TFSA or RRSP? Cutting through the Confusion

When it comes to choosing between a Tax-Free Savings Account (TFSA) and a Registered Retirement Savings Plan (RRSP), there are plenty of details to keep you up at night. It’s important to look at the pros and cons of each plan, so you can develop a financial plan that’s right for you.

Your personal Financial Plan should include the income per year you will need after you retire to have the retirement lifestyle you want. Your Plan should also calculate the amount you will need to contribute to TFSA or RRSP per year to achieve this.

This will help you determine the difference between your current tax bracket and the tax bracket you will experience after you retire. It’s easy to assume your income will be less, so your tax bracket will be less, but that is not necessarily accurate. Many government income programs allow clawback provisions that put many seniors in shockingly high tax brackets!

Clawbacks are just like a tax and they can be an unexpected cost. If you look at the breakdown of the three most common clawbacks, you can see the difference between having a TFSA or an RRSP. Here’s how the three clawbacks break down:

1.      Low income (less than $20,000) – 50% clawback on GIS

2.      Middle income ($35,000-$85,000) – 15% clawback on the age credit

3.      High income ($75,000-$120,000) – 15% clawback on OAS

You can own the same investments in your TFSA as your RRSP. The main difference is that RRSP contributions and withdrawals have tax consequences, while TFSA contributions and withdrawals don’t.

Therefore, the answer to TFSA vs. RRSP is primarily based on your marginal tax bracket today compared to when you withdraw after you retire.

Rule of Thumb

RRSP is better if:

  • You will be in a lower marginal tax bracket during retirement. Example: Today you’re making $100,000 and you will receive $35,000 during retirement, you can get a tax refund of 43% on your current deposits and pay only 20% tax on your retirement withdrawals, giving you a gain on the actual value of your RRSP of 23%.

TFSA is better if:

  • You will be in a higher marginal tax bracket during retirement. Example: Today you’re making $40,000 and you will receive $20,000 during retirement, you can get a tax refund of 20% on your current deposits and pay out 70% when you make retirement withdrawals. This figure includes lost GIS from the clawback. This saves you a 50% loss on your entire RRSP.

You can choose either an RRSP or a TFSA if:

  • You will be in the same marginal tax bracket during retirement.

Other Details to Consider

If you are still unsure if an RRSP or a TFSA is right for you, answer these two important questions:

1.      How will I use my tax refund?

  • TFSA is best if you plan on spending your RRSP tax refunds. Example: if you deposit $10,000 to either a TFSA or an RRSP and then spend the refund, the TFSA will give you a higher retirement income. You need to reinvest your tax refund for RRSPs to provide you the same after-tax retirement income as TFSAs.

2.      Is the withdrawal flexibility from my TFSA a pro or a con?

  • Flexibility is good, but if you are tempted to withdraw before retirement, RRSP might be a better choice.

Sound Financial Planning

It is advisable to plan on retiring with a taxable income in the low-to-mid level tax brackets. Since the cash that you live on can vary from your taxable income, it’s important to remember that TFSA withdrawals that are non-taxable. They can give you cash income that is not taxable income. Other tax deductions must be factored in to figure out the tax bracket you will be in.

Example: Basic government pensions are $20,000. OAS is $7,000 maximum, based on your number of years residing in Canada. CPP can range from $0 to $13,000, depending on how much you’ve deposited in the past. From here, calculate your income from your RRSP and TFSA and any other investments. You can generally withdraw 3-4% (depending on how you invest) of your RRSP or TFSA each year and have it last as long as you live.

This should help you determine which plan is right for you. You can plan to be in the right tax bracket. If you currently earn $80,000 and will retire with $50,000, you may be tempted to think TFSA is best since you will get a refund of 31% today but will pay 34% at withdrawal. However, with only $5,000 per year from non-taxed TFSA, your taxable amount is down to $45,000 which puts you in the 23% category, so RRSP is actually better. In this example, you need enough TFSA for the $5,000 per year but the rest should go into RRSP.

Important Note

Don’t forget to adjust for inflation! All of your retirement calculations need to factor in inflation. It will roughly double your cost of living in 20 or 25 years.

Forgetting to include inflation is the most common error many people and advisors make in estimating retirement income and how large of a nest egg you will need.

What about non-registered investments?

In some cases, non-registered investments may actually be better. Just maximizing TFSA and RRSP is not always the best answer. If your taxable income in retirement will be in a higher tax bracket than now, non-registered investments might be a smarter choice. If using your TFSA to the maximum will still leave you in higher tax brackets, non-registered investments will give you more cash at lower tax brackets than RRSP.

Example: Currently you make $80,000 and you plan to retire with $80,000, you get a 31% refund now but will have to pay as much as 44% when you withdraw because of the OAS clawback. Upon retirement, you can only get $45,000 at lower tax bracket rates than your current tax bracket.

If you plan on getting $20,000 from government pension, then you need to plan now for enough RRSP to give you $25,000 income. The rest should be in TFSAs. However, that won’t be enough. You will still need $35,000 more. That’s when non-registered investments might pan out better for you than RRSPs.

But don’t forget the taxes. Non-registered investments are not always tax free, depending on how they are invested, and the interest is always taxable. Capital gains, however, are only half taxable. Dividends are given preferred tax rates but they also get higher clawbacks because the income for determining clawbacks is the “grossed-up dividend”, which is 38% more than the dividend.

Let’s look at a worst-case scenario for non-registered investments: a senior making $20,000 gets a dividend of $1,000 which has a clawback of $690 (50% of $1,380). In this case, there is no income tax, but you still lose $690 out of the $1,000 in reduced GIS income.

If you sell a bit of your non-registered investments each month, you can get a nice, low tax rate on the cash. My term for this is “self-made dividends.” Since your cash income is made up of your capital gains and your original investment, the tax is very low, often only 10% of your withdrawal.

Bottom Line

1.      RRSP –

  • medium working income $50-80,000 and modest retirement savings
  • high working income over $90,000

2.      TFSA –

  • low working income under $45,000
  • medium to high working income with no retirement savings
  • medium to high working income with large retirement portfolio

How much should I save?

Generally speaking, a modest savings would be $500,000-$700,000 when you retire. Factoring in inflation, this would amount to approximately $1 million to $1.4 million if you plan to retire in two decades.

Plan in Place

Now is the time to prepare a Financial Plan that will help you sift through the options while understanding all the details such as tax brackets, clawbacks and inflation. In my experience, when my retired clients have a portfolio consisting of a good RRSP or pension, a strong TFSA and some non-registered investments, we can come up with a good plan for how much they can withdraw annually while minimizing the amount of taxes that are required.

With a mix of fully-taxed, low taxed and non-taxed sources of income, we can plan effectively for you to receive the cash for the retirement you want, while remaining in lower tax brackets.

A sound financial plan that cuts through the confusion of TFSAs and RRSPs set you up for a comfortable and worry-free retirement. It will have the optimal strategies that are right for you.

Understanding the Differences Between Financial Advisors and Brokers

Advice Channel
Advisors Channel

As a fee-only financial advisor, I am surely biased to this type of advisor. I do think everyday investors are much better off if they have someone in their corner who is recommending a particular investment product because it actually is the best product for them, given their circumstances and life stage. Not because there’s a commission on the sale at the end of the day.

That doesn’t mean, though, that you shouldn’t be mindful of possible issues – and that’s for any financial advisor, whether fee-based or full-service brokers. For that matter, you also should be mindful of potential drawbacks to other options that may seem (superficially, at least) appealing.

Let’s look at the options.

Fee-only financial advisors are considered advantageous because there’s no inherent conflict of interest as there can be with full-service or commission-based brokers. Brokers often recommend investments owned by their company, which is an inherent conflict.  You simply have to consider whether the products recommended are going to be best for your personal financial goals.

What you pay for is financial guidance, planning and assistance. This may be a flat fee. Some advisors charge a percentage of your account’s assets. You may be able to negotiate the amount. But, the fees you pay do not fluctuate according to the type of investments that are being recommended. What you get with this approach is objectivity and investment advice that’s unbiased. Your interests and your advisor’s are aligned.

The commission-based approach to financial advisory services is less the norm today than in the past. You open an account or buy a stock or bond and your advisor gets a percentage. Recurrent trading may also be encouraged – which may not be good for investors with a longer-term perspective. This all can pose a conflict with your best interests and goals.

And on the do-it-yourself front? Well, as attractive as this might sound on the surface, consider the relevance of the saying about the attorney who represents himself. For investment purposes, you might find good information online, but it’s just as likely you’ll find speculative information, if not real fake news. Investing is a risky business; if you don’t have the time or the expertise to do an adequate job of qualifying research, get a professional to help. Your future – financial and otherwise – depends on it.

Speaking of your financial future, it’s never too early to start planning for it. That means Millennials – and even the oldest Generation Zs who are just entering the workforce – should be putting money aside as they think about their long-term financial goals. It’s a challenge, of course, especially for those who are still trying to pay off college. Retirement is maybe too much to think about, right?

With that said, I’ve developed a service package to make it less painless. My new Robo-Advisor Professional service package is specifically targeted to the needs of Millennials and utilizes an in-depth financial data collection sheet, as well as a plan discussion with myself, to collect essential information about your financial background and goals.  This provides a strong base of understanding for clients to invest in ETFs through WealthSimple with a superior portfolio manager with a track record of beating the index.

ETFs are ideal for those with more limited resources, as a “wrapper” around a group of securities. They have a cost advantage over individual stocks and can be traded commission free. They’re similar to mutual funds, but with more flexibility as they can be traded throughout the day, not just once.

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Tax Free Savings Accounts

“To (contribute) or not to (contribute), that is the question.”
–  The Tragedy of Hamlet, Prince of Denmark, Act III, Scene I, written by William Shakespeare;
(the word “be”  replaced with contribute)

Written by Steve Nyvik, BBA, MBA, CIM, CFP, R.F.P.
Financial Planner and Portfolio Manager, Lycos Asset Management Inc.

What is a TFSA?

A Tax Free Savings Account, or TFSA, is a Canadian government approved investment account designed to encourage you to save tax effectively for your needs.

Contributions to a TFSA are not deductible in computing income for tax purposes.  However, the income and gains (or losses) on investments held within a TFSA are not included in computing income for tax purposes or taken into account in determining eligibility for income-tested benefits or credits[i].  And withdrawals from a TFSA are also tax-free[ii].

Contribution Limit

TFSA contribution room accumulates every year, if at any time in the calendar year you are 18 years of age or older and resident in Canada[iii].  You will be able to make total TFSA contributions up to the contribution limit that you have available.

You will accumulate TFSA contribution room for each year even if you do not file an income tax and benefit return or open a TFSA[iv][v].

Years

TFSA Annual Limit

2009

$5,000

2010

$5,000

2011

$5,000

2012

$5,000

2013

$5,500

2014

$5,500

2015

$10,000

2016

$5,500

Cumulative Total

$46,500

NOTE:  The TFSA annual room limit will be indexed to inflation and rounded to the nearest $500.

Unused contribution room will be carried forward to future years.  For example, if you contribute $2,000 to a TFSA in 2009, your contribution room for 2010 will be $8,000 ($5,000 for 2010 plus the $3,000 carried forward from 2009).  There will be no limit on the number of years that unused contribution room can be carried forward.

Any amounts withdrawn from your TFSA in a year will be added to your contribution room in the following year[vi].  This will give you the ability to re-contribute an equivalent amount in the future[vii].

Excess contributions are subject to a penalty tax of one percent per month.

Qualified Investments

A TFSA can hold the same investments as a Registered Retirement Savings Plan (RRSP).  The RRSP qualified investment rules accommodate a broad range of investments including, for example, mutual funds, publicly-traded securities, government and corporate bonds, guaranteed investment certificates and, in certain cases, shares of small business corporations.

“In kind” Contributions

You can make “in kind” contributions (for example, securities you hold in a non-registered account) to your TFSA, as long as the property is a qualified investment[viii].

You will be considered to have disposed of the property at its fair market value (FMV) at the time of the contribution.  If the FMV is more than the cost of the property, you will have to report the capital gain on your income tax return.  However, if the cost of the property is more than its FMV, you cannot claim the resulting capital loss.  The amount of the contribution to your TFSA will be equal to the FMV of the property.

Withholding Tax on Foreign Income

As a TFSA is typically not viewed to be a qualified pension plan, income from foreign investments within the TFSA is likely subject to withholding tax which is usually not recoverable.  This can make foreign income paying investments less competitive to a Canadian investment where there is no withholding tax.

The withholding tax rate and any exemptions available depend on the tax treaty that Canada has signed with the country where the company issuing the investment is located.  For example, the withholding tax rate on dividends for U.S. stocks and American Depository Receipts (ADRs) is 15 per cent[ix].

Income Attribution Rules

If you transfer property to your spouse or common-law partner, the income tax rules generally treat any income earned on that property as your income.  An exception to these “attribution rules” will allow your spouse to take advantage of the TFSA contribution room available to him or her using funds provided by you: the rules will not apply to attribute income earned in a TFSA back to you.

Treatment on Death

When you die, your TFSA from the date after your death loses its tax-exempt status.  In other words, investment income and gains that accrue after your death will be taxable, while those that accrued before your death will remain exempt.

A TFSA permits you to designate a beneficiary whereby the TFSA assets bypass your estate thereby avoiding probate and legal fees.

Where you designate your spouse or common-law partner as the successor account holder (and he or she survives you), the account will maintain its tax-exempt status.  In effect, the TFSA continues with your surviving spouse as now being the owner of the TFSA and any income or gains continues to grow on a tax-exempt basis.

If you name a beneficiary someone other than your spouse or common law partner, future tax-exempt growth is lost, but you’ve at least avoided probate and legal fees and any delay to transfer assets.  The financial institution[x] would require receipt of your certificate of death and a letter of direction to transfer the TFSA assets to the designated beneficiaries.

Transfers on marriage breakdown

On the breakdown of a marriage or common-law partnership, an amount may be transferred directly from the TFSA of one party to the relationship to the TFSA of the other.  In this circumstance, the transfer will not re-instate contribution room of the transferor, and will not be counted against the contribution room of the transferee (the recipient).

Non-Residents

An individual who becomes non-resident will be allowed to maintain his or her TFSA and continue to benefit from the exemption from tax on investment income and withdrawals.  However, no contributions will be permitted while the individual is non-resident, and no contribution room will accrue for any year throughout which the individual is non-resident.

U.S. Citizens, U.S. Residents or Greencard Holders

If you are a U.S. citizen or U.S. resident, you should seek advice from your U.S. Tax accountant as a TFSA is not considered a qualified pension and may be disregarded for U.S. tax purposes (i.e. it might be viewed like a Grantor Trust).  As such, the TFSA may be subject to adverse U.S. income and estate tax consequences.

Should you contribute to a TFSA or RRSP?

If you do not have enough to contribute the maximum to both an RRSP and TFSA, the choice of which to contribute to will depend on your particular circumstances.  The important factors that impact the decision include:  (i) the particular use of the funds, (ii) your marginal tax rate at the time of contribution, and (iii) your marginal tax rate at the time of the anticipated withdrawal.

Where your marginal tax rate at the time of contribution is the same as the time of withdrawal, the contribution to an RRSP or TFSA may have almost equivalent results.

It may make better sense to contribute to an RRSP where:

  • the marginal tax rate for RRSP withdrawals will be lower than the marginal tax rate when contributions are made; or
  • you are planning to buy a home (qualifying withdrawal for the $25,000 Home Buyer Plan) or attend a post-secondary educational institution (where the withdrawal will be a qualified withdrawal under the Lifelong Learning Plan).

It may make better sense to contribute to your TFSA if:

  • you expect the marginal rate at the time of withdrawal will be higher than the marginal rate at the time of contribution; or
  • you anticipate that RRSP withdrawals in retirement may cause the loss of Guaranteed Income Supplement (GIS), a clawback of your Old Age Security or a reduction in other benefits (eg. like increasing your payment threshold for BC PharmaCare benefits where the government pays the cost on eligible prescription drugs and medical supplies).

The Next Step

To help develop your estate plan including beneficiary designations for your TFSAs, RRSPs and RRIFs, please contact our financial planner, Steve Nyvik.  He will work together with your estate planning lawyer to help custom design and implement your estate plan.  Estate Planning is included as part of the service for Steve’s clients of Lycos Asset Management Inc.  Steve can be contacted by calling: (604) 288-2083 or by email: Steve@lycosasset.com

 

[i]       In other words, income or gains within the TFSA or withdrawals from a TFSA have no impact on income tested benefits and credits including Old Age Security (OAS), the Guaranteed Income Supplement (GIS), Employment Insurance (EI) benefits, Canada Child Tax Benefit (CCTB), the Goods and Services Tax Credit and the Age Credit.

[ii]      Administrative or other fees in relation to TFSA and any interest or money borrowed to contribute to a TFSA are not deductible.  There is no prohibition in the Income Tax Act on an individual’s ability to use their TFSA assets as collateral for a loan.

[iii]      A person determined to be a non-resident of Canada for income tax purposes can hold a valid SIN and be allowed to open a TFSA; however, any contributions made while a non-resident will be subject to a 1% tax for each month the contribution stays in the account.

[iv]      The TFSA dollar limit is not prorated in the year an individual:

  • turns 18 years old;
  • dies; or
  • becomes a resident or a non-resident of Canada.

[v]      There is no lifetime limit to the amount of contributions.

[vi]      You must keep records on your TFSA transactions to ensure that you do not exceed your TFSA contribution room.  The Canada Revenue Agency (“CRA”) will receive from your financial institution, where you have a TFSA, information each year as to contributions and withdrawals.

You can request from the Canada Revenue Agency a TFSA Room Statement.  You can also log into your CRA online account to obtain your contribution room based to the end of the previous tax year.

[vii]     The easiest way to establish a record of your TFSA contribution room is to file a tax return annually, even if you have no taxable income.  Your TFSA contribution room can then be seen through Canada Revenue Agency’s My Account or Quick Access e-services, or you can phone CRA to get the balance.  However, the amount reported will only be correct as of January 1st of each year, after financial institutions have reported all TFSA transactions for the prior year, which may not be until the end of March.

[viii]     You cannot exchange securities for cash, or other securities of equal value, between your accounts, either between two registered accounts or between a registered and a non-registered account (these transactions were known as swaps).

[ix]      You may be required by your financial institution to file IRS Form W-8BEN-E in order for the withholding tax to be reduced from 30% to 15%.

[x]      Financial institutions eligible to issue RRSPs will be permitted to issue TFSAs.  This includes Canadian trust companies, life insurance companies, banks and credit unions.

Interest Rates Rising – the sequel

Mal Spooner is a veteran fund manager and currently teaches at the Humber College School of Business.
Mal Spooner is a veteran fund manager and currently teaches at the Humber College School of Business.

No doubt you’ve noticed about half the industry pundits cautioning that the US Federal Reserve is closer to ‘tightening’ monetary policy.  What this implies for us regular folk is that they will introduce monetary measures that will allow interest rates to rise.  We have enjoyed a very long period of inflation and interest rate stability following the financial crisis (a crisis almost forgotten by many).  Despite a recent slowdown in come economic indicators, efforts by governments around to world to jumpstart an economic recovery did bear some fruit.  The rebound in profitability, employment and growth has been particularly robust in the United States.  Both Europe and China are now making efforts to replicate this success by bolstering liquidity in their financial systems as the US did.

So what’s to worry about?  Savvy investors will have already noticed that interest rates in the world’s strongest economy have already begun to rise, even before the FED has taken any action.  This is what markets do – they anticipate rather than react.  Some forecasters predict that although interest rates are bound to trend upward eventually, there’s no need to panic just yet.  They suggest that there’s enough uncertainty (financial distress in Europe, fallout from falling energy prices, Russia’s military ambitions, slow growth in China) to postpone the threat of rising rates far into the future.

Yield Curves 2015-05-02_15-28-30

What they are ignoring is that the bond markets will anticipate the future, and indeed bond investors out there have already begun to create rising interest rates for longer term fixed-income securities.  The graph illustrates that U.S. yield curves have shifted upward.  The curve shows market yields for US Treasury bonds for various maturities back in February compared to rates more recently.  So what’s the issue?  If investors hang on to their bonds while rates are rising, the market value of those bonds declines.  This often comes as a surprise to people who own bonds to avoid risk.  But professional bond traders and portfolio managers are acutely aware of this phenomenon.  So they begin to sell their bonds (the longer term-to-maturity bonds pose the most risk of declining in value) in order to protect themselves against a future rise in the general level of interest rates.  More sellers than buyers of the bonds pushes down the market price of the bonds, which causes the yields on those same bonds to increase.

Many money managers (including me) have learned  that despite how dramatically the world seems to change, in many respects history does repeat itself.  For example, while writing my CFA exams back in the mid-1980’s, I was provided with sample exams for studying, but they were from the most recent years.  I figured it was unlikely that questions on these sample exams would be used again so soon, and managed to do some digging in order to find much older previous exams.  I reasoned there are only so many questions they could ask, and perhaps older exam questions might be recycled.  I was right! In fact several of the questions on the exam I finally wrote were exactly the same as the ones I’d studied from the old examination papers.

In my experience recent history is not useful at all when devising investment strategy or trying to anticipate the future, but often a consideration of historical events further back in time – especially if trends in important economic drivers are similar – can be very helpful indeed.

The consensus is that interest rates will rise eventually.  But it is human nature to stubbornly hang on to the status quo, and only reluctantly (and belatedly) make adjustments to change.  What if what’s in store for us looks like this:  Consistently increasing interest rates and inflation over the next decade?  This has happened many times before (see graph of rising 10-year Treasury bond yields from 1960-1970).

US Treasury Yields 1960 - 1970

Before you rant that things today are nothing like they were then (and I do agree for the most part) consider the following: Is the boy band One Direction so different today compared to The Monkeys then?  And wasn’t the Cold War simply Russia testing the fortitudes of Europe and America just like the country is doing today?  Weren’t nuclear capabilities (today it’s Iran and North Korea) always in the news?

Yes there have been quantum leaps in applied technology, brand new industry leaders in brand new industries.  China’s influence economically was a small fraction of what it is today.  So where is the commonality? The potential for rising interest rates coming out of a recession.  The US government began raising rates in 1959, which caused a recession that lasted about 10 months from 1960 – 1961.  From that point until 1969 the US economy did well despite rising interest rates and international crises.  But which asset classes did well in the environment?

Growth of $100 - 1960 to 1970

Could the disappointing 1st quarter economic data be hinting that we might also be entering a similar transitioning period?  Inflation is bad only for those unable to pass higher prices along to customers.  If the economy is strong and growing then real estate and stock markets provide better returns.  Since the cumulative rate of inflation between 1960 and 1970 was about 31%, investors essentially lost money in constant dollars (returns below the rate of price inflation) by being invested in the bond market.  They would have done better by simply rolling over short-term T-Bills.  An average house in the US cost about $12,700 in 1960 and by 1970 cost $23,450 – beating inflation handsomely.

Do I believe we will see a repeat of the 60’s in terms of financial developments?  Yes and no!  There will be important similarities – especially in terms of stock markets likely performing well enough and the poor prospects for the bond market. There will be differences too.  The outlook for real estate is clouded by the high level of indebtedness that has been encouraged by extremely depressed interest rates over the past few years.  Higher rates mean higher mortgage payments which might serve to put a lid on real estate pricing, or cause prices to fall significantly for a period of time before recovering.

Companies that have substantially financed their acquisition binges with low-cost debt will soon find that unless they can pass along inflation to their customers their profit margins will be squeezed.  Who will benefit?  Commodity producers have had to significantly reduce their indebtedness – commodity prices tend to stagnate when inflation is low, and even decline when economies are growing slowly.  In a global context, these companies have had a rough time of it.  It is quite possible that their fortunes are about to improve.  If Europe and China begin to enjoy a rebound then demand will grow and producers will have more pricing power – perhaps even enjoying price increases above the rate of inflation.

Do I believe any of this retrospection will prove useful?  I hope so.  The first signs that a different environment is emerging are usually evident pretty quickly.  If there were a zero chance of inflation creeping back then why are some key commodity prices showing signs of strength now?

recent aluminum price recent copper price data

If we begin to see inflationary pressures in the US before Europe and Asia, then the $US will depreciate relative to their currencies.  In other words, what might or might not be different this time is which countries benefit and which countries struggle. Globalization has indeed made the world economy much more difficult to come to grips with.  Nevertheless, there are some trends that seem to be recurring over the years.

There will be recessions and growth spurts.  In recessions and periods of slower growth, some formerly stronger industries and companies begin to lose steam as a paradigm shift takes place, but then other industries and companies gather momentum if the new reality is helping their cause.  This is why I’ve biased my own TFSA with commodity-biased mutual funds (resource industries, including energy) and a European tilt.  You guessed it – no bonds.

Any success I enjoyed while I was a money manager in terms of performance was because exercises like this one help me avoid following the mainstream (buying into things that have already done well) and identifying things that will do well.

 

 

 

 

 

 

 

Why You Should Contribute this RRSP Season

Now that it’s RRSP season, it’s time to  dust off your finances and see if you can  boost your retirement nest egg, and get  a tax deduction as well. Here’s what  you need to know about RRSPs.

RRSP: The Basics

If you have Earned Income, a Social  Insurance Number and are 70 or  under, it’s possible to contribute to  an RRSP. RRSP season is the first 60  days of the year when it’s possible to  make a contribution and apply the tax  deduction to the previous year. You can  still lower your previous year’s tax bill —  and improve your retirement portfolio  — as long as you are within that 60 day  time threshold.

How much can you contribute?

The contribution for the year is the  lower of 18% of your Earned Income  from the previous year or the maximum  annual contribution limit for the  taxation year (less any company sponsored  pension plan contributions).  For income from 2014, the maximum  contribution is $24,930.

One of the great things about the RRSP   is that you have the ability to carry  forward unused contribution room. For  most taxpayers, the easiest way to find  your RRSP limit is to look for your CRA  Notice of Assessment. When your tax  return is processed, Canada Revenue  Agency sends this to you each year.

How the RRSP Can Benefit You

Not only do you receive a tax deduction  for your contributions you also benefit  by growing your wealth over time,  making for a happier retirement.  Over the long-term, tax deferred  compounding really helps your RRSP  grow faster. In your RRSP, you can hold  any number of investments, including  stocks, bonds, and various funds. If you  consistently invest money, the magic  of tax deferred compounding means  your nest egg grows better over time,  resulting in a larger portfolio in the end.

Defer the tax deduction

Another great feature of the RRSP is the   fact that it’s possible for you to defer  your tax deduction if you wish.  If you know that you will be in a higher  tax bracket next year, or the year after,  you can make your contribution this  year, pay tax as usual, and “save” the  deduction for a time when your higher  tax bracket means that you benefit  more. And, in the meantime, your  investment continues to grow taxdeferred.

Other uses of the RRSP

Finally, it’s possible to use your RRSP  to achieve other financial goals. If you  have been saving up to buy your first  home, your RRSP can be used in your  strategy. Say you’ve been saving up,  and you have $25,000 to use as a down  payment on a home. You also have  $20,000 in unused RRSP contribution  room. You can take part of that chunk  of capital you have saved up and use it  to fill up your contribution room. Now,  you have a tax deduction. Because you  can use money from your RRSP penalty  to buy your first home, you can turn  around and take that money out again  for use in your down payment.

So, you have a tax benefit, just for  knowing about this little trick.  It’s also possible to use your RRSP  to give yourself a student loan. You  can borrow up to $20,000 to pay for  qualifying education, but you have  to pay it back over 10 years. Still, it’s  better to borrow from yourself — and  pay yourself back — than it is to pay  interest to someone else.

Before RRSP season comes to a close,  evaluate your situation and determine  whether or not it makes sense for you  to employ a new strategy. RRSPs may  not be for everyone but it still remains  the best tool for retirement savings  because of its powerful tax benefits.

Jim Yih is a best-selling author, fee-only  financial advisor, a professional speaker  and the founder of the award winning  blog www.RetireHappy.ca. You can find  him on twitter @jimyih.

RRSP Season – Again?

RRSP season is almost upon us!  We’ve been told time and again that we need to make a contribution to save for our future.  The hard part is not so much making the contribution as deciding where to put it.

Early in my media career it was mandated that I take an arms-length approach to investing.  If I mentioned a stock on air it was thought that the media attention could move the stock price.  It didn’t happen, or at least not that often, but it did force me to invest differently.  I’m not a financial planner, but personally I figure that my best investment is simply not letting the government take my money away from me.  My return, in that context, is based on my tax rate.

If I’m taxed at 18 percent, then I ‘earn’ 18 percent by saving on taxes, even for a small contribution.  18 percent is almost twice the result for the Canadian stock market did in 2014!   The trick is to try to keep that, maybe to grow it.

The simplest solution is to put ones money in the bank.  You earn next to nothing, but you know that it’ll be there when you need it.  Pretty lame.  The next best solution is to earn some interest.  That would mean investing in the bond market.  Over the past 3 decades that’s proven to be a good idea as interest rates generally declined; as rates fall, bond values go up.  The problem now is that interest rates are near historic lows.  If rates go up from here, then bond prices will go down.  Sure, if you hold bonds until they mature you’ll get your capital back plus any interest they’ve paid, but the wait is the problem.  Government bonds may be the safest place to invest but they pay the poorest rates.

To get any kind of return, an investor is faced with taking on more risk.  That risk is manageable, but requires expertise and the returns may be only slightly better than marginal.  If an investor is willing to take on even a bit of risk, then the stock market is the place to look.  Over the past year, global markets were up 2.1% as measured by the Dow Jones Global Index.  That’s hardly robust and the range was very broad: The Merval (Argentina) was up 59%, the Russian Trading System Index was down 45% (both in US$ terms).  Closer to home, over the past 5 years the S&P/TSX Composite faired OK at up 23%, but underperformed the US’s S&P 500 which was up almost 80%!

For 2015 it’d be easy to make recommendations, and many do.  What’s lost on many investors is that those recommendations are dynamic – they change over time!  For example, the oil and gas sector has been hurting as oil prices have declined significantly from a year ago, and can go lower, but there’s a point at which the stocks themselves start to represent some very real value.

Here’s where I throw in the towel!  In my early media days I put my money into mutual funds.  They were diversified globally and across sectors, plus professionally managed.  Over time I realized that many, no … most, fund managers didn’t beat their benchmark indices.  If the Dow Jones was up 10% then the large-cap American fund in which I was invested, often wasn’t!   That hurt!  I expected more!  Some of these managers I knew and respected, but the markets were beating them!

I was so disappointed that I took things into my own hands I bought some ETFs (Exchange Traded Funds) that tracked their indices in sort of a ‘If-you-can’t-beat-‘em-join-’em’ approach.  I bought some blue-chip stocks and harvested dividends. That was fine until the market corrected.  The blue-chips collapsed and the indices screamed lower.

I’ve come to realize that the biggest service that a professional manager can give is giving decent growth while protecting capital when things go sour.  They call it upside and downside capture.  If the market is up 100, how much did the manager get?  More than 90 percent of that?  If it’s down, how much is the manager down?  I’m back to using mutual funds a lot, stock and bond.  The markets are sure to be volatile as interest rates change and the economy lurches forward.  I need someone to watch-over my investments.  Do I make the most money?  No.  Do I care?  No?  I’m looking to keep most of what I’ve kept from the tax man … maybe grow it.

GICs, RRSPs and TFSAs – what make sense for you?

As usual for this time of year, financial institutions across Canada are trying to find a way to separate you from your money – not actually stealing it but rather asking you to give it them (lend) in return for some interest over some period you select.

There are traditional GICs that pay a fixed rate for each year in the term you choose.  There are “rate-riser” GICs where the nominal annual rate increases each year – usually contained in 3-year versions.  Some are cashable before maturity, others are locked-in (unless you happen to die of course).  Some companies issue and promote index-linked or equity-linked GICs and even use words such as “risk-free” to try and confound potential purchasers.

The traditional parts of the banking system (banks, trust companies, credit unions and caisse-populaires) generally restrict their offerings to those with maturities of 5 years and less.  The only reason being that they can then promote “your capital is fully guaranteed or protected” by deposit insurance through CDIC (Canadian Deposit Insurance Corporation) or the CUDIC (Credit Union Deposit Insurance Corporation) or some other provincial or territorial equivalent body.  All true, of course, but what does that really mean to you and I?  Nothing, quite frankly.

On the insurance side of the fence, these same products are available but terms can (if you so choose) stretch up to 20 years and are also protected to similar limits by ASSURIS – the insurance industry equivalent to CDIC and CUDIC coverage.

GIC ladders are increasingly popular as people are reluctant to lock in large sums for a single term since no-one is able to predict future rates – and if rates go up, everyone wants in!  A ladder works quite simply.  You divide your investment into say 10 equal pieces. With 1/10th, you purchase 1 year GIC, with 1/10th you purchase a 2-year GIC – then repeat until all 10 pieces are used.  You now have 1/10th of your money coming due every year so you can catch rising rates and are protected from dropping rates.  As each matures, you then just buy 10-year GICs.  Do this with each years’ deposit to your RRSP and TFSA, and in a short time, you have a well-balanced GIC portfolio.

No doubt you have heard or read about Equity- or Index-linked GICs.  Many financial institutions market variations of these products.  The intention is to provide the guaranteed return of your principal and give you the potential of higher returns based on some external equity fund or market index.  There are no options for early withdrawal.  Let’s visit with Sarah and Lee.  They are making plans for their annual contributions and are frustrated with the choices available for several reasons.

This product is not always available.  Many institutions only offer these products during “RRSP Season”.  In addition, sales of new issues are sometimes suspended because of periods of poor market performance.

Limited choice of terms.  Usually these products are only offered for a 3 or 5 year term.  If Lee and Sarah want a different term, they are out of luck.

Limited choice of equity or index links.  The company offering the product makes the investment choice.  All issues have a maximum rate of return that they will pay – a cap on returns.  Clients are in a take-it or leave-it position.

Lee and Sarah are looking for greater choice and control over their investment, both in duration and the investment performance portion of the GIC.  They are looking for a better way to invest and get the best of both worlds.  There is good news for them – it can be done and without the restrictions of the other products.

Lee and Sarah, together with their financial advisor designed their own equity-linked GIC with no restrictions, full flexibility and no cap on returns.

First, they choose their own term.  In most cases, a longer term – say 5 to 7 years at least, is preferable.  Time is their friend since it gives the equity portion of their investment a higher probability of good returns.  A term of 10 years or more is even better!

Next, they buy a plain, regular, off-the-shelf redeemable GIC to guarantee their full principal. After discussing things, they decide a 7-year term is appropriate and they have $75,000 to in their current plans.  After pushing a few buttons on a financial calculator and knowing the 7-year GIC rate is 4%, they need to deposit $56,993 today so it will be worth $75,000 in 7 years.

Finally, they choose their equity investment.  With just over $18,000 left to invest in equities, they now consult their advisor for an appropriate solution.  They can use mutual funds, segregated funds, Index funds, ETFs or individual stocks or bonds.  Their advisor will have them complete a Risk Tolerance questionnaire to determine appropriate choices.  This will be their profit with no cap!

Sarah and Lee are happy to have control of their investment with no upside limits and no restrictions on liquidity or withdrawal.  Shouldn’t you take control of your choices?

Don’t try and make your decisions in a vacuum.  A well-qualified advisor is your friend – particularly one has access to broker-direct services throughout both the traditional and insurance-industry GIC product line.  Check with the Money Magazine, Fall 2014 issue and you can see that sometimes using a deposit broker can increase yields on traditional GICs by up to 40%!

I Want Tax free Income

The LinkedIn discussion considered ROTH vehicles invested in equities and “cash value” Life Insurance as two ways to obtain Tax Free Income… something was missing.

Why not buy tax free muni bonds in the form of Closed End Funds (CEFs)…. more than 6% tax free, in monthly increments, plus the opportunity to take profits (taxable, yes) and compound the income until it is needed. Or spend it right away, for that matter.

The vast majority of Tax Free CEFs continued (raised even) their monthly payouts during the financial crisis, and no payments were missed.

ROTHs have a “lock up” period, and cash value life insurance…. someone please tell me how this provides tax free income and when.

If left in the ROTH vehicle, should one still be buying equities? or investing in income producers?

Experienced, taxable CEFs pay in the 7% to 8% range right now… and seemed to be financial crisis proof in 2008 through 2010.

Growing income portfolios is my business… can’t be done nearly as well with funds and insurance policies. For over 6% tax free income right now, create a diversified portfolio of tax free CEFs.

Yes, market value fluctuates, but with little or no impact on income production. I want tax free income too… and this is how I get it, both personally and for my managed portfolios.

The principles explained in this video webinar are equally applicable to the Tax Free Income building portfolio:

https://www.dropbox.com/s/b4i8b5nnq3hafaq/2015-02-24%2011.30%20Income%20Investing_%20The%206_%20Solution.wmv?dl=0

Retirement Income Investing: The Dreaded RMD

All of us are approaching retirement, many of us are already there, and some of us (myself included) are thinking about the ultimate IRS slap-in-the-face… The Required Minimum Distribution. It’s time to make sure that your retirement income program is actually ready.

Every investment program becomes a retirement income program eventually.

First off, you need to get to a place where you can say:

“a stock market downturn will have no significant impact on my retirement income”

This applies to everyone; income development is always important, and Tax Free Income (outside the IRA or 401k) is The Very Best. Only private “safe haven” 401k plans are capable of focusing on income development.

Retirement readiness requires active consideration of your asset allocation, your overall diversification, and most importantly, the quality of your holdings. Those of you who are relying on 401k assets to fund your retirement income requirements need to look inside the program.

If you are within five years of retirement, repositioning at the top of a stock market cycle (now) is essential; if you are in retirement, get your portfolio out of any employer plans and into your IRA… you just can’t protect yourself  (and especially, your income) in Mutual Funds or ETFs.

If you are approaching 70, the RMD is “in your face”… here’s how to handle it:

• Position the portfolio to produce slightly more income than you must take from the program.

• Take the income monthly and DO NOT pay the taxes in advance. Lump sum withdrawals require uninvested cash reserves and/or untimely sell transactions.

• Move the RMD disbursements into an individual or joint account and reinvest at least 30% in Tax Free Income CEFs.

• If you hold equities (in addition to the RMD income producers you need), set your profit taking targets lower than usual… and maintain the Cost Based Asset Allocation.

I’m relatively sure that some of you are currently dealing with the RMD incorrectly… with “lump sum + the taxes” distributions.

Some of you have been to my ongoing series of “live SRS portfolio review, Income Investing Webinars”.

Follow this link to the recording of the January 22nd private presentation and don’t hesitate to post it where ever you like… wouldn’t it be cool to have this presentation show up on YouTube.

https://www.dropbox.com/s/28ty6z5dkgn5ulu/Retirement%20Income%20Webinar.wmv?dl=0