Tax-free savings enhance pensions

The simplicity of the Tax Free Savings Account is a great advantage because it is easy to explain.  Your contribution limit is the same whether you are a member of a pension plan or not.  This provides one of the first opportunities for people who belong to good quality pension plans to tax shelter additional savings from tax.

The RRSP contribution room formula is designed primarily to assist those individuals without a pension. The formula is straight-forward – you are able to contribute 18 per cent of your earned income.

Let’s look at Alice who works for a company without a pension plan.  Last year Alice earned $60,000 so her maximum RRSP contribution limit would be $10,800 (18 per cent x $60,000).

Alice’s husband Peter also earned $60,000 last year working for a company with a pension plan.  The main difference is Peter is a member of a pension plan.  Peter’s maximum RRSP contribution limit this year is reduced by a pension adjustment of $6,940.  Peter’s maximum RRSP limit is $3,760 ($10,800 – $6,940).   The pension adjustment varies depending on many factors.  The better the pension, the greater the adjustment on the RRSP room.  The key point is that Alice will be able to contribute more to her RRSP.

Employees belonging to municipal, government, or private pensions may benefit the most from the TFSA.   One of the disadvantages to belonging to a pension plan is the above illustrated pension adjustment (PA).  The PA grinds down the amount you can tax shelter in your RRSP.  For people who belong to a good pension, this leaves very little room to contribute to their own RRSP.

The TFSA will benefit people like Peter who have not been able to shelter all of their savings from tax.  Several strategies could be used to implement the TFSA for early retirement.  Different bridging options are generally available as you near retirement.  The TFSA can certainly be a source of cash if you choose to take a reduced pension or retire early.

Many of the good quality pension plans are starting to disappear.  These are often referred to as defined benefit plans.  With a defined benefits plan, you as the employee do not have to make investment choices.

In the future you will see less of these types of plans.  Instead, companies may provide defined contribution (money purchase) plans with you as the employee making the investment decisions.  Companies would rather shift the level of investment risk to their employees rather then incur the risk of poor markets.  This essentially means that people who belong to defined contribution pension plans have to assume more of the responsibility for their investment decisions.

We encourage people to look closely at the quality of their plan and the different investment options available.   When speaking with clients with defined contribution pension plans we ask them to provide us copies of periodic pension statements, along with the investment choices they have.

The main reason we ask for this information is to ensure that we are looking at their complete investment holdings.  Often at times we see that people do not fully understand the investment choices they have made within their pension.  Prior to doing any investing in a non-registered account, RRSP, or TFSA, it is important to obtain an understanding of the investments within your pension.  The biggest reason to do this is to ensure that all of your investments are combined for purposes of determining your asset mix (percentage of cash equivalents, fixed income, and equities).  This exercise often reveals improvements for your portfolio, including strategies to minimize tax, reduce investment costs, and avoid duplication within accounts.  Having a complete picture enables your investment advisor to discuss risk and design an appropriate strategy.

Members of pension plans should consider working with an investment advisor to assist them in mapping out a comprehensive financial plan.  The plan should include the TFSA and possibly an RRSP.  Payments from a pension plan are fully taxable (other than the pension income amount currently at $2,000 annually).  If your spouse is not receiving a pension then you may split the income with your spouse.  Add some tax-free withdrawals from a TFSA and you should be able to considerably enhance your after tax cash flow at retirement.