Part II – RRSP Turns 60: Still a Good Bet for Retirement

Registered Retirement Savings Plans (RRSPs) were first introduced 60 years ago, created by the federal government to help people who didn’t have a work pension to save for retirement by socking away pre-tax money.

In 1957, the threshold for the RRSP was the lesser of 10 per cent of income or $2,500.  Over the years the threshold methodology has changed.  Over the years, the threshold methodology has changed. Since 1991, the income threshold of 18 per cent of income has been used.

Starting in 1996, and continuing to today, the new contribution ceilings were indexed to the rise in average wages.

For 2017, the annual maximum, or contribution ceiling, is $26,010, which is reached when earned income is at $144,500 for the prior year.  After you file your 2016 tax return, the government communicates to taxpayers their 2017 RRSP contribution limit on the Notice of Assessment.

The calculation for the RRSP contributions limit is adjusted for individuals who have a work pension.   This reduction is referred to as a pension adjustment and also shows up on your Notice of Assessment.

A pension adjustment is done for both Defined Benefit Plans, where employers bear the risk of market-value changes, and Defined Contribution Plans, where employees bear the risk.

Pension plans have been deteriorating over the last decade.  Individuals who either do not have a pension through work, or do not have a good quality pension, should consider having an RRSP.

Outside of the two types of pensions, some employers will offer a program to help build up your RRSP, or other accounts.  In some cases, these are matching type programs, where you can put in a certain percentage of your salary, and your employer will match it, up to a defined threshold.  These are often referred to as a group RRSP and it is worth participating in.

If you have an RRSP program at work, then having that one is a must.  As you are typically restricted by the types of investments you can invest in with a group plan, we encourage people to also have one external RRSP account.

The external RRSP account would hold all the contributions done outside of your group plan.  In some cases, individuals can transfer funds from a group RRSP to an external RRSP.  In other cases, the funds must stay in a group RRSP until you cease employment with the sponsoring company.

You should receive a statement for any company sponsored pension.  Reviewing this statement is especially important if your plan is a Defined Contribution Plan where you had to make investment choices.

You have made decisions to determine the percentage to invest in fixed income versus equity and whether to have Canadian equities versus foreign equities.

If you have a group RRSP plan, you likely can view information electronically and also receive statements more frequently.

All of this information should be provided to your financial advisor, prior to making any financial decisions regarding your external RRSP.

As the quality of pension plans has deteriorated, the methodology of how to invest funds within an RRSP has changed for some investors.  The three broad categories are cash equivalents, fixed income, and equities.

In 1957, a 90 day treasury bill (cash equivalents) could be purchased with an interest rate of 3.78 per cent, climbing to 17.78 per cent in 1981.

Investing RRSPs in conservative investments, such as cash equivalents, provided decent enough returns during this period.  The latest T-Bill auction of 2016 had the 90 day treasury bills paying a yield of 0.50 per cent.   Most would agree that putting the investments within your RRSP into cash equivalents would not provide the returns to keep pace with inflation, especially after tax is factored in.

Bonds are a type of investment that is classified within fixed income.   The reason most investors purchase bonds is for capital preservation and income.  In order to achieve the goal of capital preservation, it is advisable to invest in investment-grade bonds.  Yields on these bonds are at historic lows.  The yield curve is also very flat, so purchasing a longer term investment grade bond does not increase the yield significantly enough to warrant the potential risk if interest rates rise.   The primary reason to hold bonds in an RRSP portfolio today is capital preservation.

Equity investments provide both growth and income.  In fact, the right types of common shares can pay dividend income that exceeds the interest income on most investment-grade bonds.  Portfolio values will fluctuate greater as the equity portion increases.

An advisor can put together a portfolio of lower risk stocks, often referred to as “low beta” that can reduce this volatility.  We feel those who tolerate increased volatility will be rewarded in the long run by holding the right equity investments.

Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria.  His column appears every week in the TC.  Call 250.389.2138. greenardgroup.com 

This is for information purposes only. It is recommended that individuals consult with their financial advisor before acting on any information contained in this article.  The opinions stated are those of the author and not necessarily those of Scotia Capital Inc. or The Bank of Nova Scotia. ScotiaMcLeod is a division of Scotia Capital Inc., Member Canadian Investor Protection Fund.

A proactive advisor can cut your taxes

Clients are often unaware of investment alternatives, credits, loss-recovery options

I ask every new client to sign a Canada Revenue Agency (CRA) form T1013 – Authorizing or Cancelling a Representative. This authorizes CRA to release tax related information to me, referred to as a “representative.” It is an invaluable tax tool to proactively help clients.

Canada Revenue Agency’s website (cra-arc.gc.ca) is a great resource for general information.   On this website, representatives can access their client’s tax information. When I have clients sign the T1013, I request Level 1 authorization which enables me to view information only. There is no ability to make changes. The most obvious benefit for clients in signing the T1013 is that they no longer have to bring in a copy of their annual tax returns and applicable notices of assessments. This information is available online. I use it for a variety of purposes, primarily to give proactive advice to save tax dollars. Here are a few situations clients have encountered to which I was able to provide solutions as a result of having the T1013 on file.

Situation 1: In examining Mr. Red’s tax return, we noted he had to pay $456 in interest and penalties to CRA for not making his quarterly instalments on time.

Solution: We brought this to Mr. Red’s attention and provided automatic solutions that could help him. The first was that we could begin withholding tax on his RRIF payments. The second was that we could contact Service Canada and request that withholding tax be taken on CPP and/or OAS payments. A manual option was that we could make his quarterly instalment payments to CRA for him directly from his non-registered investment account.

Situation 2:   Mrs. Brown is a new client who transferred in a non-registered investment account. During our initial conversations, she said she prepares her own tax return. My evaluation of her past returns showed there was no carry-forward information for realized gains or losses on her investments. I confirmed that she had sold many investments over the years, but had not recorded these on her tax return.  

Solution: I explained that all dispositions in a taxable account must be manually reported on Schedule 3 (no tax slip is issued for this). We assisted her in obtaining previous annual trading summaries to calculate the numbers needed to adjust her previous tax returns.

Situation 3: Mr. Black has been contributing to his RRSP for many years. In the last year, his income dropped substantially and he was comfortably in the first marginal tax bracket. Mr. Black said he projected that his income would continue at the current level or decline as he approaches retirement.              

Solution: It no longer made sense for Mr. Black to continue to contribute to his RRSP account. His savings should be directed to a Tax Free Savings Account.

Situation 4: Mr. Orange received penalties for over-contributing to his TFSA accounts. In our first meeting, he explained that he had several TFSA accounts and had lost track of his withdrawals and contributions.

Solution: We outlined the rules with respect to TFSA accounts and any replenishment for a previous withdrawal must occur in the next calendar year. I also had him sign the T1013 form. I printed out all of his TFSA contributions and withdrawals from the online service. I recommended that he consolidate his TFSA accounts. I also provided copies of the CRA reports, including a report which shows his current year contribution limit.

Situation 5: Mrs. Yellow has been a long time client whose health has deteriorated over the years. In reviewing her tax returns, I noted that he was not claiming the disability tax credit.

Solution: I provided her with a copy of the Disability Tax Credit form T2201. I advised her to bring this to her doctor to have the form signed and submitted. A few months later, Mrs. Yellow received a letter back from CRA with their approval for her application. They also approved backdating her eligibility to 2009. In assisting Mrs. Yellow and her accountant with the T1-Adjustment form, we projected that she would receive a tax refund of $12,490. From now on, Mrs. Yellow will be able to claim the disability tax credit every year, resulting in significant tax savings.

Situation 6: Mr. White has, in the last few years, completed his own tax return using Turbo Tax. He has correctly reported the taxable capital gains on line 127 of his tax return during this period. Unfortunately, Mr. White did not initially key in his loss carry-forward information. Many years ago, Mr. White had a significant net capital loss on a real estate investment, and was not aware that he could apply his net capital losses to reduce his taxable capital gains on the stock sells.  

Solution:   I arranged a meeting with Mr. White and explained to him the importance of keying in the carry-forward amounts when starting to use Turbo Tax. I also showed him how he can use a T1-Adj form to request CRA change line 253 – Net capital losses of other years. Mr. White had to submit four T1-Adj for each year he missed applying his net capital losses. Combined Mr. White received a refund of $47,024 after all reassessments.

Situation 7: Mrs. Green has recently transferred her investments to us. We noted a few investments with significant losses that she has held in her account for many years.   There is little hope that these investments will recover in value. In reviewing Mrs. Green’s online account with CRA, I looked up all of her previously reported taxable capital gains and net capital losses. In this analysis, I noted she had substantial taxable capital gains three years ago that brought her income into the top marginal tax bracket.   Net capital losses can only be carried back up to three years. Mrs. Green was unaware net capital losses could only be carried back up to three years.

Solution: I recommended that Mrs. Green sell most of her investments that were in an unrealized loss situation. By selling these she triggered the tax situation and created the net capital loss. I printed off the T1A – Request for Loss Carryback form and explained to Mrs. Green how the form works. Mrs. Green was able to recover $29,842 after CRA carried the loss back and reassessed her tax return from three year ago.

Situation 8: Mr. Blue had stopped working at the age of 62, but his spouse was continuing to work a few more years. In looking at his CRA online reports, I noted he was collecting CPP and that this represented most of his income, which was below the basic exemption.  He had not thought about taking money out of his RRSP early as Mrs. Blue was continuing to work and they had enough money flowing in from her income and in the bank to take care of the bills. Mr. Blue had a sizeable RRSP account and Mrs. Blue will have a good pension when she retires that can be shared.

Solution: I explained to Mr. Blue that when he starts collecting OAS, pension splitting with his spouse, and having to withdrawal from his RRIF that his taxable income will increase significantly. We recommended that he convert a portion of his RRSP to a RRIF and begin taking income out on an annual basis immediately. We mapped out a plan to keep his taxable income around $35,000. With these early withdrawals, our projections would keep both Mr. and Mrs. Blue in the top end of the first marginal tax brackets throughout retirement.

Situation 9:   Mrs. Purple is extremely busy with work and has a great income. It is definitely advisable for Mrs. Purple to maximize her contributions to her Registered Retirement Savings Plan (RRSP). Unfortunately, Mrs. Purple never seems to find the time to photo copy her notice of assessment and provide this to her advisor. She was frustrated that last year, she missed contributing to her RRSP because her advisor did not phone.

Solution:   When Mrs. Purple came to see me I explained the benefits of the T1013 form. One of the main benefits is that I can go on-line and instantly obtain her RRSP contribution limits and unused portions for the current year.   I proactively contact each applicable client and advise them of their limits and recommended contribution level based on projections of current and future income levels.

Financial tips for blended families

Opening the communication channels is key when helping couples in blended family situations.   This communication should absolutely start on Day 1 for blended families, and should be part of the account opening process. A good advisor will ask probing questions beyond the checklist of mandatory questions to first open an account.  

With new blended families, it is not always easy to have open communication with both parties. Often, they have different advisors and different financial institutions.   If this is the case, then it is common for the couple to maintain the status quo with their separate finances.   I always encourage couples in blended families to come in together, even when they are maintaining separate finances. Once this happens, and once there is open discussion and communication, then progress can be made on a variety of financial decisions.

Often there is a disparity between the value of assets, or net worth, of each party. Rarely are the assets equal. One party may have more equity in real estate, while the other has more stock and bond investments.  

Making objective financial decisions can be challenged by the simple notion that “blood is thicker than water.”   For example, many parents want to provide for their children from a previous marriage. However, this can conflict with the many tax benefits provided for married or common-law relationships. This conflict is especially challenging when it comes to estate planning. Below I have listed a few common assets and basic challenges couples in blended families may face.

Non-Registered Account:  The term taxable account or non-registered can be used inter-changeably. Often young people do not have non-registered accounts as they are busy paying off mortgages and/or contributing to their registered accounts, such as RRSPs.   Older couples with adult children are more likely to have taxable accounts when they enter a blended family.   When a person has non-registered investments just in their name, this is called an Individual Account.   The monthly statements and confirmation slips have just the one person’s name on it, and the year-end tax slips (i.e. T5 and T3 slips) are in same one individual’s name.  

Couples in a first marriage, and who have built up equity together, will open up a taxable account called Joint With Right of Survivorship (JTWROS). This type of account has many benefits for couples, including income-splitting. The primary benefits of these joint accounts are probate is avoided, income tax continues to be deferred, such as for unrealized capital gains, and simplicity of paperwork after the first spouse passes away.  

Some couples have two JTRWOS with each person being primary on their own respective account. By primary I mean their name is first on the account and their social insurance number is on all tax slips. This enables couples to still keep funds separate, but it will still provide the same above benefits.

Tenants in Common:  Another option for taxable accounts is Tenants In Common. With Tenants in Common a taxable account is set up with two or more owners, where the ownership percentages do not have to be equal. Upon the passing of any owner, their portion represents part of their estate, and the other owners do not have the right of survivorship.   Many of the benefits of JTWROS are lost with Tenants In Common, but for some couples this may be the right decision. A couple that would like to combine their assets to pay household bills, could simply allocate the ownership based on the amount originally contributed. If Spouse ”A” puts in $300,000, and Spouse “B” puts in $700,000 then the allocation for ownership could be 30 per cent for Spouse A and 70 per cent for Spouse B.   If either spouse passes away, their Will would dictate how their proportionate share is divided.  

Registered Accounts:  The two most common types of registered accounts are Registered Retirement Savings Plans (RRSP) and Tax Free Savings Accounts (TFSA). RRSP and TFSA accounts can only be in one person’s name.  

However, with both of these types of accounts you are able to name a beneficiary. With couples in a first marriage and building equity together, your spouse is likely always named the beneficiary on registered accounts.   At the time of death, Canada Revenue Agency allows the owner of an RRSP (called an annuitant) to transfer their RRSP to their surviving spouse or common-law partner, on a tax-deferred basis. If there are financially dependent children because of physical or mental impairments, then it also may be possible to transfer the annuitant’s RRSP on a tax-deferred basis. Outside of these two situations, the annuitant’s RRSP is fully taxable in the year of death.

A person who has a spouse, and chooses to name an adult child the beneficiary should understand the tax consequences. If you name your spouse the beneficiary, your spouse receives 100 per cent of the value until the funds are pulled out gradually (taxed when taken out). If you name someone other than a spouse, the funds are deemed taxable in one large lump sum, so the marginal tax bracket of 45.8 per cent could easily be reached. Many people would cringe if they could see the amount of tax paid to CRA from RRSP accounts resulting from a lack of planning.  

Although the TFSA has no immediate tax issues on death, there are still some benefits to naming your spouse or common-law partner the beneficiary.   As an example, let’s look at a blended family with Spouses C and D. Spouse C has $48,000 in a TFSA and Spouse D Has $52,000.

Spouse C has the option of naming the Estate the beneficiary, naming Spouse D the beneficiary, or naming another individual such as a child or children from a previous marriage. If Spouse C names the Estate the beneficiary, then the account would likely have to be probated to validate the Will. The Will would provide us direction as to who the beneficiary of the TFSA will be. If Spouse C named Spouse D the beneficiary, then we can roll over the entire $48,000 into Spouse D’s TFSA account (without using contribution room). After the roll over, Spouse D would have a TFSA valued at $100,000 – all of which is fully tax sheltered. The roll over can be done once we receive a copy of the death certificate – and no probate is required for the transfer of assets. The only time individuals are permitted to put more into their TFSA accounts, other than their standard annual limits and replenishing amounts withdrawn in an earlier year, is when their spouse or common–law partner passes away and they are named the beneficiary.

If Spouse C named the children from the first marriage the beneficiary, then Spouse D does not get the additional room and the children could receive the funds but would not be able to roll this amount into their own respective TFSA accounts without using their available room.  

While there are many solutions available for blended families, it is important to talk about these options and then document the plan.   Gathering all the information and creating a plan that both parties are content with can take some time. A plan should include all standard types of assets such as personal residence and vehicles, as well as liabilities. One of my most rewarding moments as a Portfolio Manager is assisting my clients with their plan. A plan ultimately provides peace of mind for clients in what is often viewed as a complex situation that was either too sensitive to talk about or simply not addressed.

On having enough financial resources through retirement

Balancing living for today and not running out of money in retirement is perhaps the greatest financial challenge most people face.  Even financially well-off people wonder if they have enough for retirement.

In past decades, people with limited resources have received assistance through government funded programs, including subsidized residential care and extended care.  There is a general concern about how the government will be able to continue funding assistance programs for seniors and whether they will be able to offer the same level of assistance in the future.  This is a real concern given the rising costs of these programs, especially given increasing number of seniors as the population ages.

A baby born today in British Columbia has a life expectancy of 81.7 years according to Statistics Canada.  If you’re 65 years old this year, StatsCan suggests that your life expectancy is 85.7 years.  Both of these life expectancy numbers are at the highest levels they have ever been.  Although recent studies have suggested that babies born today may actually have a shorter life expectancy than their parents as a result of health issues such as increased obesity and diabetes.    

With financial planning, assumptions are made with respect to rates of return, inflation, income tax and life expectancy.  The younger a person is, the more challenging it is to project these assumptions.  Rates of returns have fluctuated significantly for both fixed income and equity markets over the years.  Federal and provincial governments can make future modification to various programs such as benefit payments, income taxes or credits that will have a direct impact on your retirement income.   One of the assumptions to consider in retirement financial planning is your life expectancy.  The chart below shows the required savings for different life expectancies and demonstrates how your life expectancy can make a material difference.

In all scenarios, the assumptions are identical where the rate of return is four per cent, inflation is two per cent, and income tax is at 30 per cent.   For illustration purposes, we will assume an individual requires $50,000 annually after tax.  The following table gives you a financial view of the capital required in a RRIF account at age 65 with the following different life expectancies:

Life Expectancy           Savings Required @ Age 65

            75                                $522,439

            80                                 $745,470

            85                                 $959,956

            90                                  $1,166,227

            95                                  $1,364,592

            100                                $1,555,361

Another variable is the type of accounts in which investors have saved funds.  If you have funds in a non-registered account or a Tax Free Savings Account then the numbers are lower than the table above.  Having a combination of accounts (non-registered, TFSA, and RRIF) at retirement provides you the benefit of smoothing taxable income and cash flows.

Building up sufficient financial resources before you retire takes away the reliance on government funded programs and the concern of running out of money.  Financial security is achieved when you have enough resources to dictate the quality of care you receive as you grow older.  Often at times in financial plans we factor in the assumption that the principal residence could be sold to fund assisted living arrangements.  I’ve never prepared a financial plan with the assumption that the government will be paying for a client’s long term care. 

I also advise my clients to understand the issue of incapacity and how to manage this should it arise.  When planning for the most likely outcome, many people will become incapacitated (mentally or physically) for a period of time before they die.   In some cases the period of incapacity can extend for a significant length of time.

I encourage clients to take appropriate steps to deal with the financial cost of incapacity and think about how their finances would be managed if they became incapacitated. 

While they are still able, clients should ensure all legal documents (will, power of attorney, representation agreement) are up to date.  Part of this process involves reviewing the beneficiaries on all accounts to ensure consistency with your estate plan. Simplify finances by closing extra bank accounts and consolidating investment accounts.  All government benefits such as OAS and CPP as well as pensions (RRIF and RPP) should be deposited into one account, which makes it easier to budget for excess or short-falls.  Most expense payments should be automated. 

If you lose capacity or interest, it is easier for your power of attorney to review one bank statement for transactions.  In many cases, a meeting with a client and the client’s legal power of attorney is necessary to set up a “financial” power of attorney.  This power of attorney allows a person the ability to request funds to be transferred from your investment account to your bank account, if funds are running low.  Clients can set up managed accounts where a portfolio manager can act on your behalf on a discretionary basis.  Financial mail can also be sent to the power of attorney.  When bank and investment accounts are consolidated, your power of attorney can easily review and monitor the accounts through monthly statements or online access.

 

Kevin Greenard, CA FMA CFP CIM, is an Associate Portfolio Manager and Associate Director with The Greenard Group at ScotiaMcLeod in Victoria.  His column appears every second week in the Times Colonist.  Call 250-389-2138 or visit greenardgroup.com

 

 

Benefits to early conversion of RRSP to RRIF

The Registered Retirement Savings Plan (RRSP) is for “saving.”   This savings and tax deferral within an RRSP can continue until the age of 71.  In the year you turn 71, you have to either close your RRSP by either taking the money out, purchasing an annuity or transferring it to a Registered Retirement Income Fund (RRIF). 

From a taxation standpoint, it is rarely advised to de-register 100 per cent of your RRSP in one year and withdrawal the cash.  This would only be advised when an RRSP is very small or there is a shortened life expectancy or financial hardship.   Purchasing an annuity as an RRSP maturity option is a final decision that can not be reversed.  Upon your death, the annuity option often leaves nothing for your estate or beneficiaries.  

For many reasons, conversion of your RRSP to a RRIF is the most popular and flexible method.  Most of your savings will continue to be tax deferred with a minimum withdrawal amount being determined annually based on the previous December 31 value.  In the year a RRIF is set up, there is no minimum withdrawal amount.   All RRIF’s set up after 1992 are considered non-qualifying.  The following minimum RRIF withdrawal amounts are the non-qualifying annual percentage by age on December 31st: 

Age                 Per Cent        

72                    7.48    

73                    7.59

74                    7.71

75                    7.85

76                    7.99

77                    8.15

78                    8.33

79                    8.53

80                    8.75

81                    8.99

82                    9.27

84                    9.93

85                    10.33

86                    10.79

87                    11.33

88                    11.96

89                    12.71

90                    13.62

91                    14.73

92                    16.12

93                    17.92

94 or older      20.00

To illustrate how the above schedule works, we will use 71-year-old Barry Campbell who has saved $1million in his RRSP.  Barry is single and he chose to convert his RRSP to a RRIF account in the year he turned 71 and he will begin taking annual payments next year.  Barry has had years of complete deferral but this is coming to an end.  Based on the above minimum RRIF schedule, Barry will be required to withdraw $74,800 ($1 million x 7.48 per cent) and have this amount included in his taxable income.   Unfortunately, Barry doesn’t have a choice at age 71.  Based on Barry’s total income with the RRIF, he is projected to have half of his old age security clawed back (required repayment) based on his high income.  If Barry were to pass away, the majority of the RRIF would be taxed at 45.8 per cent.  Unfortunately, Canada Revenue Agency (CRA) would receive nearly half of Barry’s lifetime savings within his RRIF.   

We feel it is important for clients to understand the taxation of a RRIF in a most likely scenario of normal life expectancy and shortened life expectancy.   RRIF accounts for couples greatly reduce the taxation risk of shortened life expectancy by being able to name your spouse the beneficiary and avoid immediate taxation of the full account balance.  In 2007, CRA introduced pension-splitting, which provides taxation savings for most couples with eligible pension income. RRIF withdrawals at age 65 or higher are considered eligible. 

Beginning in 2009, CRA introduced the Tax Free Savings Account (TFSA) that provides tax savings for individuals and couples.  The savings is a result of all income (interest, dividends, and capital gains) generated within the TFSA not being taxed ever.  There is no taxation upon your death.  The amount that can be put into a TFSA is limited by a relatively small amount each year. People who are serious about saving for retirement often contribute to both an RRSP and TFSA.

Given the introduction of pension splitting and the TFSA, many people should be looking at converting their RRSP to a RRIF before the age of 71.  When we are helping clients with the optimal time to convert their RRSP, we look at their marital status, health/genetics, and other investments.  With other investments, we create two baskets (A and B) to analyse what we call the “bulge.”  A bulge is when you have too much concentration in either basket A or B.  Basket A is the total amount in your RRSP accounts.   Basket B would include bank account balances, non-registered investments, and your TFSA – none of which will attract tax on the underlying equity if used.  Basket A may also include your principal residence if the intention is that this will be sold and the capital used to fund retirement.  

We caution investors not to create a bulge – having too much in either basket means you may not have the right balance as you enter retirement.  Taking advantage of deferral opportunities over time often makes sense.  Having too much in basket A means you may have very little flexibility if an emergency arises and you need cash (new roof, vehicle).   If A / (A + B) is greater than 75 per cent (a bulge) then we would recommend you speak with an advisor to determine in you should convert your RRSP to a RRIF early.  Above, we noted Barry has $1 million in basket A.   Barry also has $250,000 in basket B.  With these numbers Barry has a bulge percentage of 80 per cent. 

A financial plan prepared while you’re working largely results in savings strategies to reach your retirement and other goals.  In retirement, a financial plan is prepared to create withdrawal strategies that are tax efficient and smooth out your income during your lifetime.  They can also be prepared in conjunction with estate planning.   

Kevin Greenard CA FMA CFP CIM is an Associate Portfolio Manager and Associate Director with The Greenard Group at ScotiaMcLeod in Victoria.  His column appears every second week in the TC.  Call 250-389-2138.

As tax time looms, it’s prudent to get your plan in place

This time of year you should be talking with your financial advisor about where to put your hard earned money.  Will you contribute to an RRSP or pay down debt?  Or should you do both by contributing to an RRSP and using the tax savings to pare debt?

Contributing to an RRSP should be done with a view of keeping the funds committed for a longer period of time and pulling them out at retirement, hopefully when you’re in a lower income tax bracket. This option is suitable for individuals who have stable income.  If it’s debt reduction, you always have the flexibility of taking out equity in your home later on if capital is needed. On the other hand, if you need capital and your only access to savings are from your RRSP you will have to make one of the most common RRSP mistakes – deregistering RRSPs before retirement and paying tax. In addition, you will not have the RRSP contribution room replenished.

Since 2009, financial options were further complicated with the introduction of the Tax Free Savings Account (TFSA). The main benefit of an RRSP is the deferral of income within the account until the funds are pulled out. Another is the tax savings in the period in which the contribution is first applied. The TFSA has the same first benefit of an RRSP, deferral of all income including interest, dividends and capital gains. TFSA contributions do not provide you a tax deduction; however, withdrawals are not taxed at all. Withdrawals can be replenished in the next calendar year. .

Business owners have the ability to have active small business income taxed at a lower rate. Most owners are encouraged to pull out only the income they need to live on. The rest of the income is left in the corporation. Income paid out of the corporation is either through dividends wages, or both. Should business owners still contribute to an RRSP or TFSA when income is already taxed at low rates?  Wages paid helps future CPP benefits and also creates RRSP deduction room.  Dividends paid can be tax efficient, but do not create RRSP room and have no benefit for CPP purposes.  Some organizations provide RRSP programs that involve matching and length of service programs that are linked to the member’s RRSP.

Singles have a higher likelihood of paying a large tax bill upon death. With couples, the chances that one lives to at least an average life expectancy are far greater. Couples can also income split where the higher income spouse can contribute to a spousal RRSP.

If you have a good company Registered Pension Plan (RPP), you may not have a great a need to have an RRSP. If a person had debt and a good RPP then the decision to pay down debt is a little easier than someone that doesn’t have an RPP at all. Individuals who have no other pensions (not counting CPP and OAS) really need to consider the RRSP and how they will fund retirement.

Income levels below $37,606 in BC are already in the lowest income tax bracket. Contributing $5,000 to an RRSP while in the lowest bracket would result in tax savings of approximately $1,003 or 20.06 per cent.  Income over $150,000 is taxed at 45.8 per cent and this same contribution would save $2,290.   I would encourage the lower income individual to put the funds into a Tax Free Savings Account or pay down debt depending on other factors. If the lower-income individual’s income increased substantially, then the option to pull the funds out of the TFSA and contribute them to an RRSP always exists.

In order for your advisor to provide guidance about the right mix between TFSA, RRSP, or paying down debt, they require current information.  In some cases, your advisor should be speaking with your accountant to make sure everyone is on the same page.  Every situation is unique and your strategy may also change over time.  Preparing a draft income tax return in late January or early February helps your advisor guide you on making the right decisions.

The submitting of your completed tax return should be done only when you are reasonably comfortable you have all income tax slips and information. Some investment slips, such as T3s, may not be mailed until the end of March. We recommend most of our clients do not file their income tax return until the end of the first week of April.  By providing projected tax information to your advisor in January or early February you have time to determine if an RRSP should be part of the savings strategy. If it is not, the discussion can lead to whether you should pay down your mortgage or contribute to your Tax Free Savings Account.  

Most mortgages allow you the ability to pay down a set lump sum amount (such as 10 or 20 per cent) on an annual basis without penalty.  Every January you are given additional Tax Free Savings Account room. 

Rebalancing investments in two steps

A disciplined investment process begins with determining the asset mix that is right for you. By asset mix we refer to the portion you have in one of three broad categories of investments, including cash, fixed income and equities. Fixed income includes guaranteed investment certificates, term deposits, bonds, bond exchange traded funds, debentures, preferred shares, etc.. Equities are what many would refer to as the “stock market”. Life, markets and your asset mix all change with time. Decisions you made yesterday may not hold true with new information tomorrow. This is the reason that your investment strategy is not just about the markets. When you buy a house, have a child or approach retirement, your investment goals will change. As your goals change, so might your asset mix. For example, the asset mix of a very aggressive investor would not be suitable for someone who is retiring in the coming years. Just as major life events change us, we can also look at major market events as changing the way we look at our portfolio. For some investors this may be an opportunity for reflection. You may ask yourself if your “normal” asset allocation is still valid once you have considered any changes in your life. If that answer is yes, then when markets change as they do, it may also be time to consider rebalancing your portfolio back to its original mix.

Interest rate changes and market movement results in fluctuations between asset mix. From the day you begin investing, your asset mix is constantly changing. To illustrate, we will use Thomas and Heather Bennett who invested in a portfolio with the following asset mix: Cash 0 per cent, Fixed Income 40 per cent, and Equities 60 per cent. Asset classes do not change at the same rate. Over time, stocks may grow faster than bonds making the growth in your portfolio uneven. For example, the Bennett’s portfolio that started with 40 per cent bonds and 60 per cent equities could drift to 30 per cent bonds and 70 per cent equities if the stock markets rise, or alternatively the other way to 50 per cent bonds and 50 per cent equities if a stock market correction occurs. Regardless of the direction of the change in your portfolio, it is necessary to remember the importance of the reasoning behind your original asset allocation. Although it may seem counter intuitive to sell an asset class that is doing well or buy one that is not, however that is precisely what is required if the fundamental principle of “buy low – sell high” is to be followed. By rebalancing your portfolio, you are staying the course and increasing the potential to improve returns without increasing risk.

Disciplined rebalancing can provide comfort by taking the emotion out of your investment decisions. It does not seem natural to sell a portion of your investments that have done well and buy more of those that have been more sluggish. This discipline allows a reassuring way to buy when it is difficult and sell when it seems counterintuitive. When markets are down, human nature would have us get out rather than buy low, but a disciplined rebalancing process can prevail in the long run.

Although at times, the changes in the market may not be large enough for an investor to feel that there is any need to rebalance, the benefit to doing so can be significant over the long run with compounding returns. It is important to talk to your advisor initially to determine your optimal asset mix that you are comfortable with, often documented in an Investment Policy Statement (IPS). Once you have a documented IPS then your advisor can establish a customized portfolio that matches your IPS.

Rebalancing to your optimal asset mix should be done at least once a year. Prior to rebalancing, it is important to periodically review you IPS to ensure that you’re comfortable with the asset mix. Changes in market conditions and interest rate outlook are factors to discuss with your investment advisor when revising the asset mix within your IPS. Your personal goals, need for cash, and knowledge level may also result in your asset mix needing to be adjusted.

The asset mix is the macro decision within the IPS and is the first step in rebalancing. Step two of rebalancing is looking at the micro items, such as sector exposure and individual companies you have invested in. It also may involve looking at geographic exposure, credit quality and duration of fixed income, and mix between small, medium, and large capitalized companies. Up above, we noted that the Bennett’s initially wanted 60 per cent in equities and started with total investments of one million. The equity portion of $600,000 was divided into 30 companies with approximately $20,000 invested in each company. Over the last year, the Bennett’s now have a portfolio valued at $1,080,000 with 63 per cent in equities and 37 per cent in fixed income. Step one for the Bennett’s rebalancing of the asset mix would result in them selling three percent of equities, or $32,400, and allocating this to fixed income.

Step two in the rebalancing process highlighted that several stocks performed very well and are above the new individual recommended position size of $21,600 ($1,080,000 x 60 per cent divided by 30 companies). We also noted that stocks in two sectors performed very well and have resulted in the portfolio being too concentrated in those sectors. Step two of the rebalancing process resulted in the Bennett’s selling a portion of the star performers in the overweight sector.

When significant deposits and withdrawals are made then this is an ideal time to look at both macro (step one) and micro (step two) rebalancing. This could be when you are making an RRSP or TFSA contribution or when you have to decide what to sell to raise cash for your goals. If no deposits or withdrawals are made then periodic meetings with your investment advisor should have ‘rebalancing your portfolio’ as an agenda item. Some people may want to rebalance quarterly while others may feel an annual check up is sufficient.

Where to put your Savings – RRSP or TFSA?

It’s not always easy deciding where to put your savings.  Tax time is approaching, and investors must decide whether to make a Registered Retirement Savings Plan (RRSP) contribution.  At the same time you’re given a further amount that you can contribute to your Tax Free Savings Account (TFSA).  Also in the mix is whether or not to apply savings to reduce your mortgage if you still have one.

The Tax Free Savings Account (TFSA) has some amazing features that make it attractive and flexible, but the majority of people are not yet utilizing the TFSA, likely because of limited savings.  The Tax Free Savings Account started in 2009 when the annual contribution limit was set at $5,000.  However, effective in 2013, the new annual contribution limit is $5,500.  For those individuals who have not yet contributed to a TFSA, and were 18 years or older in 2009, the total accumulated amount that can be put into a TFSA now is $25,500.

The maximum RRSP contribution limit for 2012 and 2013 is $22,970 and $23,820, respectively.  The decision on whether to contribute to a TFSA or an RRSP is primarily focused on your current income and your future expected income.   We will use three different people, approximately 50 years old, to illustrate different outcomes assuming both the TFSA and RRSP are invested for twenty years and compounded growth of four per cent.  We will assume that each individual is considering a $20,000 RRSP contribution.

■ Mr. Wilson is in a high income tax bracket now (40 per cent) and he feels that he will also be in the same high income tax bracket in twenty years when he enters retirement.  For the current year, the $20,000 contribution would reduce Mr. Wilson’s current income tax liability by $8,000.  If Mr. Wilson didn’t contribute to an RRSP he would have $12,000 ($20,000 current savings less the $8,000 additional tax for not making an RRSP contribution) to invest in a TFSA.  Let’s look at the value of both the RRSP and TFSA funds after 20 years.  The TFSA would be valued at $26,293 and the RRSP would be valued at $43,822.  At first glance, the RRSP seems better, but it’s not – they are equal.   TFSA withdrawals are not taxable.  If Mr. Wilson is in the 40 per cent income tax at retirement (same tax rate as when he contributed initially) then any withdrawal from his RRSP is also subject to 40 per cent tax.  If Mr. Wilson withdraws $43,822 from his RRSP, then $17,528 is payable in tax and the net amount of $26,293 is equal to growth in the TFSA.   These are equal because Mr. Wilson’s income tax rate did not change at the time of contribution and at retirement.

■ Mr. Baker is in a high income tax bracket now (40 per cent) and he feels that he will be in a lower income tax bracket (20 per cent) in twenty years when he enters retirement.  For the current year, the $20,000 contribution would reduce Mr. Baker’s current income tax liability by $8,000.  If Mr. Baker didn’t contribute to an RRSP he would have $12,000 ($20,000 current savings less the $8,000 additional tax for not making an RRSP contribution) to invest in a TFSA.  Let us look at the value of both the RRSP and TFSA funds after 20 years.  The TFSA would be valued at $26,293 and the RRSP would be valued at $43,822.  Similar to Mr. Wilson above, the TFSA withdrawals are not taxable.   If Mr. Baker’s marginal income tax rate drops to only 20 per cent at retirement (half of what the rate was when he contributed initially) then any withdrawal from his RRSP is subject to 20 per cent tax.  If Mr. Baker withdraws $43,822 from his RRSP, then $8,764 would be the estimated tax and the net amount of $35,058 is higher then the TFSA balance of $26,293.   The RRSP option is better because Mr. Baker’s income tax rate was high when he contributed to an RRSP and was lower when he withdrew the funds from the RRSP.

■ Mr. Watts is in a low income tax bracket now (20 per cent) and he feels that his income will rise in the future and he will be in a high income tax bracket in twenty years when he enters retirement.  For the current year, the $20,000 contribution would reduce Mr. Watt’s current income tax liability by only $4,000.  If Mr. Watts didn’t contribute to an RRSP he would have $16,000 ($20,000 current savings less the $4,000 additional tax for not making an RRSP contribution) to invest in a TFSA.  Let us look at the value of both the RRSP and TFSA funds after 20 years.  The TFSA would be valued at $35,058 and the RRSP would be valued at $43,822.  Although the RRSP is still higher in 20 years, Mr. Watt’s income tax bracket has increased to 40 per cent.   Again, TFSA withdrawals are not taxable.  If Mr. Watt’s is in the 40 per cent income tax bracket at retirement (a higher tax rate then when he contributed initially) then any withdrawal from his RRSP will be subject to 40 per cent tax.  If Mr. Watt’s withdraws $43,822 from his RRSP, then $17,529 would be the estimated tax and the net amount of $26,293 would be lower than the TFSA amount of $35,058.

■ The decision between the mortgage and TFSA is fairly easy.  If you have a mortgage then I generally advise for the conservative approach of completely paying off the mortgage prior to contributing to a TFSA.  As noted above, the contribution limit accumulates so that you can contribute to your TFSA once your mortgage is paid off.  The sooner you get rid of paying non-deductible interest costs on your mortgage the sooner you’ll be able to make bigger leaps in your retirement savings.  The focus should always be on your net worth.  At the end of each year, ask yourself if your net worth has moved in the right direction.  Increasing your assets (i.e. investments) or reducing your liabilities (i.e. mortgage) will increase your net worth.

■ The decision between the mortgage and RRSP is not as easy as the TFSA.  The best option for high income individuals in the top income tax bracket is generally to contribute to an RRSP and then immediately use the tax savings to pay down the mortgage.   If you do not have a mortgage then you should consider contributing to both an RRSP and a TFSA if cash flow permits.  This strategy works very well if your income tax rate is high today, especially if your income is expected to be lower at retirement.