New Tax Free Savings Account is so good we bet it won’t last

The Tax Free Savings Account is the best opportunity for investors today to minimize tax during their life, and into retirement.   The younger an investor is, the greater the benefit of the TFSA.  The long-term benefits of the TFSA seem almost too good to last.   The government has stated that withdrawals from a TFSA are tax-free.  Not only are they tax-free, they will not impact income-tested benefits, such as the guaranteed income supplement or Old Age Security claw back.

In 2007, the mandatory RRIF conversion age was moved from 69 to 71, with the first required minimum payment at age 72.  Pension splitting was also introduced in 2007.  Another minor benefit was the increase to the pension income amount from $1,000 a year to $2,000 a year.  This essentially allows investors to pull $2,000 out of a RRIF account each year tax-free beginning at age 65 (assuming that the pension income amount is not applied to other eligible income).  People should modify their financial plans based on the above announcements and new TFSA.

By combining all the factors noted above, the benefits for people who have a savings plan in place are excellent.  We will use Stephen, who turned 19 on January 1, 2009, to illustrate our point.  In our calculations, we assume inflation of three per cent and annualized rate of return on investments of six per cent.  We also assume that Stephen’s ten highest earning years will be when he is 55 through 64 (when he is in the 30 per cent income tax bracket).  Stephen plans on retiring on his 65th birthday.

Early Years

Stephen should contribute the maximum amount annually to his TFSA every year beginning at age 19 until age 64.  If this discipline is set early Stephen will have accumulated close to $1.9 million in his TFSA by his 65th birthday.  Between 19 and 31, any extra savings should be accumulated for a down payment on a home.  By purchasing a personal residence Stephen will be taking advantage of one of Canada’ best tax-exempt investments.  When Stephen is 30 he meets Sharon and they soon get married.  Sharon is the same age as Stephen.  For illustration purposes, and to keep this scenario realistic, we will assume that they only have the cash flow to fund Stephen’s TFSA (or half in each).

Age 31 – 56

Together they buy a home when they turn 31.  In their middle earning years they should focus on first paying down the mortgage.  By removing their non-deductible debt as soon as possible, they will save thousands of dollars in interest costs.  Assuming a 25-year amortization schedule, they will be mortgage free when they are 56 years old.  Sharon has twins when she is 36 years old.  Sharon has directed some of her excess savings into starting a family Registered Education Savings Plan (RESP) for their children.  During this period we recommend contributing $2,500 for each child for fourteen years to maximize the Canada Education Savings Grant of $7,200 per child.

Age 57-64

After the mortgage is gone and RESP contributions cease, Stephen and Sharon will have a little extra cash flow.  Both Stephen and Sharon should redirect the cash flow previously dedicated to mortgage payments and RESP contributions to making their first RRSP contributions.  We assume Stephen has the higher income.  In today’s dollars, we recommend he contribute approximately $7,000 for six years between the age of 57 and 62.  This should fund two life annuities beginning at age 65 paying $2,000 a year each.  This is equal to the pension income amount and should essentially be tax-free.  The cost of these contributions is approximately $4,900 annually as Stephen will receive a tax refund of $2,100 for each of the six years (30 per cent x $7,000).

Retirement

When Stephen and Sharon are 64 they should convert their RRSP accounts to RRIF accounts and schedule to take their first payments at age 65 ($2,000 per year each).  Both should apply for Canada Pension Plan (CPP) retirement benefits.  Stephen is eligible for the full CPP; however, Sharon worked part time and qualifies for a lower CPP amount.   Stephen and Sharon should make an application to share CPP, this will reduce the household tax liability.  In addition, they should both apply for OAS to begin once they turn 65.

At the beginning of retirement, Stephen and Sharon will have accumulated approximately $1.9 million in their TFSA account.  Readers should factor in inflation when looking at this number.  $1.9 million in 46 years will not be worth the same amount as it is today.  With a three per cent real rate of return, the equivalent amount (in today’s dollars) is approximately $488,000.  In today’s dollars, Stephen and Sharon will also have $26,900 and $28,500 in their RRIF accounts, respectively.  If we assume that both Stephen and Sharon have life expectancies of 90 years, then the TFSA should fund annual tax-free cash payments of approximately $137,600 (the first payment is approximately $35,173 in today’s dollars).  If Stephen and Sharon were both able to take advantage of the TFSA then the TFSA should fund annual tax-free cash payments of approximately $275,200 (first payment is approximately $70,346 in today’s dollars).  In addition, they will also each receive income from CPP, OAS, and the RRIF annuity.

The TFSA brings planning for low taxable income at retirement to new levels.  People who use the TFSA will pay more annual taxes during their working years from not maximizing RRSP contributions.  This sacrifice will be rewarded at retirement when taxes will be extremely low.  Stephen and Sharon will not have to worry about having their old age security being clawed back.  In fact, if they plan right, their income may be low enough to qualify for medical benefit assistance and/or other income tested benefits.  Better yet, they may qualify for the tax-free guaranteed income supplement (GIS).

After doing the math we came to the conclusion that the TFSA is such a good deal for Canadians that it likely will not last long term in our opinion.  If it does last more than ten years then possibly some of the rules will change.  In the meantime, it makes sense to consider how the TFSA can benefit your overall retirement savings strategy.

Tax-Free Savings Accounts have arrived

Beginning in January 2009 all Canadian residents over 18 will be able to contribute annually to a Tax Free Savings Account (TFSA).

For 2009 the limit is $5,000, and although you do not receive a tax deduction for contributing, all income within the TFSA grows tax-free and there is no tax on withdrawals.  In the following years, the annual limit will be indexed to inflation and the annual additions to contribution room will be rounded to the nearest $500.

Nearly everyone should have a TFSA.

Why?  You can save tax-free and still have the flexibility to withdraw your savings at any time, for any purpose.  The new TFSA should be a very important component of all financial plans and investment strategies.  Although initial contributions may be small, it will grow into a substantial amount over time.

Contributions to a TFSA may be the best option for many people, replacing RRSPs as the first place to save money.  Others may find that the TFSA compliments their RRSP savings.  It really comes down to what your taxable income is today and what you project it will be in the future.  A couple who each save $5,000 a year (at the beginning of each year) for 25 years would have combined accounts of approximately $676,000 if the investments earned a seven per cent annualized rate of return.

Nearly every financial firm today has a campaign marketing these new accounts.  Although small at this stage it is important to map out your strategy for the TFSA and how it fits into your overall financial plan.   Here are 10 tips to consider for the TFSA:

1) Financial Plans – The first step prior to setting up a TFSA is to see how it fits into your current financial plan.  After you go through some future contribution and growth numbers you will see that the TFSA will be one of the most important components of your financial plan.

2) Low or High Risk – Many people are torn between choosing conservative cash equivalents and fixed income investments, or choosing higher risk options such as equities.  The underlying investment options are extremely important.   We would encourage people to look at both short-term and long-term goals when choosing investment options.  The choice should be suitable given your risk tolerance, other investment holdings, and cash flow needs.

3) Investment Flexibility – It is likely that the investment you choose may change over time.  Ask the financial institution, where you are considering opening up a TFSA, what types of investment options they have.  It may be that you are limited to savings accounts, term deposits, and/or proprietary mutual funds.  You may find that direct equities, index shares, bonds, or non-proprietary mutual funds are a better option.  If you deal with a firm offering all options, it provides more flexibility this year.  This is especially important if you feel you may want to make investment changes in the future as your TFSA grows.

4) Understanding Fees – Watch for annual fees, transaction fees, withdrawal fees, and transfer fees (if you move your TFSA to another firm).  Some financial firms may have different account options available including transactional, fee-based or managed.  It is important to obtain an understanding of the account type and all current and future fees.

5) Contributions – Not everyone will be able to deposit $5,000 in early January.  Consider contributing $200 as an initial investment in early January then set up a monthly pre-authorized contribution of $400 per month at the end of every month.  This is a perfect pay-yourself investment account.  Care should be taken not to over contribute to your TFSA, as a penalty tax will apply on the excess amount.

6) Beneficiary – Carefully select the beneficiary of your TFSA.  We are encouraging couples to name each other as beneficiary to take advantage of the tax free roll-over.  If you are single, you should obtain an understanding of what happens to your TFSA is you name someone other than a spouse as a beneficiary.  It is possible to name your estate as beneficiary.  However, fees such as executor and probate are often avoided if a beneficiary is named.

7) Withdrawal – One of the most attractive components to the TFSA is that it may be replenished if a withdrawal is made.  Some restrictions apply relating to replenishing a TFSA in the same tax year.  We envision multiple reasons why someone would need to make a withdrawal, such as: education expenses, home purchase or renovation, vacation, health care expenses, car purchase, etc.  Another reason a person may make a withdrawal is to shift funds into an RRSP.  If you are in a low income tax bracket, it likely makes more sense to contribute now to a TFSA.  If in the future you are in a higher income tax bracket (making greater than $38,000 annually), and can commit the funds for retirement, it may make sense to roll some funds from your TFSA into your RRSP to obtain a tax deduction.

8) Low Income Years – The TFSA will immediately benefit seniors who are currently receiving income-tested benefits and we encourage those with low incomes to take full advantage of the TFSA.  Higher net worth individuals may consider using the TFSA for withdrawals to fund the first few years of retirement.   As an example, a person could have $500,000 in an RRSP at age 65 and $300,000 in a TFSA.   By using the TFSA for the first five years it may be possible that you will also receive income tested benefits (i.e. guaranteed income supplement, old age security) provided the rules do not change.

9) Sheltering Income – If you follow Tip 8 then chances are you have the ability to contribute funds back into your TFSA when you begin pulling funds out of your RRSP and RRIF accounts.  Although the RRSP and RRIF withdrawal is taxable, the proceeds may be deposited into the TFSA to tax shelter the future investment income component.

10) Talk To An Advisor – We encourage you to speak with a financial advisor to discuss opening a TFSA.   An advisor should obtain an understanding of your cash flow needs, taxation matters, goals, and risk tolerance.  With this knowledge they should be able to guide you in the right direction.

 

Financial plans provide some clarity

We’re told over the course of our entire lives about the importance of saving to reach other goals, especially when it comes to retirement.   Most people agree that having a financial plan is important to provide clarity.

Unfortunately most people have never had a properly prepared financial plan.  For those who have a plan, few stick to it over time – especially during the down-turn we’ve all witnessed lately.

Most plans require you to gather both personal and financial information.  Your financial planner is able to input this information and generate a variety of documents ranging from a simple concept to a comprehensive financial plan.

The information you gather is mostly concrete and is based on actual amounts as of a certain date.  As well, you will have to make some projections as to the level of income you would like at retirement.  Your financial planner will also establish various assumptions or estimates (inflation rates, life expectancy, investment returns).

The best part of a financial plan is the list of savings required to meet your goal.  As an example, a typical financial plan may recommend that a couple each maximize RRSP contributions and save $500 per month in non-registered savings.   These savings are required whether we are experiencing good times or bad.

Unfortunately when markets decline, many people stop investing.  This often has a bigger long-term impact on your financial situation then for someone who continues to save.  By continuing to invest during difficult times people are essentially dollar cost averaging.  By dollar cost averaging we mean that some investments are purchased at higher amounts and others are purchased at lower amounts.

Rather than stopping the amount you save, consider saving more.  By saving more, at any time, you increase your chances of reaching your goals.

After a financial plan is prepared, it is important to update your financial planner with details of any significant changes in your life.  Significant changes may include family death, marriage, birth of child, inheritance, sale or purchase of a property, significant raise, job loss or health issues.

A typical financial plan may have an investment return assumption of 7 per cent annually.  It would be unrealistic for returns to be exactly 7 per cent each year.  On average, over time this is what is used as an estimate.  When investment returns are significantly different – that is a one-year deviation of 20 per cent or more – we recommend updating the financial plan.

When returns are greater than expectations then three things can be discussed.  Consideration should be given to shifting the investment portfolio more conservative as the required returns are now lower.  Another discussion point would be lowering the required amount of periodic savings.  The last item to discuss is the possibility of either retiring younger or having more funds available at retirement.

When returns are lower than expected it is important to assess how this will impact your financial situation.  For some people it may involve saving a little more or working a little longer.  We would prefer these two options rather than encouraging people to take more investment risk.

For younger people, a negative year in the markets has minimal impact to long-term financial plans.  The older a person is, the more the stock market may have an impact on your financial situation.  This is the reason why a person’s investments should shift towards fixed income (bonds, GICs, term deposits) the older one becomes.

The best part about a financial plan is that it provides some clarity relating to savings and long-term goals.  The conclusion after a significant decline or increase in the stock market is a change in the required periodic savings.  The most important component to long-term success is to continue saving during all market conditions.

Safe, secure GICs have downsides

Guaranteed Investment Certificates, or GICs as they are commonly known, are extremely popular savings vehicles.  They are the classic safe investment vehicle that provide a low-risk and low-return combination. Furthermore, many investors prefer GICs as they are a simple guaranteed investment that returns capital plus income.

The Canadian Deposit Insurance Corporation raised this guarantee from $60,000 to $100,000 in the 2005 federal budget.  CDIC provides valuable protection for investors primarily concerned with capital preservation.  When investors place money in eligible deposits they are automatically insured to a maximum basic coverage limit of $100,000, including principal and interest.  For information, visit www.cdic.ca

For all the simplicity and safety of GICs, investors sometimes pay little attention to the risk that their low interest earning investments may not preserve purchasing power over time. Interest rates on GICs are currently at low levels and when one considers the impact of taxes and inflation on their investments, the real rates of returns (return after accounting for inflation) can be negligible or potentially negative.

Let’s look at an example:  William has $300,000 in a non-registered annual pay GIC yielding 4 per cent, and has a marginal tax rate of approximately 43 per cent.  We will assume inflation is at 2.3 per cent.

GIC Income $300,000 x 4 Per Cent = $12,000

Taxes at 43 Per Cent                        =  ($5,160)

Net Return                                       =  $ 6,840

A net return of $6,840 is approximately 2.3 per cent.  With inflation at 2.3 per cent or higher the “real return” will be negative.  Investors with long-term objectives need to understand that the safety of GICs can actually erode the real purchasing power of their investments. In many cases, investors requiring income to provide for their day-to-day expenditures will be forced to encroach on capital as the real returns will be insufficient to meet their needs.

Clients dependent on GICs as their sole investment vehicles need to consider diversifying a component of their investments into alternative types of securities to provide inflation protection, generate tax-effective income, and to build long-term wealth.

Some tips for GIC investors:

Tip 1

We encourage investors to place no more than $100,000 per individual issuer.  Solution:  deal with a firm that is able to issue multiple issuers of GIC’s (as CDIC covers up to $100,000 held per issuing company).

Tip 2

GICs generate interest income which is fully taxed if held in a non-registered account.  Solution:  we encourage investors to look at the structure of their investments and consider putting GICs in their RRSP, as is the normal recommendation for most income generating products.

Tip 3

Occasionally we see GICs purchased near the end of the year in non-registered accounts.  Rather than purchasing a GIC at the end of the year it may make sense to put these funds into a high interest savings account until early January.  This would allow you to defer the annual interest one year.  A $100,000 one year GIC at 4.5 per cent purchased on December 6, 2006 would have $4,500 in taxable income for 2007.  Solution:  waiting until after December 31, 2007 to purchase a GIC would defer this taxable income one full year.

Tip 4

Many financial institutions will ask you if you would like to set up an automatic renewal of your GIC investments.  It only takes a few minutes to discuss rates and reinvestment options with your advisor when investments mature.  During these discussions you may want to consider different options and terms.  Most importantly you should make sure you are receiving a competitive rate.  Solution:  cancel all automatic renewals and ask your advisor to give you a call when your GICs mature.

Tip 5

Many structured products are attaching the “GIC” name in their advertisements.  One of the benefits of a GIC is its simplicity, transparency, and security.   Why does a GIC need to have some type of complicating feature to it?  Do those extra features benefit you or do they provide the issuer with more benefits?  Solution:  speak with your financial advisor for more information and avoid structured products that you do not understand.

Tip 6

Before purchasing a GIC you should determine if it can be transferred or sold.  Some GICs can be transferred to other institutions and some cannot.  In addition, most GICs cannot be sold prior to maturity.  Solution:  speak with your financial advisor for more information and attempt to purchase GICs that are transferable.

 

Size of the bond market surprises new investors

New investors are often surprised to learn the sheer size of the bond market.  The Canadian secondary debt market is approximately 30 times greater than the total Canadian equity trading market.

If a bond is purchased at its new issue price the value is normally $100 per $100 par value (also known as face value).  However, most new issue bonds are not floated to the general public, but are bought by the large investment dealers such as the Canadian banks.  The general public has access to buy bonds in the secondary market from these dealers where bond prices will be trading at their perceived value based on many different factors such as world or county specific economic news, interest rates, credit rating, etc.

Due to the numerous variables, bonds are rarely trading at exactly $100 in the secondary market.  Bonds that trade at a higher price than their par value ($100), say $102, are said to be trading at a “premium.”  Bonds that trade at a lower price, say $97, are trading at a “discount.”

We will use XYZ bond to illustrate bonds trading at a premium or discount.

The original XYZ bond was issued at 100 with a four per cent coupon and a five-year term to maturity.  Most bonds in Canada pay their coupon on a semi annual basis (twice per year).  Therefore in this case, the client would receive a fixed amount of two per cent per six months on the total face value of the bonds purchased.  After the initial issue date, the price is not fixed and will fluctuate prior to maturity based on several factors as mentioned above.

Bond prices move inversely to interest rates.  Therefore, if interest rates have increased after a year from when XYZ bonds were initially issued, the price of the bond will decrease.

Many clients find this relationship difficult to understand so let’s use an example to illustrate why this occurs.  Let’s say that interest rates rise to the extent that a new five-year ABC bond, which is similar in term and credit quality as XYZ bond, when initially issued at par is paying a coupon of five per cent.  All else being equal, investors would find the ABC bonds more attractive than the four per cent coupon XYZ bonds issued a year earlier.  Therefore the market in general would sell the XYZ bond, causing the price to drop, in order to buy the more attractive ABC bond.

The opposite may happen to bond pricing if interest rates decline.  If new bond issues are currently paying three per cent coupon, the market would be more inclined to buy higher coupon paying bonds such as the XYZ bond paying four per cent.    The market would buy the XYZ bond, pushing its price above those that are issued at three per cent causing the XYZ bond to trade at a premium.  If XYZ is trading at $102, the premium above $100 can be seen as payment for a higher coupon.

Here are some key tips in acquiring bonds;

  • Never buy a bond solely on the coupon alone.  Yield to maturity for bonds is often the more important number to review as it allows bonds of different coupons and maturities to be compared to each other.  Yield to maturity is the total return, made up of interest and repayment of principal that you will receive if you hold the bond to maturity.
  • For taxable accounts, you should ensure that you are reporting all capital gains from bonds purchased at a discount and all capital losses from bonds purchased at a premium.
  • The coupon component on bonds is considered interest income.  We encourage investors to hold investments that generate interest income within a registered account, such as an RRSP or RRIF, if they have the option.
  • If you are an investor in a high tax bracket and have bonds in a non-registered account, consider those trading at a discount.  Bonds trading at a discount will result in both interest income and capital gains.  The taxable capital gains is more tax efficient than the interest income component.  Naturally, the higher your tax bracket, the greater the benefit of investing in bonds trading at a discount.
  • If you have capital loss carry forwards and are avoiding equity markets then you should ask your advisor to look for bonds trading at a deep discount.  This will convert part of your total return to capitals gains.  The capital gain component generated on a bond held to maturity may be offset by your capital loss carry-forward room.
  • We recommend sticking to “vanilla” type bonds versus those that have features that you may not understand or that do not appear to benefit you.  Before purchasing, you should obtain a complete understanding of all features (i.e. extendable, callable, changes in coupon rates) on bonds and determine how this may impact you as the holder.

Property tax deferment assists seniors

The Property Tax Deferment Program in British Columbia was established in 1974 intending to assist seniors and the disabled.  The program ensured that the property tax burden each year would not result in an individual having to sell their home to cover this obligation.

Property Tax Deferment is a low-interest loan program that assists qualifying homeowners in British Columbia in paying the annual property taxes on their homes.

The general Property Tax Deferment qualifications require that you:

  • Be the registered owner(s) of the home
  • Be 55 years of age or older OR a surviving spouse OR a person with disabilities as defined in the Regulations to the Land Tax Deferment Act
  • Be a Canadian citizen or permanent resident under the Immigration Act
    (Canada)
  • Have lived in British Columbia for at least one year immediately prior to applying
  • Apply on the home in which you live
  • Have a minimum equity of 25% in your home based on assessed values as determined by BC Assessment
  • Pay property taxes to a municipality or the Surveyor of Taxes
  • Have a current fire insurance policy on your home

Only one spouse must be 55 or older where the home is registered in both names. At the time of application, the owner must turn 55 during that calendar year to qualify.  You can defer your taxes as long as you own and live in your home and continue to qualify for the program. The deferred taxes must be fully repaid, with interest before your home can be legally transferred to a new owner, other than directly to your surviving spouse or upon the death of the agreement holder(s).  A one-time administration fee of $60 is applied to new approved deferment agreements. You can renew your agreement each year. A $10 fee applies to approved renewals.

For more information and how to apply, visit the Ministry of Small Business and Revenue’s website at www.sbr.gov.bc.ca/individuals/Property_Taxes/Property_Tax_Deferment/ptd.htm

You can also get information by email at ruraltax@gov.bc.ca or call toll free through Enquiry BC at 1-800-663-7867 and request a transfer to 250-387-0555.

Interest Charges

If you choose to defer your property taxes the deferred balance will be charged simple interest at a rate not greater than 2 per cent below the rate at which the province borrows money.  The interest rate is set every six months by the Minister of Small Business and Revenue. A key benefit to note is that the deferred amount is charged simple interest, this is better than compound interest that charges interest on interest.  Another benefit is that the interest rate charged is not greater than 2 per cent below the rate at which the province borrows money.  Currently the interest rate is 4 per cent and is set for the period October 1, 2007 through March 31, 2008.  The rate may change every 6 months and will be reset again on April 1, 2008.

Means Test

One of the most interesting components to this program is that there is no mention of a means test.  Individuals of all income levels may apply provided they meet the general qualifications.  Although the program may have been designed for those struggling to pay expenses, others may also take advantage of the terms of deferment.  With the interest charges as low as they are, individuals may choose to defer their property taxes for a variety of reasons.  From an investment standpoint this may make sense if an investor feels they could generate an after tax return greater than the interest charges.

2007 NUMERS FOR VANCOUVER ISLAND

Jurisdiction

Number of Households

Amount Deferred

Saanich

1226

3,723,526.07

OakBay

397

1,722,057.09

Nanaimo

608

1,476,037.12

Victoria

499

1,311,649.94

GulfIslands rural

377

1,062,124.15

North Saanich

297

1,036,382.67

Alberni rural

358

905,610.57

Courtenay rural

304

832,482.65

Central Saanich

233

677,423.29

QualicumBeach

293

642,293.37

Sidney

196

554,595.76

Duncan rural

237

520,359.86

Esquimalt

142

398,481.40

Parksville

177

370,281.98

North Cowichan

187

352,273.32

Courtenay

182

332,549.68

Nanaimo rural

136

330,322.49

Comox

169

309,192.76

Campbell River

158

278,931.66

Ladysmith

61

117,722.63

Colwood

66

111,855.34

Sooke

56

110,461.66

Langford

65

105,306.76

Lantzville

39

99,547.61

View Royal

56

93,768.79

Port Alberni

73

92,139.41

Source:  Ministry of Small Business and Revenue – Property Taxation Branch

Four Strategies to Consider

  • Strategy 1:  The most basic strategy is to use the funds that you would normally use to pay property taxes to fund day-to-day expenses.  This strategy is essentially the main reason the program was put into place.
  • Strategy 2:   Another strategy for the use of the funds is to build up your investment savings.  Topping them up now may prevent you from running into financial problems in the future.
  • Strategy 3:  For individuals who are 55 plus and still earning significant income, redirecting the cash to top up your RRSP contribution may be a prudent move.
  • Strategy 4:  If your ultimate objective is to enhance your overall estate value then proceeds could be used to fund a life insurance policy.

Prior to implementing any of the above strategies, you should contact your accountant and financial advisor to see what course of action is appropriate for you.

 

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.

How to map a comfortable retirement

How much should you be contributing to your RRSP?  Start with a basic plan

Studies have revealed that most people do not have a financial plan and most do not maximize RRSP contributions.  Without a plan it may be difficult to determine when you may retire comfortably.

It also may be difficult to determine how much you should be contributing to an RRSP.  There are many different types of financial planning reports with different degrees of information that advisors may provide, but financial planning does not have to be complicated and time consuming.  From our experience, investors primarily want to know if they are going in the right direction to reach their goals.   The missing piece to the puzzle for most people is determining how much they should be contributing monthly to their RRSP to meet their retirement goals.

The first question we ask our clients who are wondering if they are on track is, how much monthly income (in today’s dollars) do you feel you need to live on?  This is a very important question and you are the best person to answer this.

Several financial planning articles try to give guidance as to what this amount should be.  We have read some articles that suggest 50 per cent of your pre-retirement income, while other articles suggest 150 per cent. This is a huge range leaving many people confused.

Rather than focusing on your current income or using a percentage of pre-retirement income, we recommend giving careful thought to what your plans are for retirement and what this might cost in today’s dollars.  Giving your advisor this number will speed up the process considerably.

Certain types of income are indexed to keep up with inflation.  Typical types of monthly income that are currently indexed are Canada Pension Plan (CPP) and Old Age Security (OAS).  If you are unsure of the amount you may be eligible to receive for CPP, you may request a statement online through the Human Resource Development Canada website (www.hrsdc.gc.ca/en/isp/cpp/soc/proceed.shtml).

Individuals with a defined benefit plan may also find that their pension is indexed.   Pension administrators should periodically send out pension calculations to their active members.  You should also be able to request this information from the administrator.  Other types of income may not be indexed, such as annuities (although they can be).   You should provide your financial planner details regarding your expected sources of income.

The last question you will have to answer is when would you like to retire?   Once you have gathered the above information your advisor should be able to give a rough calculation on whether you can retire without selling significant assets such as your personal residence.

Every financial plan or concept will have various assumptions embedded in the calculations.  One assumption is the expected rate of return your assets will achieve during your lifetime.  Life expectancy itself is another assumption.  Future tax rates and actual retirement age are other assumptions used in calculations.

Here’s an example of how a small change in an assumption may have a significant impact.

■ Mr. Sanderson is 50 and has compiled some information for us.  Based on the information provided today we have projected that, at age 65, his future monthly after-tax income will be approximately $2,058 from Canada Pension Plan, Old Age Security and independent pension plan.  He feels that he needs $4,000 monthly after-tax at retirement to cover expenses representing a shortfall of $1,942.

This shortfall represents $23,304 annually in today’s dollars ($1,942 multiplied by 12).  With a three per cent rate of inflation the future annual amount would be approximately $36,307 when Mr. Sanderson is 65 years old.  Mr. Sanderson has an RRSP with a current value of $149,000.  The missing piece that Mr. Sanderson would like to know is how much he requires in his RRSP at age 65.  Or more specifically, what is the monthly amount he would need to contribute to meet his retirement goals.  Mr. Sanderson mentioned that his health is good and would like us to use a life expectancy of 88 years.  He also would like us to do two calculations, one assuming a very conservative rate of return of six per cent and another assuming a seven per cent rate of return.  Mr. Sanderson has an average tax rate of 25 per cent.

Six Per Cent:  Mr. Sanderson would have to accumulate approximately $829,000 in his RRSP by age 65.  He would need to make initial monthly contributions of $1,363.78 into his RRSP beginning in 2008.  The cost of this contribution is only $1,023 per month because of the RRSP tax deduction.  Every year Mr. Sanderson would have to increase his monthly contributions by the rate of inflation (three per cent).

Seven Per Cent:  Mr. Sanderson would have to accumulate approximately $755,000 in his RRSP by age 65.  He would need to make monthly contributions of $912.64 into his RRSP beginning in 2008.  The cost of this contribution is only $684 per month because of the RRSP tax deduction.  Every year Mr. Sanderson would have to increase his monthly contributions by the rate of inflation (three per cent).

The above highlights how a single percentage point can make a huge difference.  The required monthly savings is $1,364 if his RRSP returns six per cent versus only $913 if his RRSP returns seven per cent.  The other assumptions noted above may also have a significant impact.  Be careful when looking at financial material or plans that have unrealistic long term return expectations.  The above also highlights that it can be difficult for investors to reach their retirement goals if they are too conservative.

The above illustration provided Mr. Sanderson a quick snapshot to see if he was on the right track.  A change in the assumptions may have a significant impact on whether retirement goals are met.  The above calculation does not replace a comprehensive financial plan that may include non-registered investments, real estate holdings, mortgages, debt and other factors specific to each person’s situation.