Deducting contributions will require strategy

Confusion often results between the terms “RRSP deduction limit” and “unused RRSP contributions.”  Both of these terms are used on the RRSP Deduction Limit Statement at the bottom of your Notice of Assessment from Revenue Canada.

Yesterday, our column dealt specifically with the term RRSP deduction limit.  This column outlines how the unused RRSP contributions is integrated with RRSP deduction limit.

Most investors who contribute to an RRSP claim the deduction immediately on their tax return.  Investors should understand that they do not have to claim the deduction immediately.  In some cases it is recommended that you do not claim the deduction immediately.  If you carry forward an amount it is referred to as “unused RRSP contributions.”

Why would you contribute to an RRSP and not claim the deduction immediately?  The main reason is to shelter the income from tax.  Once you have made the contribution into an RRSP all income generated within is deferred regardless if you have claimed the deduction.  Two other main reasons why you may not claim a deduction immediately are the contribution exceeds current year taxable income, and future income is expected to be higher.

We have provided three illustrations below with different situations where a person may have unused RRSP contributions at the end of the year.

ILLUSTRATION 1

Mr. Bloomberg recently received a significant inheritance of $200,000 from his mother who passed away.  Mr. Bloomberg came to see us and asked for our recommendations.  Prior to our meeting we asked Mr. Bloomberg to gather some information together including his mortgage statement and 2006 tax Notice of Assessment.  We noted that Mr. Bloomberg had $78,000 left on his mortgage with a very small penalty for prepayment.  We recommended that Mr. Bloomberg repay this debt.  Next we looked at his Notice of Assessment and noted that he had a $79,754 RRSP deduction limit.   Mr. Bloomberg is earning approximately $58,000 per year, but over the years, he has not been maximizing his RRSP contributions.  Mr. Bloomberg expects to work for at least another five years and believes that his income will increase over current levels.

Based on the information gathered we recommended that Mr. Bloomberg contribute $79,754 to his RRSP.  Based on his current level of income Mr. Bloomberg should speak with his accountant and determine how much of this contribution he should claim in the current year and how much he should carry forward as unused RRSP contributions.

ILLUSTRATION 2

Mrs. Thomson recently became a widow at the age of 55.  Her deceased husband had a life insurance policy with a death benefit of $250,000.  Mrs. Thomson mentioned that she has no debt and approximately $77,300 in RRSP deduction limit.  Mrs. Thomson is planning to work another ten years and has expected income during this period of approximately $50,000 a year.

We recommended that Mrs. Thomson shelter $77,300 from tax immediately.  However, we also recommended that she claim the deduction over the next few working years.  At the beginning of every year we would encourage Mrs. Thomson to roll some of the remaining non-registered funds to top up her RRSP.  Based on $50,000 a year, she will have another $9,000 each year in additional RRSP room.  She may also want to take advantage of the $2,000 excess contribution that CRA allows over the deduction limit.

ILLUSTRATION 3

Over the last 20 years Mr. Reuter has worked hard as a realtor.  His knowledge and expertise has been in real estate and he has focused nearly all of his investments in that area.  Mr. Reuter has never contributed to his RRSP and has an RRSP deduction limit of $143,600.  Mr. Reuter is now in the process of selling one of his rental properties.  We have estimated that his taxable capital gain on this property will be approximately $33,800 and the total proceeds will be approximately $389,000.

We explained to Mr. Reuter that contributions to an RRSP may offset the taxable capital gains.  We also provided Mr. Reuter some information on alternative investments that he could focus on outside of real estate.  We recommended that he could use a portion of the proceeds from the rental property and contribute $143,600 to his RRSP.  He could deduct enough to reduce the capital gains tax and his real estate income in the current year.  The remainder of the contribution he may carry forward as “unused RRSP contributions” to offset against future rental properties that he sells and his real estate commissions.

Excess Contributions

When you have an unused RRSP contribution amount it is important that you monitor this amount along with the RRSP deduction limit line.  Be careful that the unused amount does not exceed your deduction limit by more than the $2,000 buffer that CRA allows.

If the unused amount exceeds the deduction limit amount by more than $2,000 then you have made what is referred to as an excess contribution.  Excess contributions are subject to a one per cent tax on the excess amount for every month they are left in the RRSP.  If you have excess contributions, you may have to complete and send a T1-OVP return with payment to your tax centre no later than 90 days after the end of the year in which the unused contributions exist.  Failure to file this return may result in further interest and penalties.   We would encourage all investors who have an excess contribution to proactively deal with their mistake before CRA sends you a letter.

Understanding RRSP terminology and your existing tax situation may ensure that you take full benefits of your options, including when to deduct your RRSP contributions.

RRSP deduction limit has value

Registered Retirement Savings Plans have been around since 1957, allowing investors to sav for their retirement while providing a shelter on tax.

One of the most significant legislation overhauls to RRSP legislation was in 1991 with the carry forward provision.  Now investors no longer have to make a “use it or lose it” decision.

The provision allowed unused RRSP contribution limits after 1990 to be carried forward.  The RRSP deduction limit is included on your Notice of Assessment that Canada Renue Agency sends after you file an income tax return.

Your RRSP deduction limit may be carried forward indefinitely.  This is an important component for everyone to note, considering most people have incomes that increase over time.

Consider Mr. Samson, who is 25 years old and has been a professional student for much of his life.  He decided in 2006 to start working and earned $40,000.  In 2007, Mr. Samson’s RRSP deduction limit is $7,200 ($40,000 x 18 per cent).  Mr. Samson feels that he will be making a larger salary soon and would rather dedicate his current year earnings to paying off his student loans.  He does not lose the $7,200 RRSP deduction limit.  Every year that he does not contribute to an RRSP he will be accumulating a greater deduction limit to be used in the future.  If his income increases then he may save more in taxes by delaying his RRSP contribution.

Marketing by financial institutions may be one reason people rush out and make last minute contributions.  It may also be recent news question whether Canada Pension Plan and Old Age Security will exist when they retire.  Or perhaps it is some internal fear of having enough to live on at retirement that pressures so many into making RRSP mistakes.

Check your Notice of Assessment and your deduction limit before you make any contributions.  You should understand what each line represents.  If you are a member of a defined benefit plan then your statement will have pension adjustments.  If you are a member of a defined contribution plan you should factor in contributions made through work.

The sum of both of these contributions should be factored in prior to making any additional RRSP contributions.  Care should be taken to ensure that you do not contribute over your deduction limit.  Canada Revenue Agency provides a buffer of $2,000 before an excess contribution is subject to tax.

Here’s another illustration to make the point:

For nearly 20 years Mr. Phillip has focused his after tax savings to paying down his mortgage.  At 50, he is proud that he is mortgage free.  Mr. Phillip has managed to accumulate approximately $97,200 of RRSP deduction limit.  Now that he is mortgage free he would like to accelerate his retirement savings but does not know where to begin.  Mr. Phillips annual income is $85,000 and he has been dedicating approximately $1,500 a month towards mortgage payments.  Annually Mr. Phillip’s RRSP contribution room is increasing by approximately $15,300 (18 per cent x $85,000).   We discussed with Mr. Phillips that since he no longer has to make monthly mortgage payments, he should consider making monthly pre-authorized contributions to his RRSP.   We mapped out a plan that he could contribute $1,950 monthly to his RRSP, claim the amount as a deduction and save taxes.  The net amount would likely be close to his previous monthly mortgage payment of $1,500.  Best of all, by age 61, Mr. Phillip should have caught up and fully utilized his RRSP deduction limit.

Contribute Early

Time has an amazing way of compounding investment returns.  Investors who begin contributing early to their RRSP are more likely to be financially prepared for their retirement years.  The sooner people begin investing; the longer the savings will be able to grow on a tax sheltered basis.  Tax deferred compounding over a larger number of years should naturally result in a greater accumulation of funds.  One benefit to waiting later in the year to contribute is the greater certainty you will have regarding your income levels and your actual deduction limit.

Avoid Mistakes

If a person pulls funds out of an RRSP, they do not recover the deduction limit.  This amount is lost.  Clearly understanding that your RRSP deduction limit will not vanish if not used should ease some financial pressures.

An RRSP should generally be set up to fund your retirement and involves a long-term discipline.  If you feel that you will likely have to make a withdrawal then you should consider waiting until you are confident that the funds are committed until retirement.  We would rather see someone miss out on a little bit of time to ensure they are not making the mistakes that some people make.

 

The top 10 mistakes made with RRSPs

A Registered Retirement Savings Plan is not for everyone, but for those who are considering RRSPs or have them, it pays to head off some of the most  common mistakes.

Prior to setting up an RRSP, determine whether you are likely to make one of the following 10 common mistakes:

1.  Often people rush to make a last-minute RRSP contribution and give little thought to the underlying investment.  Spend a few minutes to remember how long it took you to earn that money and slow the selection process down.  Solution:  If you are in a rush we recommend that you consider making contributions to your RRSP in cash and look at all your available investment options prior to making an investment decision.

2.  Over contributing to your RRSP may result in T1-OVP penalties and interest.  This past year we noted a campaign by Canada Revenue Agency that resulted in several letters being sent to individuals who have made over-contributions.  Solution:  Before you contribute to your RRSP, be certain of your limit.

3.  Making contributions to an RRSP and pulling the money out before retirement.  Often this results in more tax being paid than what you initially saved as a deduction.  The shorter the time period between the contribution and withdrawal, the less likely you are to have received tax deferment of income.  Contributing funds and withdrawing the funds uses up your contribution room, which is a big negative.  Solution:   Avoid contributing to an RRSP unless you can commit the funds until retirement.

4.  People who have an RRSP account should understand that all income generated in the account is tax deferred.  This is by far the biggest advantage of an RRSP.  Over time, this should save you much more in taxes than the initial deduction for the contribution.  People who have non-registered investments understand that income generated in these accounts is taxable.  Pulling funds out of an RRSP prior to age 72 is generally the wrong decision when non-registered funds are available.  There are some exceptions, such as shortened life expectancy.  Solution:  Using the capital within your non-registered investments first will reduce your current annual income and defer taxes further.

5.  Some people have multiple RRSP accounts held at different financial institutions.  They may have $10,000 at institution A from a 2004 RRSP contribution, $6,000 at RRSP institution B from a 2005 RRSP contribution, and $8,000 at institution C from a 2006 RRSP contribution.  This may result in additional RRSP fees being charged to you and result in you paying more fees than you need to pay.  More importantly, your investments become more difficult to manage.  Solution:  Consolidate your RRSP accounts at one institution for better management, to reduce fees, and to open up more investment options.

6.  Underestimating life expectancy is also a common mistake.  All too often people in their 60’s begin pulling money out of their RRSP solely to avoid paying a large tax bill if they were to pass away.  We encourage people to plan for the most likely outcome rather than the worst-case scenario.  Solution:  Avoid early withdrawals and ensure that you take full advantage of the deferral benefits of your RRSP.

7.  When you open an RRSP account you must make a beneficiary selection.  If you are married or living common law then the natural choice is your spouse for the tax-free rollover provisions on the first passing.  Often widows will still have their deceased spouses named as beneficiary.  We have seen cases where people have remarried and have their ex-spouse still listed as a beneficiary.  In some cases naming your estate may be the best option.  Solution:  Speak with your advisor and ensure you have the correct beneficiary on your RRSP account.

8.  We encourage people to give careful thought to the type of investments they hold within their RRSP and outside of their RRSP.  Good structure decisions are important and are easier when all of your investments are at one institution.  To illustrate this we will use an individual that has equity investments within their RRSP that may generate dividend income and future capital gains (all income within an RRSP is treated as regular income for withdrawals).  Let’s also assume that this same individual has GICs and term deposits at the bank that are not within their RRSP.  Although this individual does not require income, he is being taxed every year on the income.  Solution:  Have interest generating investments within your RRSP along with equities that you may trade from time to time.  Outside your RRSP consider investments that are long term holds that generate primarily capital gains.  For non-registered accounts, Canadians are not taxed on unrealized gains until the investment is sold.  If you purchased a basket of blue chip equities outside of your RRSP and held them for 20 years you would not be taxed on the gain until the investment is sold.  In effect you have created two types of tax deferred plans.

9.  People who do not have pension income (not including CPP and OAS) should ensure that they are taking all planning components into consideration before requesting early RRSP withdrawals.  Withdrawals from an RRSP are not eligible for the pension income amount and they are not eligible for income splitting.  Solution:  If you require funds then we encourage you to wait until at least age 65 and then convert funds to a RRIF before withdrawal.  RRIF income received at age 65 or older may be eligible to be split and qualify for the pension income tax credit ($2,000 each per year).

10.  One of the biggest mistakes we see is failure to make an RRSP contribution.  Individuals who are making large salaries without a pension need to take advantage of their RRSP contribution room.  Not having the discipline to set aside funds for retirement will result in making sacrifices at retirement.  Solution:  Consider making an RRSP contribution.

Locked-in plans require careful thought

Employees who retire, terminate their employment early, or find their pension plan being discontinued need to make some important decisions.  Some pension plans are being closed and employees have the “lump sum” or “annuity” option.  Other people are faced with a difficult choice, which we discussed in our last article.  Do you take a lump sum of money from the pension today, purchase an annuity, or wait to receive a monthly cheque at retirement?

The lump sum option allows the fully vested (owned) pension benefits to be transferred to a locked-in registered plan.  This article focuses on lump sum transfers to locked-in accounts.

So, what is a locked-in account?  This type of investment account is registered and is one where the plan issuer signs an agreement with your employer to “lock-in” your pension plan proceeds until retirement.  A lump sum from your pension plan is transferred into the registered locked-in investment account.  The age at which the funds may be released, and to what uses they may be put, vary with the pension legislation governing the plan.  Any amounts earned by the plan also become locked-in.

Withdrawals are generally not allowed from Locked-in Registered Savings Plans (LRSP) or Locked-In Retirement Accounts (LIRA), except in limited circumstances such as shortened life expectancy, small balance or financial hardship.  The governing legislation controls these funds, even though the employee can invest them as they wish (similar to an RRSP).  Some provinces have been changing their legislation with respect to locked-in accounts.

Governing Jurisdiction

Knowing the jurisdiction of your pension will assist your financial advisor in setting up the correct account.  In B.C., locked-in accounts are generally referred to as Locked-in Registered Savings Plans (LRSP).  In Alberta, Saskatchewan, Manitoba, Quebec, New Brunswick, Ontario, Newfoundland, and Nova Scotia these accounts are referred to as Locked-In Retirement Accounts (LIRA).

Company pension plans in Canada can be established and registered under either provincial or federal legislation. The legislation governing an individual’s funds must be established upon opening the locked-in plan, as this will determine what type of plan will be opened. The pension plan administrator or the financial institution transferring the funds should provide the information necessary to correctly identify the jurisdiction governing the funds.

Provincially Regulated Pension Plans

Most pension plans are established under provincial legislation. For all provinces and territories except Quebec, the province in which the client resides on the date they terminate employment determines the governing jurisdiction, which may in fact differ from the jurisdiction in which the company is registered.

For example, a person living in Ontario the day they terminate their employment will have their funds under Ontario jurisdiction. Even if this person moves to British Columbia and transfers their pension funds, the client must open a LIRA (the name for a locked-in plan for Ontario) and not an LRSP because the funds are still under Ontario jurisdiction.

Federally Regulated Pension Plans

For federally regulated pension plans, the person’s governing jurisdiction is Canada regardless of place of residence. This applies for crown corporations or companies under federal charter.  A person living in Alberta (which offers LIRAs) who has federally regulated funds will be required to open an LRSP, since federally regulated funds require LRSPs and not LIRAs.

Maturity Options

The earliest age in which you may transfer your LRSP or LIRA into an income account (LRIF or LIF) varies by province. The governing jurisdiction also dictates the minimum age when a client can transfer their locked-in funds.  Similar to an RRSP, locked-in accounts must be converted into an “income account” or a life annuity in the year individuals turn 69.   The 2007 Federal budget proposes to extend this conversion to when the taxpayer reaches the age of 71.

Withdrawls

The minimum and maximum withdrawal amount will fluctuate from year to year and is based on the year-end value.  The year-to-year amount will vary depending on the amount of money you withdraw, the income your plan earned and any market fluctuations that may occur.  A LRIF/LIF is similar to a RRIF in that the holder is required to receive a minimum payment out of the plan each year.  The minimum payment levels are calculated using the same method used for RRIF payments.  Additionally, these accounts are subjected to a maximum withdrawal limit. The maximum amount is established by a formula, which takes into account a discount factor and the person’s age.

In the first year an LRIF/LIF is opened, there is no minimum withdrawal required; however there is still a maximum allowable payment. This maximum is pro-rated for the number of months, including the month of transfer into the plan that is remaining in the year.

Transfer Process

Moving from a Registered Pension Plan to a locked-in plan is usually straightforward.  The first step begins with opening a self-directed locked-in registered account.  The institution name and account number will be required to complete the forms provided by your employer.  Typical forms may include a cover letter with the estimated pension value, Canada Revenue Agency forms (i.e. T2151 for direct transfer and T2037 for purchase of annuity) and a locked-in agreement.  Your investment advisor should be able to assist you with completing these forms in conjunction with setting up the appropriate account.

Cash Transfer

Lump sum pension transfers to a locked-in account generally take two to four weeks and come in as cash.  During the transfer period we recommend that individuals meet with their advisor and begin planning their investment portfolio.  For many people a lump sum transfer from their registered pension plan represents the most significant portion of their retirement savings.

Before making a final decision we recommend that you speak with your professional advisors.

 

You’ll need a plan in order to live on investments

We recommend anyone requiring income from their investments to establish a plan.

An important component of that plan is to ensure income is transferred from a client’s investment account to their banking account.

Although investment firms still issue manual cheques, the number of transactions executed electronically is rising rapidly as investors are becoming more comfortable trusting the electronic transfer of funds from one account to another.  With electronic transfers, there is no risk of mail being lost and transactions are done in a timely manner.  When transfers are done on a scheduled basis they are referred to as a systematic withdrawal plan – often referred to as a SWIP.

A financial institution usually requests a void cheque from the investor’s banking account to obtain the institution, transit and account numbers.  SWIPS are set up to electronically transfer a predetermined amount from an investment to a banking account.  Understanding the income currently being generated from the investments, maturity dates, and liquidity of the portfolio are key components to look at when setting up an appropriate SWIP.

Investors have flexibility with respect to the amount of income they would like to receive and when they would like to receive it.  The following illustrations provide an overview of how SWIPs are often used.

Illustration 1:  Mr. Jackson requires a high level of income from his portfolio. He has requested we send him all of the income from his investment account on the first of every month.  Mr. Jackson has $200,000 invested generating approximately $12,000 per year in income.  We provided Mr. Jackson with an expected income report and noted that his monthly income ranges from $600 to $2,000; however, his average income is approximately $1,000 a month.  For the month of September he earned $740 investment income.  This amount will automatically be transferred to his investment account on the first of October.

Illustration 2:  Mrs. Reynolds has several investments that generate income.  She has a mixture of common shares, preferred shares, convertible debentures, and bonds.  Mrs. Reynolds would like to see her portfolio grow a little further before she begins pulling out all of the income generated.  She has decided to set up a SWIP that automatically transfers the investment income from the income funds to her bank account on the first of every month.  The income from the preferred shares and the bonds will stay in the investment account.  At some point in the future she may increase the SWIP to include all income.

Illustration 3:  Mrs. Walker has a cash flow need of approximately $4,000 per month.  Her sources of income are from CPP, OAS, and a small pension, all of which add up to approximately $2,400 per month.  How is Mrs. Walker going to fund the monthly shortfall of $1,600?  The most obvious place to look is her investments which are currently generating approximately $800 per month; short of the $1,600 she requires monthly expenses.  We explained to Mrs. James how a SWIP can be set up to transfer a flat dollar amount, such as $1,600, even if this amount exceeds the monthly income generated in the account.  We established a plan that allowed for certain investments to be partially or fully liquidated over time to ensure the monthly payments could be sustained during her lifetime.  This included factoring in projected income amounts and maturity dates of her investments.  With this type of SWIP more planning is required.

A financial habit that sets up steady stream of savings

Many people are used to paying their household bills on a monthly basis, a routine that keeps the lights and other services connected.  But when it comes to savings and investing most individuals have a different approach.  Often savings and investments take a back-burner approach.

The easiest way to implement savings and investments into your routine is to set up a pre-authorized contribution – often referred to as a PAC.  This begins by looking at an investor’s monthly cash-flow and determining a comfortable amount to set aside.

So many financial illustrations trumpet the benefits of contributing early, even if those contributions are smaller.  The compounding effects of investment returns are an important component to consider when developing financial plans.  However, it is important to use realistic return expectations.

Some may be inclined to not do as much due diligence on investments with smaller dollar amounts.  If a PAC is established, it is important to pick a quality investment and to monitor your investment regardless of its initial size.  A quality PAC can turn into a significant nest egg over time.

Last week we mentioned that financial institution generally ask for a void cheque.  The main reason is to obtain the institution, transit, and account numbers required to set up electronic transfers between financial institutions.

With a PAC, a person must make a few important decisions.

Decision 1:  How much can you afford to contribute?  Setting aside ten per cent of your monthly income may be a guideline to get some investors started.  If this amount appears too high then consider decreasing the amount to five per cent or establishing a budget to monitor your monthly expenses.

Decision 2:  How often would you like to contribute?  Most investors who establish a PAC contribute either once or twice a month.  We recommend that individuals consider their cash inflows and match the PAC accordingly.

Decision 3:  What type of investment would be most appropriate to set up as a PAC?  Some investors choose to simply contribute cash into their investment account.  While others may choose to PAC into a money market investment or a mutual fund.  There are a wide variety of investments to choose from.  Some fund companies have established policies where an initial purchase of a set dollar amount (i.e. $500) is required to establish a PAC.

Decision 4:  What type of an account would you like to PAC into?  Many investors choose to PAC into a retirement savings account.  If an investor knows their maximum Registered Retirement Savings Plan (RRSP) deduction limit then a PAC can be set to contribute this amount over the year.  Another example may be parents who want to fund a Registered Education Savings Plan (RESP) through a $50 a month PAC.

Simple Strategy:  Investors can ease the cash flow burden of trying to come up with their RRSP contribution limit every tax season.  Let’s consider an investor that has a $16,000 RRSP contribution limit for the upcoming year.  For this investor we recommend multiplying their RRSP deduction limit by 75 per cent and dividing by 12 to obtain the monthly PAC amount of $1,000.  In either January or February of the following year, the investor could utilize their line of credit or obtain a short term RRSP loan to contribute another $4,000 to top up to the maximum.  After filing the tax return, the combined RRSP contributions of $16,000 may provide enough of a tax refund to pay off the short-term loan or line of credit.  This of course assumes that sufficient tax was withheld on other sources of income throughout the year.

PAC Changes

It is important to note that a PAC can be cancelled or changed at any time.  This may include changing the investment selection, frequency or dollar amount.

Most individuals find that after a few months they do not even notice the monthly amount being transferred from their bank account to their investment account – it has become as routine as paying the power bill.

Enhancing financial growth through re-investment

Not everyone who purchases investments wants or needs the income today.  In many they’re trying to grow a nest egg to fund a future goal, such as retirement.  These investors may want to see more growth in their portfolios and may not be attracted to investments that pay investment income.

Many investments have both a growth and income component.  Fortunately most of these same companies offer the dividend reinvestment program – often referred to as a “DRIP.”  Growth is often achieved through price appreciation of the investment and also reinvesting the income.

DRIP Illustration

An investor purchased 400 shares of the common shares of ABC Corporation currently trading at $30.  The current quarterly dividend is set at .25 per share.   Based on these values, when the dividend is payable, the investor would receive (400 x .25 / $30) approximately 3 shares of ABC and $10 cash.  After the dividend the investor would own 403 shares.

Tax Effect

Although the investor above may have requested that their dividends be reinvested, the dividend income will still be considered income for taxable accounts in the year the dividend was declared.  Investors will receive the applicable taxation slips and should ensure they have sufficient cash on hand at the end of the year to pay any tax liability.  DRIPs in an RRSP account are ideal as any income is deferred and is not taxed immediately.

Adjusted Cost

The DRIP program has investors acquiring shares at different prices with each dividend being reinvested.  For taxable accounts it is important to keep track of the costs at which the new units were reinvested.  The cost of the original purchase plus the total value of the shares reinvested on the date of the DRIP equals the adjusted cost base.

Commissions

There are no commission charges for the DRIP program.  Certain investments automatically reinvest distributions without being set up under the DRIP program.  Many investments do not have a DRIP program.  Investors can provide their investment advisor a copy of their statement and request which positions are eligible to be set up as a DRIP.

Fractional Shares

Unlike mutual funds, it is not possible to have fractional shares of common shares.  The illustration above highlights that the fractional portion (less than the amount to purchase a whole share) is paid as cash into the investment account.  Stock splits are generally a good thing for individuals that have the DRIP program.  Share prices are generally reduced resulting in a greater portion of the dividend being reinvested.

Odd Lots

Years ago investors were warned that they may have difficulties selling shares of companies if they had an odd lot.  A lot is generally considered 100 shares.  One can easily see how the DRIP program would result in an odd lot situation.  Today this is less of a concern for any position that has a moderate volume of shares traded daily.  With reorganization, spin-offs and computerized trade execution many investors have odd lot holdings.

Position Size

Investors should take care to monitor their position sizes.  Investors may find over time that certain positions that are set up as a DRIP may become overweight within their overall portfolio.  Investors who have charitable intentions may want to consider donating shares or sell a portion of their holdings as a means to rebalance the portfolio.

Cancellation

A DRIP can easily be cancelled.  An investor may want to cancel a DRIP when they begin to require income from their investments.

Growth oriented investors may find the DRIP a low maintenance way of dollar cost averaging while reducing the costs of investing and employing cash that may otherwise be earning a low return in an account.  The DRIP allows compounding of investment returns which can enhance total returns.

RESPs – Not just for kids

There are no age limits for Registered Eductation Savings Plans.  RESPs are often set up by adjult subscribers for the benefit of usual children or grandchildren.  But adults can name themselves as the subscriber and beneficiary. 

It is more common for individuals to change careers as a result of displacement or a desire to do something different.  In fact many are now working into their retirement years.  Furthering your education may allow you to pursue different opportunities that are both satisfying and rewarding.  The potential to increase your income may also be an attractive incentive.

An RESP is a great savings vehicle for adults planning to go back to school, couples with different income levels wishing to split income and investors wishing to defer investment income.

RESPs for Adults

The steps for opening a non-family adult RESP is very similar to opening an RESP for an individual child or family RESP.  You simply name yourself both the subscriber and the beneficiary.  Individuals may contribute up to $4,000 annually ($42,000 maximum contributions to the plan). Unfortunately adults are not eligible for the Canada Educations Savings Grant.  The following outlines why RESPs for adults are still worth considering for some.

Comparing RESPs to RRSPs

Both RESPs and RRSPs provide tax deferral benefits.   While similar in many respects, the following highlights the main differences:

  • RESP contributions are not deductible, where RRSP contributions are deductible
  • RESP contributors may withdraw their original capital at any time with no tax consequences, whereas withdrawals from an RRSP/RRIF are generally considered taxable income
  • RESPs must be terminated within 26 years after plan start date and individuals are not forced to withdraw funds after age 69; with an RRSP you must convert to a RRIF at age 69 and begin taking payments at age 70.

Withdrawing Income

The easiest way to withdraw income generated in the RESP is to be enrolled in a qualified post secondary institution.  After enrolment you may begin receiving Educational Assistance Payments (EAP).  In RESPs for adults, an EAP is a distribution of the accumulated investment income that is taxed in the beneficiary’s hands the year in which it is received.  Adults are not eligible for the Canada Education Saving Grant.  The EAP includes income only and no Grant portion.

Enrolling in School

In order for a beneficiary to qualify for an EAP the individual must be enrolled in a post-secondary program at a qualifying educational institution.  For institutions within Canada the program needs to be at a minimum ten hours a week for three consecutive weeks.  For institutions outside of Canada, the minimum is increased to 13 consecutive weeks.   The amount of the EAP is limited to the lesser of $5,000 and the actual expenses for the first 13 consecutive weeks.  There are no limits on the dollar amount of the EAP after 13 weeks.

Failure to Enroll

An individual may withdraw their original capital at any time with no tax consequences.  If not enrolled at a qualifying institution within ten years the individual can qualify for an Accumulated Income Payment (AIP) that represents the investment earnings in the RESP.  An AIP withdrawal is subject to a penalty tax of 20% in addition to the taxes payable when taken into income.  Other rules relating to the termination of the RESP after the first AIP payment also apply.  Individuals with RRSP contribution room available have an option to transfer up to $50,000 into their RRSP or to a spousal RRSP. This option avoids the 20% penalty tax and may provide a unique income splitting opportunity.

Interesting Points to Consider

Although the 20% penalty may be a determent for some, we feel it shouldn’t be.  Finding an economical course that lasts more than 13 consecutive weeks is an easy way to avoid the penalty.  The following are some interesting points to consider:

  • Correspondence courses qualify
  • Individuals are eligible for the EAP regardless of whether they attend classes
  • Individuals are eligible for the EAP even if they do not successfully complete the course
  • Individuals may be eligible for education and tuition tax credits

RESPs are not just for your children.  In fact, it might be your gateway to an exciting new career!

 

RESP 101 – It pays to gain RESP education

What is an RESP?  Registered Education Savings Plans are registered accounts that enable you to make contributions now towards the cost of future education.   Unlike an RRSP, your contributions are not tax deductible.  Investments within an RESP have the potential to grow and income is tax-sheltered until paid out to the beneficiary.  RESPs may be very attractive for those beneficiaries who qualify for the Canada Education Savings Grant.

The Good News: Previously the rules governing an RESP were onerous. If the beneficiary did not attend a qualifying institution (i.e. college or university), any growth, interest, dividends and capital gains went to the educational institution that was designated on your RESP contract.  The good news is that the Canada Revenue Agency has significantly modified the RESP rules. In addition to the tax advantages, there are increased savings limits and additional termination options.

General Rules:  Although contributions to an RESP are not tax deductible, any income within the plan compounds on a tax deferred basis. Furthermore, when the accumulated income is withdrawn from the plan to pay for education expenses, the student pays the taxes, not the contributor.  In most cases, this income would attract little tax because the student’s basic personal exemption along with tuition and education credits help to offset the tax liability.  Any individual can set up an RESP including grandparents, aunts, uncles, godparents and friends.

Contributions:  These plans allow the contributor (called a subscriber) to deposit any amount up to $4,000 annually per beneficiary.  Contributions may be made for up to 21 years following the year in which the plan is entered into, to a lifetime maximum of $42,000 per beneficiary. If these limits are exceeded, a one per cent per month penalty tax is charged until the over-contributed amount is withdrawn from the plan.

Canada Education Savings Grant (CESG):  The CESG grant was introduced in the 1998 federal budget.  Currently, beneficiaries are not required to have an existing RESP to accumulate CESG contribution room. Under this program the Government of Canada pays a grant of at least 20 per cent of the first $2,000 of annual contributions, directly into the qualifying beneficiary’s RESP.  Qualifying beneficiaries are generally below the age of 18 and may receive a lifetime maximum CESG totaling $7,200 per beneficiary.  Contributions for beneficiaries aged 16 and 17 will only receive a CESG subject to certain stipulations. CESG room may be carried forward until the beneficiary turns 18.  Beneficiaries must have a social insurance number to receive the CESG.  If contributions are not made to the plan then the CESG contribution room may be carried forward and used when RESP contributions are made in future years.

Education Assistance Payments (EAP):  Once the beneficiary of an RESP is enrolled in a qualified school, education assistance payments may commence.  Any income or growth earned within the plan may be paid out to the beneficiary once they are attending a recognized post-secondary institution.  EAPs are taxed in the hands of the beneficiary, who reports it as “other income” on their tax return.

No Post Secondary?  If the beneficiary of the RESP does not proceed with post secondary education, the contributions are returned to the contributor with no tax consequences and the CESG, if applicable, is returned to the government. Contributors may withdraw the income earned in the RESP if the following criteria are met:  (1) all beneficiaries named in the plan are at least 21 year old and are not eligible for EAP payments; (2) contributor is a Canadian resident and ;(3) RESP was opened at least ten years ago.   These income withdrawals are referred to as Accumulated Income Payments.

Accumulated Income Payment (AIP):  Provided the above three criteria are met, the Accumulated Income Payment that has not been paid out to the beneficiary can be returned to the contributor by either: (1) transferring up to $50,000 to the contributor’s RRSP or a spousal RRSP (the contributor must have sufficient RRSP contribution room available);(2) having it taxed in the contributor’s hands at their marginal rate plus an additional 20% tax is levied; (3) donating the income to a post-secondary institution (no donation tax credit provided).

Maturity:  An RESP has to be terminated on or before the last day of the twenty-fifth year after the year in which the plan was entered into.  The consequence of this deadline is similar to the beneficiary deciding not to pursue post-secondary education.  All contributions will be returned tax-free to the contributor and the CESG repaid to the government.  Any income that has not been paid out to the beneficiary must be returned to the contributor as an AIP.

An RESP is one of several vehicles individuals may choose to help fund post secondary education.  Rules are continually changing with respect to RESPs.  Individuals should always consult with their personal tax advisors before taking any action based upon these columns.

 

Building plan keeps investors on track

Imagine building a house without a set of plans.  How would that house look if you randomly selected flooring, furniture and window coverings without regard to how they would look together?  It certainly can be done, but we all know that when building or decorating a home, it is best to follow a plan.  Once a plan is put in place, the results can be spectacular!

Too often investors select investments without consideration given to the other investments within their portfolio.  Does purchasing that one additional investment increase or reduce the risk to the investment portfolio?  Does it increase the return potential or reduce it?  Does it compliment the other investments?

The financial equivalent to a blueprint for building a home is an Investment Policy Statement (IPS).  Ideally an IPS should be laid out in advance of the portfolio’s construction, however, an IPS can be done at any time – call it a renovation if done after the fact.  Developing an IPS normally begins with the investment advisor asking their client to answer a series of questions.  The investment advisor should review the answers to these questions with the investor and clarify any inconsistencies.  The responses to these questions, along with notes made during preliminary discussions, are the foundation to an IPS.

An IPS is part of a disciplined approach that attempts to remove some of the “emotional component” of investing.  Uncertainty about the markets, fear of losing your money, and confusion as to what is the best course of action during volatile market times can cause investors to abandon the plan.  Sticking to the IPS during difficult times is a critical part.  As we all know, we cannot individually control the market, however, we can control how we react to it. An IPS can help manage those bumpy times.

An important component of those discussions should focus on risk tolerance.  The easiest way to look at risk tolerance is by the percentage of equities in the account.  An investor who is risk averse would have a lower percentage of equities.   Investors that do not want to incur risk should have a larger component of investments such as GICs, treasury bills, and investment grade bonds (often referred to as fixed income).   As fixed income investments are not as volatile as equities, they are a key component for those seeking low risk investments and have capital preservation as a primary investment objective.  Most investors desire total returns greater than those currently offered by fixed income.  As a result, risk tolerant investors are willing to hold some component of equities.

As every investor reacts differently to volatility, it is finding that balance (also known as Asset Mix) that the investor is comfortable with.  Investors that do not assume some risk may feel they are missing out on potential opportunities, and investors that feel they are taking on too much risk may be continually worrying about their investments.

So, what are the typical characteristics of the risk-tolerant and risk-averse investor?  Typical characteristics of risk-tolerant investors are:  longer time horizon, high annual income, high net-worth, and multiple sources of income.   The typical investor who is risk-averse, would have the following characteristics:  shorter time horizon, no longer in the work force/approaching retirement, fixed income, low to moderate net-worth, and limited sources of income.

The above general rules certainly do not apply to everyone, this is the reason a customized IPS is necessary for each investor.  The most risk-tolerant investor may intentionally overweight equities while the most risk-averse investor may deliberately select mainly fixed income.  However, most investors fall somewhere in between.

Determining the balance of cash, fixed income and equities is ultimately the decision of the investor.  An advisor has several tools in which to assist their client in making this decision.  An IPS is not set in stone – changes may occur with time, life changing events and investment experience.  Some advisors may recommend increasing or decreasing the fixed income component during certain economic cycles.

One rule of thumb that is used by some investment advisors is that the fixed income component should be reflective of your age.  A 20 year-old investor should have 20% fixed income where an 80 year-old investor should have 80% fixed income.   This method of determining the asset mix is overly simplistic but it does illustrate the trend of having a larger fixed income component as an investor gets older.

As it takes time to build a house, it takes time and patience to build an investment portfolio.  Once built it still requires maintenance.  The IPS is a plan, not an immediate reflection of how the portfolio will look on day one.

After reading this article, we hope investors will try to locate their written Investment Policy Statement.  If they have one, they should ensure they are using it and that it is up to date.  If they do not have one then statistics state they are among the majority of investors without a plan.  We also hope those investors without an IPS will meet with their investment advisor to discuss the benefits of an Investment Policy Statement.