And in Reply…

My last post about knowing when you’re able to retire based on your dividend income elicited some good questions and counter-points from Robb at Boomer and Echo. The answers I have would have involved a rather long response in the comment section, so I decided to reply in a new post. For the record, here is what Robb said:

I used to think this way, how­ever I don’t think it’s real­is­tic to live off div­i­dends and never touch your cap­i­tal in retire­ment. First of all, any RRSP sav­ings will even­tu­ally be con­verted into an RRIF and face stiff with­drawal rates. Sec­ond, what if you want (or need) excess cap­i­tal in one year to pay for a car, new roof, large vaca­tion, etc.? You’d prob­a­bly look to sell off some stock to access the cap­i­tal. Finally, there’s the poten­tial to work longer than needed in order to reach a tar­get div­i­dend income stream. It’d take a mil­lion dol­lars in cap­i­tal to spin off $35,000 to $40,000 in div­i­dends. Why wouldn’t you want to tap into that mil­lion dollars?

In response, I say this:

As to the point about an RRSP

Despite working in a white-collar, arm’s length government job which requires a Master’s degree, I do not have an employer-sponsored pension of any description. Although I have contributed to my RRSP in the past, with three dependants, I don’t pay a lot of tax, so I don’t feel compelled to contribute on my own to an RRSP. Heresy, I know.

The problem with RRSP’s is that all they do is defer the tax. While that is certainly a significant benefit, the other shoe, as Robb correctly points out, will drop eventually. When that money comes out of a RRIF, the tax hit can be hard. My parents are going through this right now, and are less than pleased at seeing their nest-egg trimmed significantly.

I prefer to invest money in my TFSA and in unregistered accounts.

Unregistered accounts are great for steady dividend-payers that will probably experience relatively low price appreciation. (Don’t get me wrong; prices going up is good, but I’d rather have growth-y stocks in a TFSA, so I don’t have to pay any tax whatsoever.) In the future, I also plan on borrowing to invest in dividend-paying stocks, which will mean that the interest is tax deductible.

The great thing about TFSA’s, and a feature that is often overlooked, is that the withdrawals are not considered income. As such, in a few decades, I should be able to withdraw thousands(!) of dollars per month, and the tax man doesn’t get any of it!

Now, would it be better if I had an employer-sponsored pension plan? Of course it would be, but I don’t, so I’m making the best of it. If all of my income comes from TFSA’s and dividends in unregistered accounts, my tax rate will be very low indeed.

The final point in this equation is that means-tested benefits such as OAS will not be affected by income from a TFSA at all, so I will be able to benefit that way, too. On paper, I may well be “poor”, because TFSA’s aren’t counted in those calculations. In this case, being “poor” works to my benefit.

 As to selling stock

Robb correctly points out that surprises come up from time to time in life, many of which can be expensive. I may be picking nits here, but Robb says I’d probably look to sell some stocks. I may end up selling some stocks, but that would be the last option that I would look to. The earlier I was in my retirement, the truer this would be. If I’m in my late 60’s, I would rather make lifestyle changes than reduce my source of future income, except as a last resort. Twenty years later, in my late 80’s, I might be a bit more willing to dip into my cache of stocks, but I maintain that it won’t be my first choice.

I also feel it necessary to point out that part of my plan is to give myself a reasonable buffer. In my original article, this took the form of being able to live off 90% of my dividend income, allowing me to re-invest the last 10% so that my savings continue to grow.

So, could I sell stocks? Yes. Would I? I’d try very hard not to.

As to building a sufficient dividend income

It is important to realize that life is an end-game, and that when you go, you hope that you have spend a reasonable amount of your life doing things that you want to do, i.e. being retired. Quite rightly, Robb points out that you may need to work extra years (or even decades) to build your stockpile of dividend-paying stocks to a level sufficient to support yourself entirely. While I agree in principle that this may be a potential problem in some cases, I am in my early 40’s, so if I follow the typical path of working until the standard retirement age (which will surely be higher than 65 by the time I get there), I’ve got quite a bit of time to build my portfolio. Robb may have been assuming that I was planning on early retirement. I have to admit that in my younger years, I was, but that does not seem likely at this point. If we were making different assumptions, it is natural that we would come to different conclusions.

Finally on this topic, I’m afraid I have to take issue with Robb’s expected rate of return on a million dollars invested. If a million dollars were all invested at once, at current rates, yes, it could be expected to fetch $35,000 to $40,000 in dividend income per year. But I’m not going to wait until I retire to start investing. That same million dollars, invested gradually over a twenty-year working-and-investing period, would achieve a significantly higher rate of return. Taking into account doubling times, and virtuous circles of ever-growing dividend payments which in turn become new investments, I guess I’m just more optimistic about my long-term returns.

As to that million dollars

I realize that once my children and grown and on their own, my first responsibility is to myself and my wife, but if possible, we’d like to leave a reasonable/sizable inheritance for our children. If they know my wife and I are worth a bucket-load, they may not be so quick to put us in a home!

 

I’d like to thank Robb for his response. He made me consider my points again, and explain them more fully, and perhaps more clearly, in this second post. I also should have probably pointed out that I was mostly thinking of my own situation, which is not typical in some respects.

 

 

10 thoughts on “And in Reply…”

  1. Good point that using your TFSA and a non-registered account can make this option more realistic. And I did assume that early retirement was at least a consideration.

    My only issue with your argument is that you somehow expect a million dollars to spin off more than 3.5% to 4% in dividends. Whether you bought 1000 shares of TD stock 20 years ago for $10 per share, or you bought 1000 shares today at $53, you’ll still only get $1,880 in dividends from those shares.

    That has nothing to do with total return, only expected dividend payments, as you’ve clearly stated that you don’t want to touch the capital.

  2. The advantage of an RRSP is that your investment earnings grow tax free until you choose to withdraw. There is an advantage over the TFSA if you believe you will be in a lower tax bracket once you retire and are not dependent on government supplements. In my case with a pension and the ability to split income in retirement , I think an RRSP is the better option, at least in terms of maximizing long term wealth.

  3. Robb,
    If I had bought TD stock 20 years ago, that would have given me 20 years to re-invest the dividends. That, as well as dividend increases, and money that is coming from my day job, would have increase the dividend payouts significantly; I want to get compound interest working for me. But that takes time. (Yes, I know that inflation takes a bite out of purchasing power, but I believe that all in all, dividend increases generally outstrip inflation.)

    I don’t really think of investing in terms of total return. I think in terms of cashflow. When I buy a stock, I am buying a cashflow, not an asset I plan on selling for a profit. I want to use my dividends to buy more stock, which will then throw off more dividends. The longer I can leave that process in place, the better. Other than the fact that it affects the amount of new stock I can buy, a stock’s price is of little or no concern after I buy it. (Within reason, of course!)

    Once I retire, I stop re-investing the dividends that I need to live on. Hopefully, after I take that money out of the virtuous circle, I’ll still have some dividend money that is able to be re-invested in new shares. At that point, my cashflow won’t be increasing as quickly, but any increase is better than a decrease.

    xoxox,
    The thing that bothers me about RRSP’s is the tax you have to pay when you take the money out. It’s kind of like blowing up a big balloon in a room with a small door. Yes, your balloon is huge, but it’s going to be a lot smaller by the time you get it through the government … er, door. (OK, the analogy doesn’t hold up perfectly because balloons can change shape, but I hope you see my point.)

    With dividend stocks in a TFSA and unregistered accounts, I know exactly where I stand. The money I make in my TFSA is all mine. The dividend tax credit significantly lowers taxes payable on my unregistered accounts.

    Do I wish I had money to put in an RRSP? Yes. But until my employer starts contributing, or my income jumps significantly, (neither scenarios are very likely) I’m going to keep new money out of my RRSP.

  4. I think you are making a mistake not funding your RRSP. You are forgetting about the nice tax deduction you get from the contribution, which you could fund your TFSA with. And the money compounds tax free for all those years in the RRSP which is a huge benefit. The is especially true if you are a DG investor so you avoid tax on all those dividends!

  5. Hi Grant,

    Thanks for stopping by. I’m certainly not against RRSP’s. The tax deduction is indeed a great benefit, especially if the tax refund is used to invest in a TFSA. Another benefit of RRSP’s over TFSA’s is the higher contribution limit in RRSP’s, relative to TFSA’s.

    The thing that gives me pause about RRSP’s is that once the money is in there, it’s a big decision to get it out, with potentially big tax consequences. With a TFSA, I can access my money if and when I want, and Ottawa doesn’t get a cent. I really like the certainty of knowing at all times exactly how much money I have, and also knowing that I can get it quickly if needed. This reason may be more emotional than mathematical, but it is a factor for me, as my job situation isn’t particularly stable.

    You’re right when you say that money compounds tax-free in an RRSP, but the same is also true for a TFSA (albeit there will probably be less money in your TFSA because of lower contribution limits). Remember, too, that dividends are taxed at an extremely favourable rate, (when outside a registered plan), whereas all money withdrawn from your RRSP is taxed at your marginal rate. The idea behind this is that most people will have a lower income in retirement, but if you “screwed up in reverse” and had great returns from the investments in your RRSP, you may actually INCREASE your tax bill if you withdraw too much money after retirement. (This would actually be a great problem to have, but I think it would still stick in most people’s craw. I know my parents aren’t too happy about it.)

    Again, I’m not against RRSP’s at all, but given my situation, my TFSA is going to get more love from me over the next few years than my RRSP is.

    Jeff

    1. Jeff, yes, there are certainly different personal situations to consider. For many people it is a good thing that it’s difficult to get money out of an RRSP as they need that discipline to save adequately for retirement.

      It’s true that Canadian dividends are taxed favourably but not so for your foreign dividends which are taxed as interest income. If your asset allocation is 100% equities you are better off keeping foreign equities in an RRSP than everything in a taxable account.

  6. I think your argument may be based on some faulty assumptions. Let’s look at a very simple example. Suppose a hypothetical investor decided to invest $10,000 in pre-tax dollars into an RRSP. Because of the up front tax break this translates into an immediate investment of $10,000 into the RRSP. (I’ll assume this individual has a marginal tax rate of 50%, both before and after retirement; earns 10% per year on their investments; makes only the one deposit to the RRSP; and holds the investment for 20 years.) After the 20 year period the individual would have $67,275 in the RRSP. Now let’s assume he withdraws it all at once. After taxes he would have $33,637.50. Now if instead he had invested $10,000 in pre-tax dollars into an TFSA, this would translate into a $5.000 investment after taxes. After 20 years this would translate into a total wealth of $33,637.50. Now it may not be unreasonable to believe that your marginal tax rate will be lower after retirement, in which case the RRSP will dominate the TFSA. There is however one kicker here that should not be ignored, especially if you fall into a category in which you may be eligible for a government supplement (you of course would probably have never been in the 50% tax bracket) or if you are eligible to collect OAS. The income from an RRSP might reduce or negate the supplement. It may also increase the federal government clawback of OAS.

  7. Grant,

    You make some good points. Making money hard to get at works to the long-term benefit of a great many people. If I remember correctly, David Chilton recommended putting money into vehicles for which there would be a penalty for early withdrawal for this very reason. (I think it was him.) And yes, foreign dividend-payers should definitely be held in an RRSP.

    xoxoxo,

    Somebody who is in a 50% tax bracket would definitely be well-advised to invest heavily in an RRSP.

    In the scenario you present, the RRSP and the TFSA come out even, but it’s not hard to see that a slight change in any of your assumptions would lead to the scales being tipped in favour of the RRSP. As you mention, though, if this set of assumptions actually came to pass, the TFSA would win, due to the OAS clawback factor.

    Again, I’m not opposed to RRSP’s; I just worry that many people think more about the tax rebate when they contribute than they think about the tax bill when they withdraw the money. As I have said, my parents are going though this right now, and they had seen the money in their RRSP’s as being “theirs”, not as something they would have to share with the government. They both have very respectable pensions, so they’re taxed fairly heavily on their RRSP and RRIF withdrawals. A good problem to have, I guess.

    I’m not alone in having some hesitations about RRSP’s.

    http://retirehappy.ca/when-should-you-not-buy-an-rrsp/

    (I’m not the first commenter, “Boofus”, but I could be. When he says “taxed at 100%” I think he means at your marginal rate.)

    Jeff

  8. I just find it odd that one would worry about the tax being paid on withdrawals from an RRSP and, in particular, the view that this (in itself) might provide an argument for preferring a TFSA. The point of my previous comment was to point out that given a constant marginal tax rate there is no advantage to either a TFSA or RRSP. Both have the same tax and wealth consequences (provided you are saving for retirement). With a TFSA you pay your taxes up front, while with an RRSP you pay your taxes upon withdrawal. In order to choose one over the other one must determine how they expect their marginal tax rate to change over time and if there is likely to be a clawback situation. In other words it is too simplistic to just say (and I have heard this): I will never use an RRSP because I will have to pay taxes when I withdraw the money.

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