Now that I have started residency and am earning an income, I have started to figure out how to optimize my savings & investments. Given that I will never have a pension, savings are 100% my own responsibility.
The (multi) million dollar question is how to maximize savings and minimize time to financial independence.
The answer to this question uses the most important savings tool available to Canadians which is tax-advantaged accounts.
The two tax-advantaged accounts available for Canadians are the Tax Free Savings Account (TFSA) and the Registered Retirement Savings Plan (RRSP). These are two key tools that can maximize savings and minimize time to financial independence.
What are TFSA’s and RRSP’s?
TFSA’s and RRSP’s are both tax-advantaged accounts, which means that money invested inside these accounts will grow tax free.
However, the TFSA uses after-tax dollars, which means when money is taken out no taxes are paid on the money when it is pulled out. In contrast, the RRSP uses before tax dollars (often giving you a tax refund), which means you will have to eventually pay income tax on the money when you pull it out. The contribution limits between these accounts are different as well.
Why contribute to these accounts?
Less taxes is the MOST important reason for contributing to these accounts.
Taxes are a major drag on accumulating wealth for physicians in particular because of their high income. Right now, physicians in Ontario who make over $220,000 will pay 54% on every dollar they earn over this amount (their marginal tax rate). This means they get to keep $0.47 of every $1 they work for.
The marginal rate will increase the taxes on BOTH employment income (which we earn from seeing patients) as well as investment income (from investments).
Because physicians have high employment incomes, we will pay high income taxes and investment taxes.
This means if we can avoid or reduce these taxes it will be a major boost to achieving FI.
How big of a boost?
The question now is – how much of a boost do we get by investing in a tax-advantaged vs tax-DISadvantaged account?
The answer is: A LOT
Assuming we start out with $10,000 and never invest another dollar, and the tax rate on our investments is 27% (54%/2). In Canada we pay tax on 50% of the capital gains, so we only pay half the amount of tax on investments compared to our earned income.
This is what the difference looks like:
Registered account after 50 years: $294,570
Non-registered account after 50 years: $121,806
In other words, you will have 60% less if invested in a non-registered account.
There are other considerations not accounted for in this graph which include tax differences on dividends, changes in marginal rate with employment status amongst other things. However it illustrates the importance of considering taxes when planning to achieve FI.
What should I do?
Hopefully I have convinced you that maximizing your tax-advantaged accounts are one of the most important steps to achieving FI.
The question you are probably now asking yourself is – “which one should I maximize first?”
In an ideal world of endless money – you would contribute to both.
However, we’re not in a world of endless money.
Therefore, I suggest if you’re in the highest tax bracket, maximize the RRSP. This is because the deduction you receive from contributing to the RRSP can then be used to reinvest elsehwere.
If you’re not in the highest tax bracket (like me), then invest in the TFSA. While there is no tax refund from investing in the TFSA, you won’t have to pay income taxes when you eventually take the money out.
What’s stopping you?
If you have for some reason not yet maximized your tax-advantaged accounts, then today is the day to do it!
Commit to filling these accounts up as soon as possible by the end of the calendar year and then going forward make sure you contribute annually. These will be the most important wealth-builders for you in achieving financial independence
Which account have you maximized and why? Is there a reason why you have selected one and not the other?