Finance 101: Sharpen Your Pencils!
Finances are complicated. It’s worth knowing that most of us feel the same way. To complicate things, there’s acronyms for all the terms we need to know and financial literacy isn’t something that’s taught in school.
So, what the eff are RESPs, RRSPs, TFSAs, Non-Registered Accounts and Mutual Funds?
Welcome to Finance 101.
If this is review for you, great: reviewing only strengthens foundational knowledge. If this is new to you, great: you are in the right place!
Over the next few posts, we will go over some finance basics. It’s important that we define the essential finance terms before we get into the finer points of each.
Why are we reviewing these terms?
As someone who talks with Canadians every day about their personal finances, I find a key question that comes up is when to use an RESP, TFSA, RRSP, Non-Registered Account or Mutual Fund. And, people are often confused on what exactly a mutual fund is.
So, let’s take a few minutes today to go over some the basics.
The following are terms we will need to know for the next series of Finance 101 posts.
1. Compound Interest
Albert Einstein said, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
Compound interest is what will help you achieve financial independence.
So, it’s an important term to understand. Here’s how compound interest works:
- When you invest $1,000 into an investment and it makes a return of 6% (or $60)
- That 6% is added to your original investment.
- Now your investment will be worth $1,060.
- Boom. You just made $60 by investing $1,000. Nice!
But here’s where the magic starts.
In year two, your $1,060 investment generates another 6% return, which provides you with $63.60. Now when you check your investment it shows a handsome $1,123.60!
Now let’s draw this example over the long term:
- 20 years = $3,310
- 30 years = $6,022
- 40 years = $10,957
See how powerful compound interest can be over time?
But be careful with interest, because just as wonderful it can be, it can be harmful.
Remember what Einstein said? Knowledge is power. Think about car loans, financing your furniture, carrying a credit card balance, mortgage loans etc.— these aren’t the right kind of compound interest you want to be dealing with.
2. Tax Deferral
In Canada when we make money, we generally get taxed. In the compound interest example above, you can see every year that the investment was making money. So, what do you think? Was tax being paid?
Normally, yes tax would be paid; however, certain investment tools offer a tax deferral. This means taxes aren’t immediately charged on the investment growth (stay tuned for which tools provides this superpower).
Tax deferral works like this:
- The $60 that was made in year one was “deferred” and no tax was paid.
- In the above example, at year 40, the investment made $9,957 ($10,957 – $1,000), and no taxes were paid!
- But don’t get too excited as some investments do charge you taxes once you take the money out; however, we need roads, health care and school, so that’s okay.
Why the heck would we want to we defer taxes only to pay them later?
Because often when we are in the prime of our income earning days, we are in a high taxer tax bracket than when we retire. So, if we defer paying taxes now, we benefit because we pay less taxes later. In the meantime, we allow our money to experience the magic of compound interest for years.
3. Marginal vs. Average Tax Rate
Often these terms get confused. As discussed, when we make money in Canada, we get taxed. Canada has a progressive tax system: as you earn more money, you pay more taxes. Additionally, each Canadian pays federal and provincial taxes.
Average Tax Rate: is the percentage of your income that went to the government for taxes. As mentioned above and shown below, as you earn more income, you pay more taxes. Each time your income increases into a new “tax bracket” you pay a higher percentage only on the earned amount that is higher than the income bracket you just passed.
For example, if you made $95,000 a year, only $1,791 would of your income would be taxed at 41% ($95,000 – $93,209). To calculate your average tax rate, divide your total taxes by your gross income.
Marginal Tax Rate: this is a little more complicated because Canada uses a progressive tax system. As you make more money, your tax rate increases. In other words, you keep less of each dollar you earn. Your marginal tax rate is the amount of tax you would pay on your next dollar of income. In our example of someone earning $95,000, their average tax rate would be 22.95% and their marginal rate would be 36% (Check out this income tax calculator).
Okay, nice work! Here is what you can do now:
Find out your marginal and average tax rate (click here)
Stay tuned for the next Finance 101 post!