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Four Rules of Financial Planning
Regardless of one's financial situation, there are four essential rules to framing a sound financial plan. These are outlined in the table below and discussed in the sections that follow.
Rule 1. Prepare for the Unexpected
Ensure you build a solid foundation by putting in place an estate plan. Periodically review your plan, especially when a major life event occurs. You will need to:
Evaluate your life, health, auto and home insurance needs. Ensure you carry adequate insurance at all times.
Prepare a will, enduring power of attorney and personal directive (also referred to as a "mandate" in Quebec).
Name beneficiaries on registered plans, TFSAs and life insurance.
Rule 2. Get Rid of Non-Deductible Debt
Debt is a fact of life. But, how effectively we manage our debt and what type of debt we carry affects our lifestyle, both now and for the future. Most importantly, our debt management style sets our pattern of behaviour, which is very difficult to change.
Why Should I Focus on Getting Rid of Debt?
The cost of debt should be your first consideration in planning. Carrying debt means you’re using “after-tax” dollars to pay it back. For example, an interest charge of $100 might have a “real” cost of $140 because you have to earn $140 just to have (after tax) the $100 to pay the interest. Further, you don’t receive any tax credits for the interest you pay on your consumer debts. Therefore, borrowed money may be more costly than initially thought.
How Can I Develop a Debt Reduction Strategy?
If you want to reduce debt, here are some actions you may want to consider:
When possible, consolidate high-cost debts (such as, balances on store credit cards) to lower-cost options, like getting a line of credit from the bank. Ensure that you don’t rack up more debts on those cards going forward.
If you have extra funds to help pay down your debt, concentrate on paying down the highest interest rate debt first, while maintaining the required minimum payments on the other debts.
Cut up some of your credit cards (particularly the department store cards, which charge the highest interest rates). Having fewer credit cards also makes it easier to track purchases.
Accelerate your bank loan repayments. You’ll reduce the total interest paid over the life of the loan.
Invest in your own house by increasing your mortgage payments or by making additional payments.
What Are Some Other Debt Reduction Methods?
To resolve debt problems, another method is to build assets to attack the debt directly. Here are three possible methods:
If you or your partner’s employer permits, sign up for a share purchase plan or savings plan through payroll deduction. After one year, these investments are yours to sell and apply against your debt.
Arrange to automatically transfer money from your chequing account to an investment plan, such as a savings account or your bank’s money market mutual fund. Every six months or so, withdraw the money from the investment and apply it against your debt.
Review your expenses to see where you can cut back, for a set time period (to reduce debt) or permanently.
Rule 3. Accumulate Assets for Retirement
What are the most effective ways to build assets for retirement? Joining a pension plan and/or contributing to an RRSP are effective ways to build assets for retirement. The underlying advantages are:
You get a tax break on any contributions you make.
The investment income earned on the contributions grows without being taxed inside the RRSP account.
When you withdraw the retirement funds, you’ll probably be doing so at a lower tax rate.
How Can I Do Both: Get Rid of Debt and Save for Retirement?
You can take steps to address both problems, paying down debt and saving for retirement. Here is how:
Contribute regularly throughout the year to your RRSP.
By contributing, you will reduce your taxable income.
These contributions should result in a tax refund when you file your income tax and benefit return.
When you get your tax refund, apply it against your debt.
Alternatively, you can apply to have your taxes reduced at source, based on your regular RRSP contribution. Then take that monthly saving and apply it against your debt.
If you're able to successfully follow these steps, you will have won in two ways:
By accumulating assets for retirement; and
By attacking your debt.
TFSAs may also be used to enhance retirement savings. Money goes in after-tax, grows tax-sheltered and any withdrawals are treated as capital, not income, and therefore are tax-free.
Rule 4. Reduce Income Tax
Consider the following to help you reduce your taxes:
Take advantage of tax deductions and credits.
Avoid triggering capital gains in a high-tax year.
Consider the tax rates of each province when accepting a new job.
Use “income splitting” if you have a partner or dependants.
Income splitting is the practice of shifting income among members of your “tax family” (you, your partner and any dependant). The family will pay less tax if the highest earner can shift income to family members. Some simple examples of effective income splitting strategies are:
Use the higher income earner’s RRSP room to make a “spousal” RRSP contribution. The contributor receives the deduction, but when later withdrawn at retirement, the amount should be taxed at a rate lower than it would have been had the higher income earner owned this RRSP asset.
Have the higher income earner contribute to the lower/no income earner’s TFSA. Any amount withdrawn will not be taxed and be considered property of the lower/no income partner.
If both partners have income, have the higher paid spouse pay all the household bills. The income of the lower paid spouse is then available to buy investments for the family. The assets are in the name of the lower paid spouse; hence, the resulting investment income is also taxed at lower rates.
Following these four rules will form the basis of a sound financial plan. Underlying them all, however, is a basic rule of financial health: spend less than you make!
Savings Goal Calculator
Planning a sabbatical? Saving for a down payment on a house? What will it take to reach your financial goal? This calculator helps you find out. Enter in your savings plan and view graphically your financial results. Click the report button to get more information about your plan, and what you can do to help ensure that it is on track.
Information and interactive calculators are made available to you only as self-help tools for your independent use and are not intended to provide investment or tax advice. We cannot and do not guarantee their applicability or accuracy in regards to your individual circumstances. All examples are hypothetical and are for illustrative purposes. We encourage you to seek personalized advice from qualified professionals regarding all personal finance issues.