If you are reading this, I guess you probably want to know how one can get $65,759 for free. This won’t be a easy post to read. It will require using your brain while reading.Yet,you might still get totally confused in the end. After knowing this, if you still want to know and think you can handle the calculation, sit tight and I will show you how.
There are basically two ways to create wealth. One is to live below your means;the other one is to leverage. This post will show you how you can borrow money at a interest rate of 7.5%, achieve 7% annual rate of return, and get $65,759(in today’s dollar) in free money after tax in 20 years. Yes, in 20 years, if you don’t have that kind of patient, you don’t need to continue reading anymore. This method is meant for long term investment, not for making quick money.
In order to understand this post, you need to know the following:
1. All the interest you paid on the investment loan in Canada are tax deductible at your marginal tax rate. If you don’t know what marginal tax rate is, please see here and here
2. The RRSP contribution you have made is also tax deductible at your marginal tax rate as well. For information about RRSP, please refer to this.
3. All the investment returns you have achieved, such as interest income, dividends,capital gains, are all taxable, but a a discounted tax rate. Capital gain is taxed at 50% of your marginal tax rate. Dividends are taxed at a rate from -7.7%(hence a credit) to 23.18% in New Brunswick. Please refer to this chart for detailed information.
So now, let’s begin the real work. First of all, let’s look at all the assumptions first. We assume:
1.We borrow at a interest rate of 7.5%
2. The annual investment rate of return including all dividends and capital gains is 7%. This is a very conservative number. Statistically, sine 1969, each decade, the market annualized rate of return is around 10%. But we will play safe here using 7%
3. Our marginal tax rate is 35%.
4. The tax rate on investment return in our calculation will be 20%. Based on the linked chart above, you will see it is a very realistic figure.
5. If you are double dipping, you have enough RRSP room for the contribution.
6. The inflation rate will be 3% per year.
7. All contributions and numbers are year end value.
Here is the spreadsheet I have created for this post. Let’s take a close look now. You can see we borrow $50,000 to buy some investment. This amount never changes over the 20 years, which means we will not borrow more nor less in the future. At a interest rate of 7.5%, we will pay $3750 each year as interest charge for our investment loan.
In year 1, the tax return on our interest paid will be $1313($3750*0.35). We achieve average of 7% return on investment. Therefore, after the first year, the Assets outside RRSP will be $53,500.
Now Column F “Net Gain Outside RRSP”, see below for the calculation:
Net Gain Outside RRSP=(Assets Outside RRSP-Borrow Amount)*(1-tax rate on investment return)-Interest Paid
=($53,500-$50,000)*(1-0.2)-$3750
=-$950
So we are negative for year1 outside RRSP. Don’t worry, read further below.
Now, we take the tax return of $1313 and put it into RRSP. Since RRSP investment has one year lag, therefore the Year End RRSP Value won’t increase and will still be $1313. So add up column E and H, we get our Total Assets. And the Total Net Gain for year 1 will be F+H, which equals to $363.
For year2, the interest charge will still be $3750. However, the tax return we will get this year will be more. Why? Because we contribute $1313 last year into our RRSP. This is also tax deductible. Taking the tax refund and put into the RRSP to get more tax refund. I call it double dipping. So, for year2, we will have $1772 in tax refund $3750*0.35+$1313*0.35). The assets outside RRSP will further increase by 7% to $57,245 this year. Using the Net Gain Outside RRSP formula above plus the Net Gain Outside RRSP last year, for year2, the final Net Gain Outside RRSP is -$1,704. We are down $754 further outside RRSP. However, this is not the number you should pay attention to. As long as we have positive value for Total Net Gain,we are fine.
Similar to year1, we take the tax return of $1,772 this year and put into RRSP. Since last year’s contribution has got a year to grow itself at 7%, so the Year End RRSP Value for year 2 is $3176=$1313*1.07+$1772.
So, in year2, we stand at Total Assets of $60,421 and Total Net Gain of $1,472.
Continue this calculation for 20 years. In end of year 20, you will have total assets of $272,465(More than a quarter million!!!) and a Net Gain of $118,768. Assuming 3% inflation rate, the Net Gain of $118,768 will equal to $65,759 in today’s dollar. Not bad at all considering it is FREE and AFTER TAX.
OK, I am really tired explaining it now and your head is probably spinning as well. I will explain the no-double-dipping one tomorrow and the risk associated with this approach.
Cheers~~~~
