Here we go. This is the fifth and final post about the Steps to FI. After all, there is a purpose to all this. After lowering our expenses, increasing our income, saving the balance and then investing our savings, we should be getting somewhere, right?
You probably guessed by now that this plan is not a get-rich-quick scheme. It’s a long-term plan. You must apply those principles and stay disciplined over several years to reach your goal. On the other hand, it will also be several years less as a 9 to 5 prisoner. It’s worth it, but you have to be patient and stay the course.
Eventually, your savings, time and the magic of compound interest will do their work. One day, you will reach the amount that will, according to the 4% rule (or another withdrawal rate of your choice), cover your annual expenses. You will no longer need to work.
If you do continue to work, it will be because you want to, not because you have to.
Probably no one handles this step the same way. However, three types of people stand out:
- Eager people will not wait to reach exactly their magical number. They will quit as soon as possible and will find alternatives to make up for the missing income to cover their expenses. We could call them semi-retired.
- Patient people will wait to reach their magical number to ensure that all their expenses are covered. They will no longer have to think about working for money, ever again.
- Anxious people, on the other hand, will be more afraid to quit. What if it doesn’t work? What if they run out of money? What if a disaster strikes? Perhaps it’d be better to work for one more year, if necessary?
Do you recognize yourself in one of these?
Whichever you relate to, don’t lose sight of all the freedom that your wealth will bring you.
Hope for the Best, Prepare for the Worst
I am convinced that if you have the resourcefulness, discipline and the will to achieve FI, you will be able to handle the hazards of a young retiree’s life. However, for the anxious people, it’s important to put certain systems in place to ensure that the plan works smoothly.
No one wants a stock market drop right after resigning. Unfortunately, it can happen. If your portfolio drops by 30%, you will temporarily no longer have 25 times your annual expenses. Your money may run out faster than planned.
Therefore, it’s necessary to plan everything before pulling the plug and know how to manage a crisis.
So for the anxious ones out there, here are some strategies to consider:
How to Prepare for the Crisis
- Choose a “safer” withdrawal rate than 4%;
- Review your portfolio Asset Allocation (stock/bond ratio);
- Build an emergency fund;
- Build a Yield Shield, which involves pivoting some of your assets to earn more dividends during the first few years of retirement. That way, dividends will cover a greater portion of your annual expenses and you’ll avoid selling low during a stock market drop.
How to Manage the Crisis
- Lower expenses to the bare minimum (as close as possible to 4% of your portfolio’s new value);
- Work temporarily;
- Weather the storm in a country where the cost of living is lower (or as the Millennial-Revolution authors put it: “If shit hits the fan, we’re going to Thailand”);
- Avoid selling your stocks while it’s low by selling bonds instead and using dividends to cover expenses.
Of course, it’s not all black and white. There are different opinions on the subject. Notably, financial planner and tax accountant Ed Rempel challenges all these conventional retirement strategies in this article and offers alternative ones. 🙂
If the idea of quitting and living off your investments makes you anxious, even if the calculations work, it’s up to you to think of strategies that’ll give you peace of mind, so you can go for it!
And when in doubt, read these wise words:
There is a way out of every box, a solution to every puzzle; it’s just a matter of finding it.
– Captain Jean-Luc Picard
Gifts From the Government
You now have a foolproof plan. Your investments will generate enough income to cover your expenses forever. On top of that, there are some things that should not be overlooked.
Regardless of your age once you reach FI, you will have access to certain refundable tax credits, provided you have a low enough taxable income.
In 2020, the maximum you can get for the Federal GST/HST Credit is $443.00. The maximum amount for the Quebec Provincial Solidarity Tax Credit is $1,015.00. We are talking about $1,458 per year combined! To generate this amount of passive income by yourself, you would need $36,450 ($1,458 x 25) in investments. It doesn’t mean you can rely on it to fund your retirement, but it can be seen as a significant bonus, as long as those credits are available.
I’m not gonna lie. Our governments are very generous. But they are particularly generous with families.
As a single woman with no children, I am not the best person to explain the advantage a low taxable income can have on the various government family allowances and child benefits. However, this article from Financial Independence Hub might give you some pointers.
Public Pension Plans
Now, you cannot overlook the different sources of income available when reaching the traditional retirement age. I am, of course, talking about Québec Pension Plan (QPP) or Canada Pension Plan (CPP) for the rest of Canada, and Old Age Security (OAS).
It is difficult to estimate what these amounts will look like in several years or even decades. However, the QPP gives access to your own Statement of Participation on their website. Under section 3, you’ll find the current monthly pension amount. That amount is an estimate of the pension you will receive at the specified age, if there are no other incomes added until then.
The SimulR tool is also very interesting since it allows you to see what the QPP and OAS amounts might look like at different retirement ages (60, 65 or 70 years).
In 2020 dollars, the maximum monthly amount of OAS is $614.14, or $7,369.68 per year. In addition, the Guaranteed Income Supplement (GIS) can be added on top of OAS. For example, single persons with less than $18,624 in taxable annual income can get up to $917.29 more per month, or $11,007.48 per year.
So, yes, your investments must fund your retirement for the rest of your life, but from the age 60 (for QPP) or 65 (for OAS), you will have the opportunity to have other sources of income. At that point, you could reduce withdrawals from your investments, as your expenses will now be partially covered by these incomes.
If you need to withdraw 4% of your investments for only half of your retirement, it increases the chances that your money will survive your early retirement and outlast you. 🙂
Unless you simply choose to spend more. 😉
More Tax Optimization
It’s the previously mentioned taxable incomes that make tax optimization so relevant right from the start.
The withdrawal part is a very complex subject, which requires a lot of planning and doesn’t have a one size fits all plan. Considering that I have not yet reached FI myself, I am not in the best position to tell you what to do. However, I want to bring to your attention some of the key tax notions.
In my previous article, I mentioned that it is strategic to choose which registered accounts to maximize first. It will be equally strategic to choose which account to withdraw from first, for the same reasons.
Tap Into Your RRSP Immediately
One might be tempted to dip into that pretty large TFSA from the get-go to get tax-free income. However, that would be a mistake.
If you don’t want to end up with a huge tax bill later in life, you’ll have to start withdrawing from your RRSP (and/or LIRA) right away. Keep in mind that QPP/CPP and OAS will be taxable. If you use your TFSA from the start, you keep the taxable accounts (RRSP, LIRA, non-registered accounts) for later.
Also, the RRSP must be transferred to a Registered Retirement Income Fund (RRIF) at age 71 at the latest and a minimum annual withdrawal is based on age. For example, the minimum withdrawal rate at age 71 is 5.28% in 2020. That is well above the 4% rule. The same principle applies to the LIRA, which must be transferred to a Life Income Fund (LIF). If you’ve never withdrawn from these accounts before then, you will now have significant taxable income, in addition to QPP and OAS income. As a result, all those incomes will be taxable at the same time. This will bring you to a higher marginal tax rate. The tax bill will be brutal!
Pierre-Yves McSween’s book Liberté 45 also addresses the subject in chapter 17. He calls it the amortization strategy or the art of spreading your RRSP withdrawals to reduce your tax. Here is my rough translation:
Most people start withdrawing from their RRSP in retirement, usually around age 65.
However, at age 65, you can have other sources of income: Old Age Security, Quebec Pension Plan (QPP, which can also be delayed until age 70 to increase the monthly pension), a portion of the pension accumulated with an employer, etc. Therefore, the more you withdraw from your RRSP per year, the more likely you are to raise your marginal tax rate and lose net income.
Pay Little to No Tax
For example, by spreading your RRSP withdrawal, you can pay almost $0 in taxes. Indeed, our generous governments provide basic personal tax-exempt amounts. In 2020, the amounts are set as follows:
- Federal: $13,229.00
- Provincial (QC): $15,532.00
Of course, these amounts will increase over the years. As a matter of fact, future federal amounts are already known:
- 2021: $13,808
- 2022: $14,398
- 2023: $15,000
If you manage to keep your taxable income below the basic personal amount threshold, you pay $0 in tax. Additionally, refundable credits and family allowances will be maximized and you’ll be eligible for GIS later! Only good things, right?
Of course, if you plan to have higher annual expenses than the basic personal amounts, you will have to pay some taxes. You can do calculations with this simulator and get an idea of your marginal tax rate accordingly. You could also withdraw the balance from your TFSA and then pay no tax.
In addition, while drawing down from your RRSP and LIRA, your TFSA continues to grow. Later, it will become the main source of passive income. This income will therefore be nontaxable, forever. Very convenient when comes the time to receive QPP/CPP and OAS.
Long story short? Neglecting tax optimization is leaving money on the table. You remember what I think of leaving money on the table, right?
First, you’re probably wondering what my “number” is. It’s still a work in progress, since I still have to track my expenses over several months (even years), to have a complete picture.
However, I estimate that I would be able to cover my essential retirement expenses with about $10,000 in today’s dollars. In addition, there would be trips and activities of all kinds. I still want to live once I’m retired. 😉 Thus, I aim for $15,000 in annual expenses. With the 4% rule, I get $375,000 ($15,000 * $25) as a magic number.
However, I have to consider inflation (average of 2%) in my projections. Since I aim for FI at 35, at the latest, I have to plan until 2026.
So by 2026 at the latest, I would need $422,300 in investments to cover $16,892 in annual expenses. This number includes my DBPP commuted value that I will take once I resign. I estimate that value will be around $100,000.
That’s when I’ll have to start withdrawing from my investments. After years of piling up money, that’ll feel weird!
At that time, I am considering applying certain strategies to optimize withdrawals. Here they are, in no particular order:
- Maximize my long-term return with a high proportion of stocks;
- Use Millennial-Revolution’s Bucket Strategy for the first few years;
- Withdraw from my RRSP and LIRA right away and up to the basic personal amount;
- Optimize housing expenses with Geographic Arbitrage;
- Optimize travel expenses with Travel Hacking.
There you go. It’s still a very rough draft. I will surely make a whole post on the subject, because some points are already more elaborate than others in my plan. I’m also currently looking into Ed Rempel’s alternative strategies. However, nothing is set in stone. I still have six years to prepare for that moment, and build a foolproof plan.
Let the Chips Fall Where They May
Finally, remember that a worker’s life is not without its pitfalls. If there is one lesson to be learned from 2020, it’s that no one is safe from layoffs, bankruptcies or illnesses. Some people are currently experiencing significant financial difficulties and must deal with those situations and find solutions.
The early retiree’s life will also have its share of obstacles. If tightening your belt, going to Thailand or work temporarily are the worst-case scenarios, no one is going to cry for you. It’s all a matter of perspective.
The best way to ensure a comfortable financial future over several decades is to have a solid plan and review it on a regular basis.
Our species can only survive if we have obstacles to overcome.
– Captain James T. Kirk
This puts and end to my Steps to FI series. I hope you enjoyed it and you’ve learned something! The idea is to give you as much information as possible to help you take action. 🙂
I already have a ton of ideas for my next articles, so stay tuned!