Tag Archives: planning

Retirement Income Options – So Many Ways

As each year passes, the Canadian population becomes older on average.  The well documented effect of the boomer generation means that there are more and more Canadians approaching the age of 71, which is the year in which a taxpayer is forced to convert their RRSP’s into some form of retirement plan.

Let’s take a look at the variety of accumulation accounts at the average Canadian’s disposal, and then explore the different methods that can be used to access the funds in retirement.

We’ll start with accumulation, because the options you have at your disposal when you convert your accumulation plan to a income plan depends on what kind of accumulation asset you have.  There are two basic types of tax-deferred plan that you can have as you save for retirement, a personal plan, or an employer sponsored plan, or pension.

Personal Accounts

Registered Retirement Savings Plan (RRSP):  This plan allows for contributions of 18% of income up to an annual maximum.  A taxpayer must convert an RRSP into a retirement vehicle by December 31st in the year in which they turn 71.

Tax-Free Savings Account (TFSA):  The federal budget that was read in February introduced a which is designed to augment the tax deferred savings available to Canadian taxpayers.  Each taxpayer can contribute $5,000 per year into this, and there are no stipulations on withdrawal.

Locked-in Retirement Account (LIRA): This investment account is created when an employee leaves a company sponsored pension plan “rolls over” a certain portion of their pension into the LIRA.  Like the RRSP, the investor can control the investment decisions, but there are strict guidelines as to how the funds must be withdrawn.

Employer Sponsored Accounts

Many companies will have a pension plan for their employees, but these can take a variety of forms.

Defined Contribution Pension: This plan simply states up front what amount the company and the employee are each going to contribute to the plan.  Once the contribution is made, the funds are invested, and the employee has a variable pension depending on the investment performance of the pension fund.

Defined Benefit Pension: This plan uses a formula to determine what benefits are due to the employee upon retirement, based on years of service, income levels, etc.  The employee or the employer, or both, can contribute to the plan.  The corporation is liable to ensure that the plan is funded to meet the amounts that their employees are entitled to.

Group RSP: this is not really a group plan in the same manner that the pensions plans mentioned above are.  The group RSP functions just like a personal RRSP, except that the employer usually bears some of the costs of investing in the plan (i.e. account fees, lower fund management costs), and may match contributions as an employee benefit.

Commuted Pensions

Often, employees are given the option to “commute” their pension when they retire.  This means that they will be given a sum of money in lieu of an income stream from the pension fund.  This is most often made available to people given early retirement, and the funds are usually transferred a combination of a LIRA (tax free) and sometimes an open investment account (taxable).

A commuted pension can be a highly attractive option for a departing employee, specifically if they are planning to work again after they have left their current employer.  However, too often investors are encouraged to commute their pension in search of high returns.  However, when an investor commutes their pension, they often forgo other benefits that provide significant value.

For instance, an employee may have lifetime medical/dental benefits associated with their pension plan.  If the employee commutes their pension, they usually lose the right to have such types of benefits.  This leaves the investor open to significant long term risks of covering the cost of long-term care.

One final thought: the pension fund sees each pensioner as a liability.  When it commutes a pension, it pays an amount out to the employee to relieve themselves of that long-term risk.  When commuting a pension, be careful about taking that risk off the pension fund’s hands.  In this process, greed is not good.  A careful look at your risk management and tax planning options should be considered in this decision, not just the potential for big investment returns. 

Retirement Options

So what is an investor to do once they have reached the age of 71, and is faced with the choice between income options?  Well, it depends on the account you have used to accumulate your retirement income.

Registered Retirement Income Fund (RRIF): this account is created when an RRSP is rolled over into a newly formed RRIF.  The RRIF has an annual minimum withdrawal amount that is prescribed based on either the owner’s age, or the age of the owner’s spouse.  Since the minimum withdrawals rise as the age increases, it is usually beneficial to calculate the RRIF payments from age of the younger spouse.  The investment options are similar to an RRSP, and there is no maximum withdrawal amount that can be made in any given year.

Segregated Funds with Income Guarantees: these types of “variable annuities” have been available for many years in the US, but have really gained ground in recent years.  These are segregated funds that offer guaranteed income streams (usually 5% simple interest), with an account value that rises and falls with the investments selected.  This allows the investor to receive a guaranteed life income (usually available once investor reaches 65), while also participating in the upside of the market.  On the upside, there is potential for capital appreciation, and on the downside, the market value of the investment could deteriorate to nothing, leaving the investor with little value beyond the annuity-like contractual guarantee.  However, this is a powerful option for investors who wish to expose themselves to upside, without risk of losing an income stream.  

Life Annuity: Converting to a Life Annuity will guarantee income for life, which provides security to the individual who is receiving the funds.  However, this means that the (potential) estate value of the funds invested into the Life Annuity will be lost, should the investor die prematurely.  The annuity option can also be selected to guarantee income to age 90 (of either spouses’ age), so that if both spouses die prior to the 90th birthday chosen, there will be some estate value.

Lifetime Income Fund (LIF):If an investor elects to have a LIF, withdrawal minimums are the same as for RRIFs. LIF’s however, have a maximum withdrawal amount whereas RRIFs do not.  In some provinces, LIFs must be converted to a Life Annuity when the owner turns 80.  This means giving up investment control at age 80, which may or may not be a good thing.  Investors should be careful to manage volatility as age 80 approaches.

Locked-in Retirement Income Fund (LRIF): This is a more flexible version of the LIF, that eliminates the requirement to convert the account to an annuity at age 80 (not available in all provinces).

A note on small “locked-in” balances

If you are age 55 or older and the total value of all of your locked-in accounts is less than 40 per cent of the years’ maximum pensionable earnings (YMPE), you can request to have these locked-in funds transferred to an RRSP or RRIF, thus removing the locked-in status. The YMPE is currently $44,900, so this feature applies only to balances of $17,960 or less.

This is just a cursory look at all of the options available, but it should allow you to start to investigate the options that may or may not be available to you.  As with everything, try and determine what your objectives are before you make the decision.  Here are some basic points to consider in making your decision:

  • What kind of retirement assets do I have at my disposal?
  • Do I need a guaranteed income amount (i.e. x dollars)?
  • Do I need a guaranteed income term (i.e. for x years)?
  • Do I want to leave an estate value for my beneficiaries?
  • Do I want to manage the asset?
  • How is the asset going to be taxed if I leave a balance when I die?

For instance, an annuity might not provide the most attractive rate of return, but it will guarantee that you do not outlive your income.  For others, a prudently managed RRIF will deliver the retirement income that is needed, and maybe more.

Fall Harvest – Turn Losses into Gold?

The bad news is in, and the equity markets are up, but still down from two years ago this fall.  Investors are reeling from constant negative news, and are deeply concerned about the general state of the economy.  Some of these fears are well founded, as the world economy is going through a period where it de-leverages its market positions, and the effects will likely be a sustained global recession.  But, the prudent investor will remember that the markets will go up again, but it is still difficult to endure a portfolio loss.  It will take time to recover, but they will.

However, there is some immediate opportunity to be found, and it is not dependent on the markets.  The best way to make money right now is to take it from the taxman.  Since portfolios are generally down, you might want to take advantage of a concept known as “tax-loss harvesting.”

What is it?

Tax loss harvesting is the process of triggering capital losses to realize an immediate tax gain.  In the case where you trigger a loss in your portfolio, you have two options.

First, you can use capital losses to carry back against capital gains tax payable in 3 previous years.  So, if you have capital gains that you have paid recently, you can trigger capital losses and reclaim the taxes you have paid in the past.  At the highest marginal rate, this can mean that your current losing investments are worth as much as 23 cents for every dollar they have gone down.

Second, you can trigger capital losses and carry them forward indefinitely.  This means that you can “bank” a specific amount of capital losses and carry them forward to use against capital gains that you may have in the future.  This will allow you the flexibility to re-allocate portfolios in the future while limiting the taxes triggered upon disposition, or it could allow you the ability to take tax-free income from a portfolio through dispositions rather than through income or dividends.

How does it work?

Tax-loss harvesting can only be done in a non-registered, or taxable, account.  Transactions as described below will not work with assets held within a registered plan because you are not subject to tax on growth, and conversely, you are not able to take a benefit from capital losses.

Essentially, the point is to arrange a transaction to sell-out a position that is sitting with a significant drop in value, and then repurchase a similar holding in the same asset class.  This creates a loss, but maintains the desired asset class exposure so you don’t miss any potential upside.

In Canada, according to tax law, in order to take the capital loss, you must not reinvest in the same security for a period of 30 days.  So, assuming that you wish to stay invested, you do not want to be out of the market for a period of 30 days, specifically with markets as volatile as they are today.  This is why you sell one holding and purchase another similar one.

Mutual Fund Holders

So, let’s take for example that your portfolio holding, the XYZ Canadian Equity Fund, is down 25%.  The original cost of the funds was $100,000 – this is referred to as the “cost base.”  If you were to sell that fund right now, you would incur a $25,000 loss.  At the highest tax rate, this loss is be worth approximately $5,800 of taxes, either to be reclaimed from past taxes paid, or taxes payable in the future.

If you were to simply sell the fund and take the loss, you would have crystallized your loss, and if the market turned around, you would miss your gain on the upside.  Instead, you can sell the XYZ Canadian Equity Fund (“harvesting” your loss), and repurchase the LMNOP Canadian Equity Fund instead.  This will maintain your exposure to Canadian equity, but the two assets are different for tax purposes, so you will have gained a tax loss.

The good news for fund owners:  like it or not, most large cap equity mutual funds are essentially closet indexers (the secret is out).  So, it really makes no significant difference if you sell one company fund and buy another.  What does make a difference is the type of fund.  Do not sell a growth fund and repurchase a value fund – the return characteristics likely will not be the same.  So – do your research as far as the sector, but rest assured that broad market mutual fund managers are going to fall very close to the benchmark, making this a fairly reliable strategy for mutual fund investors.

Individual Stock Holders

For those who have specific stocks in your portfolio, the process is a little bit less ideal, but still viable.  You essentially have two options:

  • Replicate the strategy above, but instead of using funds that are similar, use stocks that are similar.  For instance, imagine that you own shares in Coca-Cola.  You could sell your shares in Coke and buy Pepsi instead.  These two companies are going to have very similar returns over the next 30 days: much of the risk in both stock prices is based largely on a global lack of liquidity, not whether people prefer one type of cola beverage over another. So, you can get out of Coke, crystallize your loss, move over to Pepsi for 30 days, and then repurchase Coke after the period has elapsed.
  • Or, you can replicate the strategy above, but instead of using funds that are similar, use an ETF or index fund to simulate the return of the asset class you have harvested losses from.  For example, you may have a holding in Bank of Montreal.  You could sell this holding, trigger your losses, and then purchase the iShares Financial Services ETF (XFN) to maintain exposure to the financial services sector.  While this is not a perfect replication of the BMO holding, you would still participate in the upside that the sector may experience while you are out of BMO for the required period.

In both the examples above, there may be fees involved for trading that should be factored in to the cost/benefit analysis.  Some brokerage houses have programs that will make a mass purchase of the losing assets in your account, and then resell them to you in 30 days – referred to as REPO programs.  These arrangements can help reduce the costs of this transaction if there are many holdings affected.

In all the proposed methods, you will note that I am not recommending one stock over another – in an ideal world, this is an impartial transaction.  We are simply trying to maintain the appropriate asset class exposure for the period following the transaction.

Best of all, this portfolio manoeuvre can create immediate value to your portfolio.  In the examples above, a $100,000 holding with a $25,000 loss will yield a $5,800 tax benefit.  On a holding that is now worth $75,000, that is an effective return of 7.73%, and can begin your portfolio as it works its way back to par.  The strategy is not perfect – it does mean more capital gains to accumulate in the future, but it may provide you with the ability to reclaim some lost taxes, and re-invest that money into the market to help ready your portfolio for market upside that will come in the future.

There’s No Place Like Home…

Believe it or not, there are people who believe that a home and a mortgage are too cumbersome to manage, and there are some financial experts who recommend that renting real estate is more beneficial than buying.

The advice is based on the assumption that real estate will not be the great investment over the next 40 years as it has over the last 40 years.

Regardless, look at the facts.  Make some reasonable assumptions:

  • First, assume that home prices only rise as fast as inflation,
  • Next, assume that your rent would be approximately equal to your mortgage payment
  • Then, assume that, instead of making a down payment, you take your down payment and invest in “the markets.”

If this was how you approached this decision, you would need an after-tax and after fees rate of return of 12.4% on your investment portfolio in order to have the same amount of equity in your portfolio as you have in your home!

Now, to be fair, you have taxes and upkeep on your home. If you assume that taxes are 1% of home value, and assume that upkeep is another 0.5% of home value, then you would still need an after-tax and after fees rate of return of 10.8%.

These rates of return, over the long term, are unachievable.  You would have to have an all equity portfolio for the entire period, and find a way to pay no tax, and still, historical rates of return show broad market equity indexes return about 10% – not enough to get you there!

Finally, one more important issue to note.  Your home is generally considered your principal residence for tax purposes.  This means that, when you sell it, there will be no tax.  So the equity in the home is yours.  If you have found a way to pay no tax on the growth of your “invested” down payment, and if you have found a way to get 10.8% to 12.4%, you will still have to pay tax on the growth eventually.

So – if the aggressive growth rates don’t turn you off, then the tax treatment might just.  Home ownership will likely remain a worthy and profitable goal.

The Child Care Expense Derby

find out who should really claim child care expenses on their tax returns

Can't decide who should claim the child care expenses at tax time?

My wife and I earn similar (but variable) incomes, and so each year we engage in what we call the “Child Care Expense Derby.”  We have the government to thank for that.  Every year I am a bit suprised by who it goes to (“and the winner is…”), but I am glad for the opportunity to get some tax back for the money we put into child care.  I always like to go to some handy tax calculators to figure out where I stand before tax time to see if I can predict the winner.  Here are two: my website (not very complicated), and TaxTips.Ca (more complicated).

The reason for the derby is this – we are never exactly sure which income will be the lowest until we get our employers’ T4’s, and then the spouse with the lowest income is the one who receives the benefit of the child care tax deduction.  Also, thew winner of the Child Care Expense Derby will be the spouse who contributes less to their RRSP.  The child care expenses can cause a big swing: tax rules allow expenses to be deducted in the following amounts:

  • a maximum of $7,000 per year for each other eligible child who is under 7 years of age at the end of the year; and
  • a maximum of $4,000 per year for each other eligible child (between the ages of 7 and 16).

This means that a family of three children under the age of 7 has deductions of up to $21,000 – nice work.  You could notice significant savings on your taxes, approximately a $7,000 tax savings for the average Canadian, who earns income at approximately a 30% tax rate.  The eligible child care is defined by CRA as on their website follows:

  • an eligible child care provider;
  • a day nursery school or day-care centre;
  • a day camp or day sports school;
  • a boarding school or camp (including a sports school where lodging is involved); and
  • an educational institution for the purpose of providing child care services.

Note that this is not an exhaustive list expenses, and other expenses, such as advertising for a care worker, or agency fees to find a care worker are also included.

The downside here is for a family that only has one income, or when the incomes are far apart (i.e. one high income and one low income), the deduction may not be as great that two mid- or high-income earners.  But it is still powerful.  Imagine a family with one income of $75,000 and one income of $45,000.  (Let’s say there are two children under 7, so $14,000 of eligible expenses).  The lower income spouse at $45,000 would reduce their taxable income by $14,000, using the childcare expenses as a deduction against income.  This would be a tax savings of approximately $3,300 for the year.

You should also note that this deduction gives you the exact same tax relief  as an RRSP deduction, so if you have to make the choice between who does what, don’t let the lower income spouse do any RRSP deduction until the higher income spouse has maximized their RRSP contribution.  This will ensure that the higher income spouse gets more deductions against their income, and that the lower income spouse does not put RRSP contributions in at an exceedingly low rate.  Some planning should help you avoid this.

This should help when it comes to deciding what to do about care for your kids, to help and reconcile the finances at the end of the year, and to generate some other tax benefits while you are at it.

Your RRSP and Long Term Wealth

Maximizing Your RRSP

RRSP’s are the central planning tool for many Canadians’ retirement objectives.  Say what you like, but the tax advantages of the deductible contribution are a powerful incentive to add to this tax-deferred investment vehicle.

It is important to note that the RRSP is just that – a tax deferral.  Most Canadians understand that their wealth accumulates tax free in an RRSP (more specifically, free from accrual taxation), however what most investors do not properly recognize is the effect of unwinding their RRSP.  If you are not careful, the tax that you are saving currently will be recouped by the government again later on.

So the bad news is that the RRSP is not a perfect vehicle.  The good news is that it does the trick up front, affording you tax incentive for savings, and defers tax on growth.  However, there are a variety of strategies that can help you maximize the after-tax value of your RRSP, both to you while you are living, and to your estate if/when you pass the assets to beneficiaries.

The Facts about RRSP’s

There are two main attributes of the RRSP/RRIF that we are looking to deal with in this article.  The first is the tax liability generated when the RRSP is converted into a RRIF and income is taken on an annual basis, and the second is the tax liability that exists when the RRSP/RRIF is passed along through the estate.

  • First – income that you receive from your RRSP is taxed just as though it were interest or employment income, meaning at your top marginal rate for the given tax year.  Most individuals recognize this in their planning.  The rules for RRIF payments is that there is a minimum amount that must be taken out each year, based on your age, or the age of your spouse (whichever is more beneficial).  This means that you can be forced to take out more than you need.
  • Second – in the year of death of the second spouse, the entire balance of your RRSP is included in order to calculate income tax payable on the RRSP/RRIF.  This income would come in excess of any other investment, dividend, and/or capital gain income declared on the final return.  This means that, if your RRSP was the only income you took in your final year (in Ontario), a $1,000,000 RRSP would have a tax liability of roughly $448,000, leaving your estate with only $552,000.

The tax treatment of the RRSP/RRIF at death is what we are most concerned about in this article – effectively, how do we reduce a tax liability that will erode almost one half of the savings you have worked so hard to accumulate?

Three simple approaches

Broadly defined, there are three different categories you can take to managing the ongoing and terminal tax liability in your RRSP.

  • Effectively manage your tax brackets while you take income from your RRSP.  Tax bracket management for estate planning takes a little bit of discipline.  Essentially what you are trying to do is remove income from your RRSP/RRIF at a tax bracket lower than what it would be at death.
  • Reconsider your asset allocation to reduce double taxation of Capital Gains in the RRSP structure.  Look at the tax treatment of the assets you have, and allocate the least tax efficient assets into your RRSP/RRIF.  Income producing assets are going to be taxed at the highest rate, so leave them in the RRSP/RRIF.  However, dividends and capital gains are tax-advantaged vehicles; leave them in your non-registered portfolio.
  • Use complimentary assets and strategies in combination with your RRSP to maximize the value that the RRSP delivers to you while you are living, and to your estate.  The first and simplest would be to incorporate a permanent insurance strategy into your planning, starting early if possible.  Simply put, life insurance will be able to fund the tax liability that exists within your RRSP/RRIF.  Furthermore, most permanent life insurance contracts allow you to accumulate assets within the contract on a tax deferred basis (returned tax-free if the proceeds pass on at death).

When considering a plan to minimize taxes, please remember that any tax driven strategy should be considered carefully by an independent tax professional.  The information presented above depends on certain assumptions which may or may not be relevant to all of our readers.

The long and the short of it is that the RRSP/RRIF is a great planning tool with powerful front end benefits that the average consumer enjoys – a tax deduction for savings.  But be careful: without proper planning, those savings will be eliminated by the government in retirement, or, at the latest, at death.  If your intent is to maximize your after-tax income during retirement, or to maximize the value of your estate to your heirs, careful attention should be paid to your RRSP/RRIF and how it is interacting with your tax rates and other assets and cash flows you have at your disposal.

Power Corrupts, Entitlement Corrupts Absolutely

  • “Power tends to corrupt, and absolute power  corrupts absolutely.” – Lord Acton, 1887
  • “Unlimited power is apt to corrupt the minds of those who posses it.” – Earl of Chatham, 1770 

In light of recent events (Tiger Woods, anyone?), many would believe the above statements to hold true.  It seems, in our society, that increasing power inevitably leads to a complete erosion of moral and ethical boundaries.  Consider former US Attorney General Elliot Spitzer, or Senator John Edwards preaching family values as a campaign slogan while committing adultery.

However, power may not be the entire story.  I recently read an article in The Economist (Jan 23-29, pp. 75-76) that looked at a study by two professors (one in Europe and one in North America), who conducted a series of experiments to see if this was indeed true.  In the tests that they organized, they arranged so that one half of the group felt entitled to their power, whereas the other half did not.

What they found was interesting.  The research suggests that the individuals who were made to feel entitled to their power were far more likely to commit immoral or unethical acts than the group that was led to believe that they did not deserve their power.  In addition, the research went on to consider the actions of those in power who did NOT feel entitled to the power they were given.  Not only were they more likely to be much more harsh in the judgement of immoral acts, but as a group, they were also more harsh on themselves when judging their own acts than on others.

Huh.

So why did I bring this up in the money column?  I think that this is a very strong analogy about how people, and specifically children, act when confronted with money (note: this is my opinion now, but go with me here).  I have seen many clients come and go, and come to know their families relatively well over the years.  I have also listened to many people speak about the plans they have for their retirement and estate plans, and most feel that leaving “too much” money would have a negative effect on their families, or more specifically, their kids.

So how do we teach kids about money and responsibility?  There are loads of fantastic resources around the web.

However, we are often so preoccupied with saving and spending wisely ( heck, that is what this column is designed to discuss! ), that we fail to consider whether or not our culture (I must have this video game/car/home/toy/etc.) is making our children to feel entitled to the money that their families earn.  Parents may work their fingers to the bone to earn this stuff, but there is likely no activity, strategy or website that will teach them the importance and impact of money unless they learn they will have to earn it, not that they deserve it.