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Hello again and welcome back to the Millennial Revolution Investment Workshop! New readers, please click here to start from the beginning.
Because so many people have asked for it, today in the Investment Workshop we’re going to talk about how to make your portfolio tax-free (or at least, as close to tax-free as possible). Because the more taxes we pay, the more money the government gets, and fuck THAT noise.
Now, we’ve previously written about how to use our tax-sheltered accounts to get the government to help fund your retirement. As a refresher, go read that article before continuing.
For Canadians, you can open up both RRSPs and TFSAs with Questrade. Simply log in, click “Open New Account,” then under Account Type select the “Retirement” tab and pick either “Individual RRSP” or “TFSA.”
Under “Offer Code” make sure you use “feb23fb6,” which will give you $50 of free trades in there.
After that, you will need to fund the account either by making a new contribution or moving over your existing accounts. For TFSAs this should always be free. If your bank tries to charge for this “service,” simply wait until December, withdraw everything from your old account, then deposit it into your new account as a new contribution come January. MAKE SURE you do it in 2 separate years otherwise you will have over-contributed to your TFSA and will get hit with penalties from the CRA.
RRSPs typically DO cost money to transfer, but Questrade has an offer where if you transfer more than $25k, they will reimburse your transfer fees. Details here.
For Americans, you typically can’t move your 401k since it’s administered by your employer. You can open up a Roth IRA, however. Just select “Roth IRA” under the “Retirement” tab.
Your Tax Shield
For all practical purposes, we have 2 basic types of tax sheltered accounts: RRSP/401Ks, where you shovel in money and lower your taxable income, and TFSA/Roth IRAs, where you contribute after tax money. When you’re working, you want to shovel as much money as you can into both these accounts. In fact, if you’re serious about retiring before you’re 65, you should be maxing both out.
Why? Because when you put money into these accounts, that money is still your money, but any investment income you make with that money is now tax-free. These two accounts put together form your Tax Shield.
If you found yourself saying “Red Alert! Shields Up!” then congratulations, you are just as big a nerd as I am. Good job.
ANYHOO, the size of your Tax Shield as determined by how much cash is in each account, and you want this Tax Shield to be as big as possible because you want your portfolio to be able to fit inside this Tax Shield as much as possible. A perfect tax-free positioning for the portfolio we’re building in the workshop would fit completely inside our Tax Shield.
Note that it doesn’t actually matter in which account you put each asset, as long as it’s inside the Tax Shield somewhere. And also, you can move assets around your different tax-sheltered accounts anytime you want. For example, if you wanted to swap your Domestic Equities in your RRSP/401k with your bonds in your TFSA/Roth IRA for whatever reason, just sell them in one account and buy them in the other. Your balance won’t have changed and because all transactions were inside your tax shield, there would be no capital gains/losses to report.
Now, as your savings and your assets grow over time, you will soon find yourself in the happy situation of your money being too big to fit inside your Tax Shield. Woe is you! Woe, I say!
At this point, you have to pick some poor guy to kick out. If this was Survivor, we would make our assets run a series of challenges and gauntlets to determine who’s the most fit in a merit-based way, then we’d completely ignore that information and just gang up on one guy in a popularity contest to vote off the island. The law of the Jungle is unforgiving.
BUT since we can’t do that, we pick the one that costs the least amount of taxes if left outside the Tax Shield. Remember, the types of income an ETF can produce are
- Taxed as marginal. Bad
- Capital Gains
- Taxed when you sell, and at a lower rate. Pretty Good.
- Eligible Dividends
- Taxed at an even lower rate. The Best.
Here, we have to sidebar to deal with Canada/US tax issues. In Canada, Dividends are better than Capital Gains because in Canada Dividends are taxed, but then you get a tax credit that can offset some or all it. Capital Gains are taxed at 50% of the normal rate. So while Capital Gains will always have SOME tax payable, a couple can make up to $100k in Dividends tax-free if they have no other income.
In the US, both Capital Gains and Dividends are taxed at the same rate, which is 0% up to $75k for a couple. So to Canadians, Dividends are better than Capital Gains, but to Americans, Capital Gains and Dividends are equally good. Interest sucks for everyone, though. Stupid Interest.
Now, that affects which assets would fare the best outside the Tax Shield. Since qualified dividends apply to Domestic Equities, those we can kick out without hurting us too badly. Preferred Shares also pay out qualified dividends. We’re not using them in this workshop, but just FYI.
If we still have too much money and not enough Tax Shield, International Equities would be the next to get kicked out. Their dividends are taxed at marginal, but at least their Capital Gains are taxed lower. Bonds would be the last to go.
So now we are as tax efficient as we can make it. When you’re working and your income is high, you will still have to pay some tax, but when you retire, something interesting happens.
Your Tax Shield actually expands. Because dividends are basically tax free when you have no other earned income, Domestic Equities basically comes back under your Tax Shield simply by the fact that you’re quitting. Fun, huh?
What About When I Retire?
Here’s where things get fun and/or tricky. You can’t spend money inside your Tax Shield. So you have to get it out. But you want to do it for free, right? I thought so.
In Canada, it goes like this.
We each have about $10k of personal exemption in our tax returns each year. And because an RRSP withdrawal counts as income, that means you can take $20k of income (per couple) out of your RRSP each year without paying any taxes. And in Canada, our TFSA contribution room goes up by $5500 each year whether we make money or not, so that means each year we should be doing this in retirement…
That’s withdrawing $20k from our RRSPs, contributing $11k of that into our TFSAs, and leaving the remaining $9k in a regular investment account. And because TFSA money can be withdrawn anytime, we then do this to fund our living expenses.
Over time, we will shrink our RRSPs until the only thing left there is bonds, and once that happens we will just withdraw the interest they generate while leaving the bonds themselves inside.
For Americans, it will be a similar but slightly different, vastly more complicated strategy. Well, it’s not that complicated, but there are more steps to it.
The hoops we have to jump through are because both the 401ks and the Roth IRAs put penalties in place if you withdraw before the age of 59 1/2, so we have to do some fanciness to get around that. Of course, if you’re above that age just ignore all this crap since it doesn’t apply to you, ya old geezer.
First, we have to convert our 401k’s to a Traditional IRA. This can be done all in one shot and is tax-free. Talk to your investment brokerage on how to do this.
Next, we roll over part of your IRA into your Roth IRA. This amount is taxable, but with no other income you should be able to get it out tax-free using your standard deductions and personal exemptions. For an American couple this adds up to around $20k each year.
Then 5 years later, you can start withdrawing that first rollover tax-free from their Roth IRA. Do this each year and you will create a pipeline of money you can get out tax-free from your Tax Shield, even though you’re below 59 1/2!
This maneuver is called a 5-year Roth IRA Conversion Ladder, and we wrote about it in more detail here.
And We’re Done
So there you have it. Make your portfolio tax-free, and you will never have to pay taxes ever again in retirement.
Now you may be wondering why in our Investment Workshop we’re only using a single investment account. That is because my actual RRSPs and TFSAs are all maxed out doing exactly this, so I had no extra room to open up accounts for this Workshop. Sorry 🙁
As always, consult with a tax professional before you actually do anything because tax laws may have changed since time of publication.
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Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions. The information contained in this blog was obtained from sources believe to be reliable, however, we cannot represent that it is accurate or complete.