Wednesday, January 27, 2010

The Great RRSP Debates

RRSPs are perceived to be one of the best savings vehicles for retirement because of some of the tax benefits of the RRSPs.  That being said, there are more and more people are questioning the validity of RRSPs and whether they really make sense?  Given many alternative uses for money, I outline three great debates of RRSPs.

Debate #1:  RRSP vs Mortgage

Generally speaking, either financial strategy is a good choice. It is better than spending the money on things that have no inherent financial value. It is also better than "investing" (I use that term loosely) in depreciable assets like cars.

Let’s compare the financial benefit of the two alternatives. First, let’s look at the mortgage. Let’s assume that mortgage rates are 6%. You might think that paying down the mortgage means that you forego paying 6% in the future and therefore the mortgage paydown has a financial benefit of 6%. Most mortgages are not tax deductible thus you must earn more than a dollar to pay down a dollar of debt. In fact, you probably need to earn about $1.50 to pay down a dollar of debt. Thus paying down the mortgage has a pre-tax equivalent of 8.8% (6%/(1-32%)). Remember the higher the interest rate on the mortgage, the more attractive it is to pay down the mortgage.

Now let’s look at the RRSP. Even if you are in the lowest marginal tax rate, you will save around 25% in tax* (combined federal and provincial). In a higher tax bracket, the RRSP might save you as much as 48% in tax savings. The bottom line is when you compare the two; a dollar put toward the mortgage saves you the equivalent of 8.8% while the RRSP saves you at least 25% in tax. Given the choice, I would take a 25% saving over a 10% saving.

One thing to keep in perspective is that this example is overly simplistic because you will have to pay tax somewhere down the road when you take the money out of the RRSP but you also get the benefit of tax deferred compounding as long as the money stays in the RRSP.

One thought is doing both might make the most sense.  You can do this by making the RRSP contribution first and then use the tax savings or refund to pay down the mortgage. For example, let’s assume I have $10,000 and I am in a 30% marginal tax rate. By contributing to the RRSP, I should save $3,000 in taxes and potentially get that in a refund. Once I get the refund, I should then take the $3,000 and pay down the mortgage. I have created $13,000 of use out of $10,000. 
*Tax rates will vary from province to province.

Debate #2:  RRSP vs non-RRSP

When it comes to investment income, capital gains and dividends have a much better tax treatment than interest. However, is it attractive enough to ignore the benefits of the RRSP?

The two key advantages to the RRSP are (a) the tax deduction and (b) the tax-deferred growth. These two benefits make the RRSP one of the most attractive financial planning vehicles available to Canadians. However, when you pull the money out of the RRSP, you will get taxed. Every dollar you pull out of an RRSP regardless of whether it is capital gains, interest, dividends or your original invested capital gets taxed at your current marginal tax rate.

On the other hand, the non-RRSP is taxed only on growth, dividends and interest. Withdrawing your capital is not subject to taxation. Astute investors will look for investments that generate capital gains and dividends because of the preferred tax treatment.

So what’s the best solution? It depends on your personal situation but most people will still benefit from the RRSP. Let’s take a look at some key factors:
  1. Investing behavior. If you are a really active investor and you like to buy and sell, trade or rebalance a portfolio frequently, you may be better off with the RRSP. Outside the RRSP, every time you trade, you create a potential tax disposition. The tax-deferred growth in the RRSP may be in your best interest.
  2. Time horizon. Generally speaking, it is rare to see investors hold the same investment for twenty to thirty years (or even ten years). The longer the time horizon, the more you will benefit from tax deferred compounding in the RRSP. It has been said that compound interest is the eighth wonder of the world.
  3. Marginal tax rates. It is important to understand what tax rate you are in at the time of the deposit but also know the your tax rate at the time of the withdrawal. This will be easier to estimate the closer you are to retirement. The ideal situation is if you take the money out in a lower tax bracket than when you put the money in.  In that case, RRSPs will always make sense
  4. Investment flexibility and freedom. RRSPs have some investment restrictions. Outside the RRSP, there are little to no restrictions of what you can do. While there is still lots of investment flexibility inside the RRSP, there is more outside the RRSP.
  5. Overall financial picture. Believe it or not, there is such a thing as having too much RRSPs. In some cases, your RRSPs may be so significant that your future income from the RRSP will push you into a higher tax bracket. In other situations, deferral of the RRSP can create a very significant tax liability down the road.
Remember everyone’s situation is different and you must take the time to assess your personal situation to see what path is best for you. These comments are general statements that may not apply to everyone.

Debate #3:  RRSP vs TFSA

In the 2008 federal Budget, Finance Minister Jim Flaherty, announced what he considers will be historical significance in introducing Tax-Free Savings Accounts (TFSA). Previous to the introduction of TFSAs, saving money could be done either in an RRSP or a non-registered savings account. The newly announced TSFA is a mix between an RRSP and a non-registered account.

RRSPs are attractive because you get an immediate tax deduction for the contribution and any investment earnings are tax sheltered as long as the money stays in the RRSP. On the other hand, the downside of RRSPs occurs when you take money out because you then have to pay the tax.

With TFSAs, you do not get a deduction when you put the money in but you also don't have to pay tax when you take the money out. Similar to the RRSP, you do not have to pay tax on any investment earnings in the TFSA giving you the benefit of tax sheltered investment growth.

With the TFSA, on $5000 contribution, you will save $50 to $80 in the first year of contribution from tax sheltered growth. Critics of TFSAs suggest that's not enough benefit to entice people to save and while that may be true, how would you feel if you found $50 on the ground today. I bet it would make your day. I'm of the opinion that any amount of money saved from taxes is in your best interest!

When you compare the benefit of the TFSA with what you would get if you invested in the RRSP, the TFSA may not be as attractive because the RRSP would give you $1250 to $2000 in tax savings from the initial tax deduction.

However, you can't properly compare TFSA with the RRSP by just looking at the tax savings going into the plans. You also have to look into the future when the money comes out of the plans. With the RRSP any withdrawal is fully taxable. That means a withdrawal of $1000 might only net you $600 to $750 after tax depending on your marginal tax rate. With the TFSA if you take out $1000, you get the full $1000.

The bottom line is RRSPs still make sense if you are saving long term for retirement and your income at the time of withdrawal is in a lower tax bracket than your income at the time of contribution into the RRSP.  Here’s a great rule of thumb to follow:
  1. If your marginal tax rate at the time of contribution is greater than your marginal tax rate and the time of withdrawal, then RRSPs have the advantage.
  2. If your marginal tax rate at the time of contribution is less than your marginal tax rate and the time of withdrawal, then TFSAs have the advantage.
  3. If your marginal tax rate at the time of contribution is equal than your marginal tax rate and the time of withdrawal, then neither has the advantage.
This article first appeared in Jim Yih's 2010 RRSP Kit which can be downloaded for free on his website.  All of my articles and blogs appear on my website  Check it out, there's lot of free information there.

Thursday, January 21, 2010

Will CPP be there in the future

Canada Pension Plan (CPP) is one of the pillars of retirement income benefits for Canadians. For the past 20 years since I have been in the financial industry, there has always been a perception that CPP may not be there in retirement.

Is the CPP in crisis?

That's what we've been led to believe for the past 20 years but the hysteria about the CPP s more of a myth than reality. Back in 1996 when there was tremendous fear that a looming pension funding crisis might cause the collapse of CPP. At that time, CPP received $11 billion in contributions but paid out $17 billion in benefits, with an asset base of about $35 billion. Unless something was done, the plan's collapse would be only a matter of time. The solution was to make some significant increases to the contribution rates and the creation of the CPP investment board to allow funds to be invested into market based securities.

CPP has come a long way since then. Today CPP is in a strong financial position and Canadians should feel good about CPP being there when they retire. Here's some of my thoughts about why I think CPP will be there in the future.
  • In 2009, the total assets of CPP sits at about $116 billion dollars and is expected to continue to grow from increased contributions and investment income.
  • Back in 2000, The chief actuary of Canada, who reviews the health of the CPP every three years, said in his 2000 report that CPP is sound for at least 75 years. CPP continues to operate on the basis of a 75 year amortization period.
  • The CPP reserve fund is segregated from general government revenue. In other words, CPP is a separate pot of money that belongs to all Canadians that have contributed to CPP. All Fund assets belong to CPP contributors and beneficiaries.
  • CPP is a pay as you go system. Part of the money that is paid into CPP through contributions is used to fund the money leaving CPP for retirement benefits. If there is not enough money to fund the outgoing funds, CPP can simply increase contribution amounts which has been a significant reason for the growth of CPP in the last 10 years.
  • The CPP was reformed in 1997 to stave off a funding crisis. And now, there is a surplus of contributions every year. In other words, there is more money coming into the plan through contributions than money going out as a result of benefits being paid to Canadians.
  • CPP is about to undergo some more significant changes to help preserve the longevity of this key asset. I will discuss some of these proposed changes in a follow up article next week.
Despite the good news, it seems that most Canadians still think CPP may not be there in the future. In fact, public opinion research conducted last month shows that almost two-thirds of Canadians are still unaware that the CPP was successfully reformed 10 years ago.

In terms of your own retirement planning, I think you should incorporate CPP into your plans and assume you will get something. The best way to figure out how much is to simply contact Service Canada to get your CPP statement of contributions.

This article first appeared on my website  Go and check out other articles on Canada Pension Plan or other government benefit programs.

Tuesday, January 19, 2010

RRSP Quick Facts 2010

It's RRSP time again and this quick reference guide might help people looking for the current rules and limits on RRSPs.  Good luck investing your money!

Who is eligible?

Anyone who has earned income, has a social insurance number and has filed a tax return can contribute to an RRSP up until December 31 of the year they turn 71. After this age if you continue to have earned income, you can contribute to a Spousal RRSP up until December 31 of the year your spouse turns 71.

This maximum age was increased from 69 to 71 in the 2007 Federal budget, giving people an additional two years to contribute.

Earned income

For most people, earned income for RRSP purposes is the amount in box 14 of their T4 slips.

Earned income also includes self-employed net income, CPP/QPP disability payments and net rental income.

Income sources that do not qualify as earned income include investment income, pensions (including DPSP, RRIF, OAS, and CPP/QPP income), retiring allowances, death benefits, taxable capital gains and limited-partnership income.

Revenue Canada's Form T1023 (Calculation of Earned Income) outlines all sources of earned income.

Contributing securities

You don't necessarily need cash to make an RRSP contribution. You can contribute (in kind) a security you already own outside your RRSP.

The "in kind' contribution is equal to the fair market value of the security when contributed. The security is deemed to have been disposed of at time of contribution. Be aware that this can have tax consequences.

Maximum contribution limits

Your allowable RRSP contribution for the current year is the lower of:

* 18% of your earned income from the previous year, or
* The maximum annual contribution limit (See chart) for the taxation year less
* Any company sponsored pension plan contributions (PA - pension adjustment)

Tax Yr         Income From         Max. Limit
2010             2002                      $22,000
2011             2003                      $22,450

1. Pension Adjustment (PA) represents the value of any pension benefits accruing from participation in a registered pension plan or deferred profit sharing plan.
2. A Past Service Pension Adjustment (PSPA) arises in rare instances where a member of a pension plan has benefits for a post-1989 year of service upgraded retroactively.

Obtaining your contribution limit

After processing your tax return, Revenue Canada sends a Notice of Assessment, which includes your next years' contribution limit. This document also shows your unused contribution room.

Or you can call your local Tax Information Phone Systems (TIPS) number, which is found in the blue pages of your phone book under Tax Services. Be sure to have your SIN and previous tax return ready.

Spousal RRSP

All or a portion of your RRSP contribution can be made to an RRSP in your spouses name.

As the contributor, you get the deduction, but your spouse is the owner of the plan. This includes common-law spouse as defined by Revenue Canada

There can be tax implications when spousal funds are withdrawn.

Foreign content rules

There are no longer any foreign content restrictions on your RRSP investments. Foreign content restrictions for registered plans were eliminated in the 2005 Federal Budget

Deadline to receive a tax deduction

The deadline for a RRSP tax contribution is always 60 days after the end of the previous year to be eligible for a deduction for the 2009 tax year. This year the deadline is March 1, 2010. Consult with your financial institutions about how they are able to accommodate deadlines.

Contributions made in the first 60 days of the year can be applied against the previous taxation year or in any subsequent year.

If you are turning 71, this is the last year in which you may contribute to your RRSP. You must convert your RRSP by December 31 in the year you turn 71.

Unused/carry forward contribution room

RRSP contribution room accumulated after 1990 can be carried forward to Subsequent years. If you are unable to maximize your RRSP contribution this year, you are allowed to make up the difference in later years.

Over contribution

The $2,000 lifetime over contribution allowance applies to those who have reached age 18 or older.

Your over contribution can be used as a deduction in future years. ($2,000 over contribution this year an be used as part of your deduction in the following year.

Any amount in excess of $2,000 will be charged a penalty of 1% per month.

What is the Home Buyers' Plan?

With the Home Buyers' Plan (HBP), you can, take up to $25,000 out of your RRSP to put towards the down payment on your first home and you won't be taxed on it. However, you do have to pay it back into your RRSP over the next 15 years.

Lifelong Learning Plan (LLP)

With the Lifelong Learning Plan (LLP), you can withdraw up to $10,000 a year, or up to $20,000 in total each time you participate in the LLP to help pay for your education. All you have to do is repay at least 10% per year for up to ten years.

Participants must start to make repayments two years after their last eligible withdrawal, or five years after the first withdrawal, depending on which due date comes first. Amounts withdrawn must be repaid within 10 years.

If you are interested in more information on RRSPs, here's a link to my 2010 RRSP Kit
For more of my articles on RRSPs, visit