

So what’s the solution?

Well I don’t really have one.  I’m no better at driving forward on an unmarked road while looking in the rearview mirror than you.  But I have a general approach that you can try to help you to get to your goals:

  • Work out what kind of returns you need to retire – be reasonable in your assumptions about your life style and government program’s availability. Likely the return won’t need to be 12%.
  • Create a portfolio that can give you a good shot at that return.  If you only need 5% to retire, then a more conservative portfolio will work.  If you need 6-7% a 60/40 portfolio will work.
  • Make your portfolio more conservative over time so that corrections have less impact on you as you near your goals, but keep your return assumptions the same.
  • Track where your investment funds should be annually/every 5 years and see if your portfolio (including money you may still be adding to to it) is meeting your objective.
  • If it isn’t, then you need to put away a bit more to guarantee the returns.
This way by the time you retire, hopefully you will guarantee you have the amount of funds you will need through both investment returns and putting enough away.

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