Three Ways to Focus Your Investment Strategy 

by Evelyn Jacks, President and Founder, Knowledge Bureau

Many investors worry about one fundamental question: “Will I have enough?” If that includes you, there is good news. The median net worth of Canadian families has more than doubled in the last two decades.[1] Individuals who have more assets than debt and are often described as “people of wealth” and they tend to be deliberate and disciplined savers. If you’d like that to include you, here are three secrets to success that can help you set your mind at ease:

  1. Have a wealth purpose:  Define “your number” – the amount of capital you need to say with confidence, “I now have enough!”
  2. Have a time horizon:  How long will it take you to get there? For most people, a sound investment strategy stretches across four lifecycles.
  3. Have a tax strategy:  Do you know how to pay the least amount of tax on your income and savings when you withdraw them? This can help you achieve your investment goals faster.   

 

Establishing your wealth purpose

It’s important to establish a finite financial goal to kick off your investment strategy, which is often described as the amount of money you need to save to achieve financial peace of mind. Many people set not only an amount, but also a specific goal and upon its achievement call this their “financial freedom day.” Perhaps it’s the day you pay off your mortgage or reach that million-dollar retirement savings milestone.

The point is everyone has a different number. What’s your number? Take the time to think this through, because it’s a critical first step to develop a sound and achievable investment strategy. 

How to keep score: 

To make it work for you, your investment strategy must also be measurable. A great way to do so is to benchmark your Personal Net Worth (PNW), defined as the difference between the value of your assets (pensions, investments, real estate, business assets) and your liabilities (credit cards, mortgages, lines of credit, etc.).  By measuring your PNW periodically, you’ve created an accountable scorecard that  will be your framework for success. For some, that might be a monthly or quarterly accounting; for others, once a year is good enough.

While analyzing your PNW can be a sobering experience for some, it can also be an exhilarating exercise because most people don’t know how wealthy they really are! You may be closer to your wealth purpose than you think: your financial freedom day may, in fact, be just around the corner.  

What’s your time horizon?

Answering this question is a critical second component to a more comprehensive planning approach for a confident financial future. Knowing your time horizon will help you make decisions about when to invest, and in which investment accounts you’ll build capital that will yield the best result. This can help sustain value against major factors that can erode your wealth, such as inflation and interest payments, and help you prioritize the order in which you’ll fund your accounts.

Begin by segmenting investment priorities according to financial needs in four specific timelines:

strategy-flow

Your immediate needs

Everyone needs an emergency account. The combination of your active earnings and savings activities must be large enough to cover four lifecycle needs; food, clothing, shelter, as well as education funding for the whole family. Why is education funding considered a basic life need? Because it builds the strength of your human capital - the ability to become employed or better employed and with that, to take advantage of employer-sponsored pension plan savings, group health and other benefits.  

Sound investment choices for adults include the Tax-Free Savings Account (TFSA) for tax-sheltered funds and the Registered Retirement Savings Plan (RRSP)[i], if you meet eligibility rules. That’s because the RRSP also contains a Lifelong Learning Plan most people are unaware of. Choose the Registered Education Savings Plan (RESP) for children, to earn lucrative grants and bonds from the government. And don’t forget where you could save money by being more prudent in your spending and borrowing. For example, it’s important to stay clear of non-deductible credit card debt. 

Pre-retirement

Retirement saving is for everyone, but particularly the young. The younger you are when you begin saving, the less capital you will need to save for your future. That’s because of the phenomenon of “compounding”; your ability to increase the returns on your investment by continuing to reinvest them. A consistent savings plan, even with small incremental investments, will help you achieve your wealth goals sooner. Once registered investment accounts are topped up, strive to earn tax-efficient capital gains and dividends in your non-registered accounts.

In retirement

After you have accumulated the assets you need to fund your retirement, it’s important to make withdrawals that are as tax-efficient as possible; by aiming to pay the least amount of tax on the periodic payments. Assuming you have diversified your investments along the way in pre-retirement, there will be many options from which to build a tax-efficient retirement income. 

  • Rule #1: Withdraw precisely. Don’t encroach on more capital than you need, and instead keep it invested to continue to grow and produce reliable retirement income.
  • Rule #2: Try to withdraw over a longer period of time, rather than in small lump sums, thereby “averaging down” taxes payable over the years. 
  • Rule #3: Where possible, income split with a spouse, particularly for Canada Pension Plan (CPP), Registered Pension Plan (RPP) or RRSP/RRIF benefits.    

After Retirement 

It’s extremely important to plan for financial continuity and transition of your assets while you are healthy and in control of your financial affairs. Who will be the beneficiary of your assets and when should those assets be transferred? If you think about that now, you can further prioritize selected investment activities. You may also wish to consider when is the best time to transfer family assets, reviewing associated tax consequences, because what matters most is what you and your beneficiaries keep, after tax. 

What’s your tax strategy?

Your investment strategy will be turbo-charged when you earn the most tax-efficient investment and pension income. You will be able to continue to maximize your future purchasing power and the time value of money, if you can defer tax into the future, or, in the case of the TFSA, avoid it altogether. For these reasons, it’s important to know that not all income sources are taxed alike.  

How investment income sources are taxed:  Interest, dividends and capital gains earned in non-registered accounts, all attract different tax treatments. For example, only 50% of your capital gains are included in income. In addition, there is no income inclusion until there is a disposition, either by sale or a deemed disposition, such as the death of a taxpayer or the transfer of capital to another individual. 

Interest and dividends are taxed at higher rates, but dividends, which represent the after-tax distribution of corporate retained earnings to shareholders, are more tax-efficient than interest. Recently, top tax rates have risen on dividends from both public and private corporations. Interest, on the other hand, is always fully included in income, even when the return compounds and accrues and becomes payable on maturity. That means you have to pay tax now to receive interest later, which is very inefficient and therefore best earned within a registered account.

Will that be the RRSP, TFSA or RESP?  When you invest more of the first dollars you earn, sooner, and defer tax into the future, you will be richer. Ensuring your strategy includes investment income that is sheltered from tax bites along the way will help make that a reality and is a great reason to invest in registered investment accounts. But they each have different purposes and features.   

Maximizing RRSP contribution limits is an important way to reduce taxes on personal income and put more whole “first dollars” to work for your future.  The contribution amount can be claimed as a tax deduction, which creates immediate tax savings that you can then apply to fund an RESP for a child’s education or a TFSA. Matching personal investment lifecycles to longer-term financial needs will help you anticipate and average down future tax consequences. As mentioned, that can include pension income splitting with your spouse, or timing the transfer of family assets to achieve the best after-tax results when your assets are flush with accrued taxable capital gains.

Clever Financial Moves

Investors with a wealth purpose and a defined time horizon for building it can do very well, confidently accumulating a substantive net worth to enjoy their financial future.  If you are vigilant about after-tax results, you can accelerate the growth of both income and capital and by extension, build overall family net worth.