Tag Archives: income

Passive Income Part Four – Accounts

Back by popular demand!–here.s Part Four and accounts are the next item on the table. But since I can.t remember the topics in parts one to three, it might be a good idea for a refresher before starting! Here.s the road we took: Part One covered why investing is handy and what to expect. Part Two focussed on costs, costs, and costs. Part Three introduced the idea of risk and how an easy to construct portfolio with a bond and an equity component could be tailor fit to suit an investor.s risk profile. Next up are the different types of accounts.

Accounts: TFSA, RRSP (or RSP), and Non-Registered

There.s three different types of accounts. Think of accounts as empty baskets or shopping carts into which you can put your investments. Just as baskets or carts have different qualities (they can be made of metal or wood; some you carry and others have wheels, etc.,) the three different types of accounts have different attributes from a tax perspective:

TFSAs (Tax Free Savings Accounts) are accounts where you can put your after-tax income. Your investments grow tax free inside the account, hence it.s name. When money is taken out of the account, it is not declared as income and you are not taxed.

RRSPs or RSPs (Registered Retirement Savings Plans) are accounts where you can put your pre-tax income (pre-tax since when you file taxes in March the CRA sends you back whatever taxes you paid on the amount that was contributed to the RSP). Your investments grow tax free inside the account. When the money is taken out, it is declared as income and you are taxed.

Think of TFSAs and RSPs are mirror images of one another. If the tax bracket in your working and retirement years doesn.t change, they are the same in terms of the savings because in the TFSA you are taxed on the money before you put it in (therefore you put in less) but you are not taxed when you take it out. In the RSP, you aren.t taxed on the money before you put it in (therefore you have more to put in) but you are taxed when you take it out.

Non-Registered accounts are simply investment accounts held outside tax shelters such as TFSAs and RRSPs. You put your after-tax income into these accounts. Growth in investments in non-registered accounts are classified as dividends or capital gains and are taxed, but at preferential rates. Some basic record keeping is necessary to work out gains and losses when doing taxes. Although there are more tax considerations and record keeping with non-registered accounts, they are incredibly flexible.

If you.re starting out, the best option is either a TFSA or a RSP. They.re tax shelters and there.s less record keeping involved. If you expect to be making the same or more income during retirement (it happens, believe it or not), go with a TFSA. If you.re not sure, start out with a TFSA. TFSAs are simpler in terms of taking money in and out. If you.re certain you.re going to be making quite a bit less during retirement, consider starting off with a RSP: this way when you put your money into the RSP, you get a lot of your taxes back (because you.re in a high tax bracket) but when you.re withdrawing from your RSP, you.ll be taxed minimally (because you.re in a low tax bracket).

Yes, I know, investing is a workout because it forces you to think about the future! As Yogi Berra once said, ‘Predictions are hard, especially when they concern the future’!

If you.re not sure what to do, start out with a TFSA and you.ll do just fine.

How to Open an Account

So you.ve decided to open up a TFSA. Very good! How do you do this? Well, there.s a couple of options. What you want is a ‘Self-directed TFSA’ account. Self-directed means that you.re in control: you.re not going through a financial advisor (who will offer value added services by directing you to their high cost products). Self-directed is the way to go

The big 5 banks all have brokerage divisions:

1. TD.s brokerage is called TDDI (TD Direct Investing)

2. RBC.s is called RBC Direct Investing

3. Scotia has Scotia iTRADE

4. BMO has BMO Investorline

5. CIBC calls theirs CIBC Investor.s Edge

It might make sense to have the self-directed TFSA with the same institution where you do your banking. You can link it with your chequing account and make deposits or withdrawals quickly and easily. The other option which give you lower cost trades is to go with an independent brokerage such as Questrade. They have lower commissions. To fund the account, you use the bill pay feature at your bank and select Questrade as a payee. You pay them as you would a hydro or a phone bill. When you set up the account, you send Questrade a void cheque so that when you do withdrawals, Questrade will do an electronic funds transfer directly into your bank chequings account. Easy. I have investment accounts at TDDI (because I bank there) and Questrade (to take advantage of low commissions).

Most of the banks allow you to do the application online. Questrade has a handy online application as well: for the ID and void cheque portions, you simply upload photos. It.ll take a few hours to get things set up.

If you.re wondering whether to go with one of the big 5 banks or an independent brokerage, I.d suggest Questrade because of their low fees. It.s easy to set up the account online and it.s easy to use bill pay on your regular bank account to fund it. Withdrawals with electronic funds transfers are also a piece of cake.

So there you have it! Accounts demystified! I think we.ll do two more instalments of the ‘Passive Income’ series before returning to regularly scheduled programming. A primer on how to buy and sell once the account is opened is coming your way. And for the final instalment, maybe a brief FAQ with some words on how my investment philosophy came to be what it is today.

Until next time I.m Edwin Wong and it.s through the passive income stream that I.m able to be Doing Melpomene’s Work. And assiduous readers who have been reading are well on their way as well!

Passive Income Part Three – Risk

Passive Income Part Two – Costs ended on a cliffhanger: it addressed why costs are important, but did not get to how costs can be controlled. It.s actually easy: find low cost investment vehicles. To find the right low cost investment vehicles and put them together in a portfolio, an understanding of risk is useful.

What is Risk?

Some say risk is a four letter word. Others say it is the danger of loss. To some risk is that more things can happen than will happen. An economist will say the technical definition which is that risk is the portfolio’s standard deviation. Standard deviation quantifies the variance in annual profits and losses. Economists like it because it can be expressed as a number and being a number, can fit into their equations. It.s hard to quantify ‘shit happens’! The economists’ definition, however, is at odds with how the word is commonly used to express ‘danger of loss’. A portfolio whose returns varies from -1% to -2% each year by their reckoning is less risky than a portfolio whose returns varies between +5 to + 15% each year because the variance in the returns of the first portfolio is smaller. According to the common usage, the first portfolio is clearly ‘riskier’ because it is losing money each year!

For today, however, risk is your tolerance to loss and gain. The more risk tolerant you are, the greater chance you are willing to stomach big losses so that in other years you will have big gains. The less risk tolerant you are, the more you prefer small gains in good years so that losses in bad years are also smaller. This principle works because risk is related to return: the more risk you are willing to take on, the greater your return should be because you are exposed to greater danger. Think of different occupations. A linesman (those guys who connect power lines carrying tens of thousands of volts) makes more money than, say, a deli attendant at a supermarket. That.s because the most dangerous thing in the supermarket is the meat cutter or an irate customer. The linesman takes on more risk and should be compensated for taking risk. It.s the same in the stock market.

So decide whether you.re low risk, medium risk, or high risk investor. There.s actually no way to really figure out until you.re invested (and feel the thrill of making money and the dejection of losing money) so just go ahead and decide. Remember what you decide as we.ll come back to it in a second. Here.s some images to help assiduous readers make their selection.

If you require helmet, reflective gear, and lights to feel safe riding a bike, consider yourself low risk:

Bike Safety Nerd - Low Risk

Bike Safety Nerd – Low Risk

If you will go for the piece of cheese provided you have safety apparatus, consider yourself medium risk:

Safety Mouse - Medium Risk

Safety Mouse – Medium Risk

If you do vehicle repairs A-Team style, consider yourself high risk:

Road Repair - High Risk

Road Repair – High Risk

Classes of Investments

There.s two major classes of investments: stocks and bonds. With stocks, you are a shareholder in the company. You are a part owner, in other words. With bonds, you lend your money to a company. They will pay you back what you lent them plus a little something extra for your trouble. The nice thing with stocks and bonds is that they.re uncorrelated. That is to say, they do not move in tandem. If one.s going up, the other.s going down. Or if one.s going up, the other.s treading water or not going up quite as much.

Now guess which is riskier? If you guessed stocks, then you.d be right. They also return more than bonds (most of the time). But they are also more volatile. That.s why you also need bonds in your portfolio. Think of them as a ballast. When the storm.s brewing and you.re battening down the hatches, bonds are your best friend, not that diamond mine in Botswana.

Now, since there are two classes of investments and when one zigs the other zags, it seems a good idea to have bits of both in the investment portfolio. Stocks are the engines that drive the portfolio.s growth during good years and bonds are the ballast that help you through the storm. How do we figure out how much of each?

Do you remember what type of investor you are from the previous section? If you.re the safety cyclist, a good starting point is a portfolio of 60% stocks and 40% bonds. If you.re the hungry mouse who will go for the cheese after putting on the necessary safety gear, a good starting point is 70% stocks and 30% bonds. If you.ll trust a 2×4 to hold up your truck while doing repairs underneath it, then a good starting point is 80% stocks and 20% bonds.

Wasn.t that easy?

Investment Vehicles

Which bonds and which stocks to I buy? That.s easy: buy them all! There are these investment products out there called exchange-traded funds or ETFs. They.re exchange-traded because they trade on the TSX (the stock market). They.re funds because they.re baskets of many individual holdings which together represent the total market. For bonds, I.d recommend Vanguard Canadian Aggregate Bond Index ETF. It has a MER (management expense ratio) of 0.19%. For something that holds around 600 different issues of bonds, it.s dirt cheap. Of it.s 600 or so issues, about three-quarters of its holdings are backed by the Canadian government (federal, provincial, and municipal) or government related entities. The remaining one-quarter are issued by companies, mainly investment grade banks and insurance companies.

For stocks, I.d recommend BMO Capped Composite Index ETF. It has a MER (management expense ratio) of roughly 0.1%. I say roughly because they just lowered it and their site frustratingly publishes the ‘Maximum Annual Management Fee’ (which is slightly less than the MER which includes trading costs and other things). I wish everyone would just publish the MER to make comparisons easier. This ETF holds around 230 of the largest companies in Canada: Royal Bank, Manulife, CNR, Valeant Pharmaceuticals, Blackberry, you name it, it.s in there.

In the following blogs I.ll discuss how to buy the bond ETF and the stock ETF. Once you.re set up, it.s a few keystrokes and clicks of the mouse. It.s that easy.

In today.s segment, I discussed risk and how knowing your risk tolerance helps you to put together a portfolio. I also recommended two investment vehicles: one for bonds and one for stocks. Notice how low their costs are: fractions of a percent. In Passive Income Part Two, the average cost of a mutual fund was flagged at 2.42%. The cost of a DIY portfolio with my two recommendation is in the neighbourhood of 0.15%. That is to say, by reading this blog, you save 94% off the posted retail price!

Stay tuned for Part Four of the Passive Income saga! Next time, the discussion will be on the burning question I.m sure all of you are asking: how do I open up an investing account? Well, that.s easy too!

Until next time, I.m Edwin Wong and investing has been how I was able to get out of the rat race to be Doing Melpomene’s Work. I hope others will be able to as well.