May 122016
 

Bar Stool Economics

Capitalism in the United States is in serious disrepute. The Bush tax cuts have been said to give the top 0.1% of Americans an average of $520,000. That is over 400 times the average tax cut received by middle-class households. Many people are upset at how tax cut policies seem to disproportionately benefit the upper class. If anything, shouldn’t tax breaks help the poorest people? 😕 Well to understand how the tax system works let’s take a look at bar stool economics.

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The origins of this parable have been attributed to Professor T.Davies from the University of South Dakota and R. Kamerschen from the University of Georgia. The following is a modified version of the original.

Suppose 5 friends go out for drinks and the total bill comes to $100. If they paid their bill the same way we pay our taxes, in proportion to income, then it would go something like this:

  • The first 2 men, the poorest, pay nothing.
  • The 3rd man pays $4.
  • The 4th man pays $19.
  • And the 5th man, the richest, pays $77

The 5 men are happy with this payment arrangement so that is what they decided to do. 🙂 Then one day, drinks at the bar were on sale, and the total bill for the 5 gentlemen came to $80. To make it fair the men still wanted to pay their bill the same way taxes are paid. So the bartender reduced each man’s bill by roughly the same amount based on their economic status. The first 2 men were unaffected because they simply continued to drink for free. The remaining 3 patrons split the $20 in savings, and paid the following amounts:

  • The 3rd man paid $2 instead of $4 (50% savings)
  • The 4th man paid $14 instead of $19 (26% savings)
  • And the 5th man paid $64 instead of $77 (17% savings)

Each of the paying 3 men spend less for their drinks than before. And the first 2 men continued to drink for free. But once outside the bar, the men began to compare their savings. “I only got $2 out of the $20 in savings,” complained the 3rd man. “Don’t look at me,” replied the 4th man. He pointed to the 5th man and said, “he received the majority of the $20 savings. The wealthy get all the breaks.”

“Wait a minute,” yelled the first two poorest men who didn’t pay. “We didn’t get any savings at all. *harumph* The system always exploits poor people like us.”

Similar to wine tasting, the discount for the men can be seen as good or bad depending on their mental frame of reference. The first 4 men ganged up on the 5th man and patronized him for being too greedy. Then they went to a Bernie Sanders rally without inviting their rich friend. 😛 Feeling betrayed and ostracized the 5th man didn’t show up to the bar the following night. The 4 remaining men decided to drink without him anyway. But when it came time to pay they discovered an unpleasant surprise. They didn’t have enough money between all of them for even half of the bill. 🙁 It appears they were in a bill pickle. 😀

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Apr 282016
 

A 50 Dollar Lesson in Personal Responsibility

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I’d like to share this joke I found on tumblr.

I recently asked my friend’s little girl what she wanted to be when she grows up. She said she wanted to be President some day. Both of her parents are liberal Democrats who support Bernie Sanders. They were standing there beside her.

So then I asked the little girl, ‘If you were President, what would be the first thing you would do?’

She replied, ‘I’d give food and houses to all the homeless people.’

Her parents beamed with pride.

‘Wow…what a worthy goal.’ I told her. ‘But you don’t have to wait until you’re President to do that. You can come over to my house and mow the lawn, pull weeds, and sweep my yard, and I’ll pay you $50. Then I’ll take you over to the grocery store where the homeless guy hangs out, and you can give him the $50 to use toward food and a new house.’

She thought that over for a few seconds, then she looked me straight in the eye and asked, ‘Why doesn’t the homeless guy come over and do the work, and you can just pay him the $50 directly?’

I said, ‘Welcome to the Republican Party.’ 😛

Her parents still aren’t speaking to me.

The point of this allegory is clear; There’s an untapped market of homeless people who could be doing yard work & making $$$ 🙂

It also addresses the hapless reality of economic inequality even in developed countries. If we want the poor to succeed we need to give them the opportunity to pursue their own dreams instead of enabling them to continue living in poverty. Government run redistribution programs are part of the problem. Giving money to the homeless without any strings attached robs them of their dignity, economic potential, and the chance to develop the internal motivation to succeed. Besides, the government doesn’t have money in the first place so when it gives money to the poor it has to take that money from somewhere else.

Some children think that their parents are all no-ing. Even so, we understand it’s wrong and destructive for parents to do their children’s homework. It undermines their children’s intelligence, sets them up for failure in life, and is not fair to other students. We also understand it’s wrong to feed fauna at the local park.

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It’s hard to say no to a begging squirrel, but we resist the urge to feed it because we don’t want it to be dependent on our generosity. We don’t want to rob these hungry creatures of their ability to be self reliant. So I think we should help the homeless through education rather than simply giving them free money with no obligations.

The ultimate freedom in life comes from being able to internalize personal goals that give us meaning and purpose. 😀

If we are kind enough to offer these gifts of self-discovery, personal accomplishment, and self worth to children and animals, then I think we ought to extend this same offer to financially unfortunate people as well. 🙂

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Random Useless Fact:

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Mar 212016
 

Retirement Account – Taxation

Many folks should use tax deferred programs such as the RRSP or 401(k). Contributions made into a retirement account is tax-deductible and can grow tax-free in the account. When it is eventually withdrawn and taxed the plan holder will likely be in a lower income tax bracket. I would personally try to keep investments that produce mostly capital gains or eligible Canadian dividends out of my RRSP. But that’s just my personal preference for tax efficiency. The picture in this link here definitely says otherwise.

Most people expect to be in a lower tax bracket when they retire so contributing money into an RRSP to defer taxation to a later date when their tax rate is lower makes sense. But some experts say it’s probably not a good idea to use RRSPs if we expect to retire in either the same or a higher tax bracket as we are in now. However, there might be another way to look at it. 😀

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What if it’s still smarter to contribute to an RRSP today even if our marginal tax rate will be higher in retirement? When we make a tax deductible contribution to our RRSP today, the immediate tax relief we get is based on our marginal tax rate. So if our marginal tax rate is 30%, then we would receive $300 by contributing $1,000 to a registered retirement account. But when we withdraw money from this RRSP (or RRIF,) the money we take out is only taxed at our average tax rate, not the marginal tax rate. For example, if we request 12 monthly withdrawals a year from our retirement account then these payments would be taxed similarly to receiving work income from a job where each payment reflects our average income tax rate.

This is due to our progressive income tax system. In Ontario for example, the first $45K of income is taxed at roughly 21%, then the next $28K of income is taxed at 30%, and so on. So if we make $100,000, then we actually pay about $26,000 of income tax, which makes our average tax rate 26%, even though our marginal tax rate would be 38%.

So I’m going to continue maxing out my RRSP contributions each year even if there’s a chance my income will be higher in my 60s and 70s than it is now. 🙂

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Random Useless Fact:

Some people on the internet can’t figure out how many girls are in this picture.

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Jul 072015
 

Determining which accounts (Tax Free, Retirement, or Taxable) to hold different investment types in

Should you put stocks in your RRSP or TFSA? What about fixed income like bonds? This post will answer these types of questions. It’s assumed the reader is already familiar with the TFSA, RRSP, and regular taxable accounts.

There are two parts to every investment decision we make; the investment itself, and the type of account to hold that investment in.

Asset allocation helps to spread out our risk so we don’t put all our eggs in one basket. But asset location is also important because different types of investment incomes are taxed at different rates. We can hold our investments in special tax advantaged accounts to shelter our profits so we don’t pay more tax than we have to. 😉

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In an ideal world all of our investments would be bought inside tax advantaged accounts such as a TFSA or RRSP. There’s little reason to use a non-registered (taxable account) if there is still contribution room remaining in our tax free or registered retirement accounts. However its possible to purchase more investments than what our tax advantaged accounts will hold. If that’s the case then investment income that is typically taxed at higher rates should take priority inside a TFSA or RRSP. So with that in mind let’s get down to the nitty-gritty. 🙂

Which Investment Vehicles to use: TFSA, RRSP, or Non-Registered

Where is the best place to put stocks, bonds, mutual funds, and ETFs? Should they go in an RRSP or a TFSA? There is no categorically correct answer but here are some general guidelines that I follow.

  • Use RRSPs for interest producing investments and U.S. dividend paying companies.
  • Use non-registered accounts for Canadian dividend paying companies and preferred shares.
  • Use TFSAs for everything else.

For a deeper look, below are two charts that go into specifics. The first chart shows how different types of investment income is taxed in different kinds of accounts for someone in the 31% marginal tax bracket. The second chart suggests the best accounts to buy different types of specific investments in. 😀

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Additional notes to consider:

  • If we hold U.S. dividend stocks in a taxable account we’ll pay the 15% U.S. withholding tax off the top. But we can claim a foreign tax credit on our tax returns to recover some or all of this amount. However we’ll pay tax at our marginal rate on the full amount of the U.S. dividend. The net result is that U.S. dividends held in a non-registered account will be taxed at the same rate as interest income.
  • Dividend income from U.S. dividend stocks in a Tax Free Savings Account (TFSA) is also subject to the 15% withholding tax, however this tax is non-recoverable. But the remaining dividend and any capital gains is not taxed.
  • Dividend income from U.S. stocks in an RRSP are exempt from the 15% withholding tax. But this only applies if we directly hold a stock or ETF traded on a U.S. exchange. If the U.S. stocks are held in a Canadian mutual fund or ETF, we will need to pay the unrecoverable 15% withholding tax on the dividends.
  • Keep in mind that although many investment incomes are tax efficient while being held in an RRSP, any money withdrawn from the RRSP or RRIF later on will be subject to income tax at the full marginal rate and could trigger claw-backs for income tested government benefits like OAS.
  • Tax efficiency should not be the only factor when deciding which account to put an investment into. Simplification of record keeping, personal financial situation, risk tolerance, and retirement goals all have to be considered.
  • For most intents and taxation purposes RESPs behave the same way as TFSAs. RRIFs and LIRAs behave similar to RRSPs.

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May 132015
 

Not in my Backyard 

I recently read an article about a lower mainland couple who doesn’t like how a neighbouring $2 million house sits empty all the time. The yard is unkempt, there are no cars in the driveway and the lack of human presence is “driving [the couple] slightly bananas.”

Sacré bleu! You mean to tell me that there are people who buy property only for investment purposes? How dare they offer above market price to purchase a house here, so that Canadians can unlock the full value of their real estate. What can we do with cash anyway? Buy a diversified portfolio of liquid assets like stocks and bonds to provide passive income for retirement? No thanks. I’d much rather put all my nest eggs into a single illiquid asset that produces no income, and lies on a major fault zone. 😛 Those pesky foreign investors who don’t even live here think they can just not contribute any waste to our sewage system, and not use the city’s garbage services, but somehow think they still have the right to pay the full brunt of utility tax and property tax. Some nerve! How dare those foreigners help fund our police, fire, and public education system when they don’t even have kids here to overcrowd our classrooms. It’s also unfortunate how quiet their house is all the time. Who would want to live beside quiet neighbours anyway? Not me. 🙄

Sarcasm aside, foreign ownership of real estate is a hot button issue around here. Should non-residents or non-citizens be allowed to purchase Canadian residential property?

There’s actually a petition to restrict foreign investment in Canada’s most expensive real estate market, which I’ve signed and shared on social media. To be frank I don’t believe this petition will bring about any meaningful change, but I think it’s an important discussion for fellow Vancouverites to have. 🙂

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click on image to sign the petition

There will also be a rally outside the Vancouver Art Gallery on May 24th, to focus on the problem of affordable housing for young people in a city where the average house costs more than $1 million. Feel free to attend and take a stand if you believe in the cause. 🙂

Foreign Real Estate Ownership

Some believe foreign ownership drives up the cost of housing which makes it less affordable to live in the city. But I think that’s largely a myth. The amount of foreign owned property is just a fraction of the overall market. Foreign investment laws haven’t changed much in Canada over the last decade. However mortgage interest rates have been cut in half over the same period. Raise the interest rate and watch as prices correct overnight.

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