Spousal RRSPs

In this post I'm going to go over the topic of Spousal RRSPs and how it can help you lower your overall tax rate. This is a strategy that I find is not being used enough and is something that all couples should at least take a look at. I will not go through in depth about RRSP, since I've already covered that in one of my earlier posts, however, I will just highlight another way to use RRSPs to lower the overall taxes in a household.

What is a Spousal RRSP?

Essentially, it's just an RRSP set up for one spouse (who owns the plan), where the other makes the contributions. This is a form of "income-splitting" (which I discussed in my previous post) by shifting income from a higher income earner, to a lower one, so that the total income between the two will be taxed at a lower rate overall.

Note: common-law partners are also able to take advantage of this plan.

How Does it work?

Basically, one spouse will contribute into the the RRSP of the other spouse, but will claim all tax deduction on their own tax return. There is a immediate benefit of the tax deduction for the contributing spouse, but also the long term overall benefit will lower the tax bill for the both of them as they will be able to withdraw more funds at a lower tax bracket in their later years.

Contribution Limits:

The total RRSP contribution for 1 spouse (for both the personal RRSP and the amount contributed into Spousal RRSP) cannot exceed the Personal RRSP deduction limit for the contributing spouse.

Example -- If the husband has a total contribution limit of $10,000 for the year, and he contributes $7000 to his own personal RRSP, that means he is only allowed to contribute up to $3000 into the Spousal RRSP (anything more then this would be subject to penalty). This $10,000 can be split up any way and there is no minimum that is required to be put into either the Personal or Spousal RRSP.

Perks:

A spousal RRSP is also a great way to defer taxes for someone who is not able to contribute into their own personal RRSP because of their age -- i.e. at age 71, the RRSP must be converted into a RRIF and there can't be any more contributions made. As long as the spouse is under the age of 71, there can still be contributions made into the Spousal RRSP, and the tax deductions can be claimed by the higher income spouse.

Withdrawal Restrictions:

When dealing with withdrawals from Spousal RRSPs, there is something that's called the '3 year attribution rule' that has to be considered. This is a rule that prevents the higher income spouse contributing into the Spousal RRSP, and then having the lower income spouse immediately (or soon after) withdraw the funds at a lower tax rate.

The 3 year attribution rule states that if the lower income spouse withdraws money from that Spousal RRSP within 3 calendar years of it being contributed by the higher income spouse, then it will be taxed in the hands of the higher income spouse. However, if it is more then 3 calendar years after the contribution, then it is taxed to the lower income spouse.

Example -- Husband contributes $3000 into the Spousal RRSP in June of 1998. If the wife were to withdraw the funds any time before January 2001, they would be taxed in the hands of the husband. However, any time after that, and they would be taxed in the hands of the wife.

Creditor Protection:

Since the (receiving) spouse actually owns the plan, the funds deposited by the contributor would be protected from any action taken against them. The only rule for this is, that there must be a consistent patter of the contributor making contributions into that Spousal RRSP which are motivated only for the tax advantages.

This strategy is also used for OAS (Old Age Security) Calculations. To avoid clawback, many couples do this in retirement in the case where one spouse's income is a lot higher then the others.

One thing to note that one spouse is still allowed to have a Personal RRSP even if the other is contributing into a Spousal RRSP. Also remember, this strategy makes most sense when there is one spouse that is earning significantly more income then the other, to balance it out to pay the lowest tax possible. If both spouses are earning around the same amount of income, then this strategy probably would not make that much sense.

I hope you've learned something from this post and if it makes sense for your situation, please use it, because it will keep more dollars in your pocket. Please also consult your financial advisor before making any decisions, and if you have any questions or require further information, please do not hesitate to contact me.

Education Savings: Part 4 --> In-Trust Account

The last topic we will discuss is opening an In-Trust account. There are a couple of different type of "In-Trust" accounts but I will just cover the basics of the Informal In-Trust accounts.

What is an In-Trust Account?

- investment account opened by an elder (usually parent or grandparent) naming child as beneficiary

- child does not have access to funds until he/she turns age of majority; determined by province (usually 18)

- once child turns age of majority, they have access to funds and can do whatever they choose with that money

- can contain several different types of investments, such as stocks, bonds, GICs, mutual funds etc...

- contributor (usually parent or grandparent) decides when they will contribute and how much they will contribute

- usually have someone named as trustee who will take care of where the funds are invested and manages the account

In-Trust accounts are a great way to save for a child's future, whether it be for education, buying a car or even something like down payment on their first home. However, just like all other strategies, it has its pros and cons.

Pros:

- There is no contribution limit

- Anybody can contribute to the plan

- There is no restriction on how the funds are to be used by beneficiary

- Tax benefits (capital gains taxed in hands of beneficiary)

- Income on income (second generation income -- i.e. re-invested dividends that produce dividends) get taxed in the hands of beneficiary**

- Contributor decides when to contribute and how much they want to contribute

**Note: In most cases the tax bracket of the beneficiary will be very low or even zero in some cases, once they reach the age of majority

Cons:

- No government grants

- Dividends/interest on funds invested by contributor are taxed in hands of contributor (first generation income) --> this can be minimized or avoided by investing into a fund with little/no distributions

- No tax deductions

- Once child reaches age of majority, they can do whatever they please with the money (even if it is against the wish of the parents)

- usually no guaranteed return (if invested in stocks/mutual funds)

- once the funds have been contributed, they cannot be taken back by the contributor

Any time the child gets birthday or holiday cash gifts, they can be invested directly into the account. Also keep in mind, the Child Tax Benefit can be deposited directly into the account as well. If the child has their own income (i.e. from chores, babysitting etc...), they can also deposit the funds into the account.

Although this strategy can be a great way to save for a child's future, it probably isn't the best choice for Education Savings. Some parents decide to use In-Trust because of the flexibility and unlimited contribution space, but not having the Government Grants is a huge con, and can drastically reduce the amount of funds that are available for the child.

However, if the parents/grandparents think there is a good chance that the child will not pursue post-secondary education, this might be something that would be beneficial for them. This strategy is often used when the contribution space in the RESP for the grant has been maxed out (i.e. $2500 already contributed to give maximum of $500 grant, in the year).

Please consult your financial advisor before making any decisions. Also, in case of more complicated trusts (formal trusts), it is also recommended to consult a lawyer so the account is set up properly and all the legalities are understood. Please do not hesitate to contact me if you have any questions or require further information.

Education Savings: Part 3 --> TFSA

One other option that is not discussed often by advisors and that is not seen as popular as the other options is using a TFSA. Even though this strategy is not used often, I still feel I should discuss it as an option that can be used by parents. I'm not going to go through all the points of using the TFSA strategy, because that can be found in one of my earlier posts (http://financialhealthblog.blogspot.com/2009/05/investments-par-3-tfsa.html).

Essentially, using this strategy can be seen as using funds from your own plan to pay for your childrens education costs. Many people would ask "why even use this strategy" due to some of the drawbacks, but I thought I would still touch upon it as an option for investors.

Pros:

- account is in your (the parents) name, so you have all control of what goes in/out of it
- the funds grow tax sheltered
- if the child does not go to post-secondary education, there are no penalties or setbacks
- you (the parents) are in complete control of the money; in case there is a trust issue in regards to the child(ren)
- funds can easily be redeemed in case of any emergency prior to or during childs post-secondary schooling
- there is no limit to how much can be redeemed at one time
- you choose how much and when you contribute

- very flexible in what is invested within the TFSA

- no penalties for stopping contributions or redeeming funds before the child(ren) goes to school

Cons:

- there is no government grant - this can make up a big difference if the child DOES end up going to post-secondary schooling
- there is an annual maximum
- usually no guaranteed performance (if invested in stocks/mutual funds)
- no insurance protection on childs life

- must be 18+ to open this account - can be challenging using this strategy if there are multiple children or a single-parent home because of the low limits

One key difference between this strategy and that of using an In-Trust Account (which I will discuss next), is that the funds in this account will always stay in the parents name, and will not automatically be put in the name of the child once he/she turns 18. This might be beneficial if there is an issue of trust with the child, in the case where the parents are not sure if the child will withdraw the funds and spend it on other things that they don't approve of.

The main reasons this strategy is not used as often as some of the others is because:
a) there no government grants; the up to $500/yr grant can make a huge difference in the amount of funds that are saved for post-secondary education

b) the max contribution limits allowed for TFSA

However, this strategy is used sometimes, especially in cases where it is complimenting one of the other strategies. Sometimes parents don't feel very comfortable with giving their children access to the funds, or might not be sure if their children will pursue post-secondary education.

The effects of maximum contribution room in the TFSA and the fact that there is no grant from the government might greatly reduce the amount that is accumulated for savings, so if you are using this strategy, please make sure you take the time to consider all the pros and cons. Also, if using this strategy, it is recommended that it be used as a compliment to one of the other strategies as well.

One important thing to note. This same strategy can also be done using an Open (non-registered) Plan by the parents. It would only make sense to do this once the TFSA has been maxed out, as there is preferential tax treatment on the TFSA.

Please consult your financial advisor before making any sort of decisions. I hope you have learned something here and please do not hesitate to contact me if you require further information.

Education Savings: Part 2 --> Cash Value Insurance Policy

As mentioned in my previous post, there are several ways to save for your child's education costs. In the last post we discussed RESPs and all of the pros/cons as well as most of the aspects of RESPs and how it works. In this post we will discuss how you can use an Insurance Policy (specifically Universal Life) as a way to fund your childs post-secondary costs. (Also referred to as a 'Juvenile Life Insurance Policy'). You can use the below strategy similarly with a Whole Life Policy as well.



In one of my original posts titled "Life Protection" (http://financialhealthblog.blogspot.com/2009/05/life-protection.html), I went through the UL strategy and listed all the different aspects, as well as all the pros and cons of using this strategy. Also, as I mentioned in that post, it is a great way to save and grow money tax-sheltered, and is often used as more of a 'investment' strategy rather then just an 'insurance' strategy.



How does it work?

Essentially it is just a regular Universal Life (permanent insurance) plan that is started in the childs name. The reason it is started in the child's name and not the parents name is because the cost of insurance would be much lower for the child then the parent. That means for the amount of premium that would be contributed, a larger portion of that would go towards the investment component of the policy. At the same time, that child would have and existing life insurance policy that could quite possibly stay with them for the rest of their life.

At the time the child enters post secondary, at age 18 for example, there would have been up to 18 years of tax-sheltered growth that can be accessed.

How to access funds:

1. The funds can be directly withdrawn from the cash value of the policy. The growth of the funds would be taxed in the hands of the child at his/her marginal tax rate, which in most cases would be low or 0. However, if the entire cash value is redeemed, and there is no more contribution to the policy, the policy would inevitably lapse (be terminated).

2. Instead of withdrawing the funds directly from the cash value, you can use the cash value as 'collateral' for getting a loan from the bank. The actual amount of the loan would be less then the cash value and the rate at which the funds are borrowed can be fairly low. Also, the interest can be capitalized -- meaning instead of paying it directly from the pocket, it will be paid out through the policy. This can be a beneficial strategy, since instead of depleting the cash value, that would continue to grow and there would be no direct payment out of the pocket.

Pros/Cons of this strategy

Pros:

- the funds grow tax-sheltered within the policy
- if the funds are withdrawn from the cash value directly, the tax rate would most likely be low or 0
- the child will have an insurance policy which would likely last them their lifetime
- the way the funds are invested can be chosen
- lifetime contribution limit would likely be higher then then that of an RESP
- if the child does not pursue post-secondary education, there is no penalty or setbacks
- funds within the policy can be used for any purpose, not only for education

Cons:

- there is no government grant or contribution
- there is usually an annual maximum that can be contributed
- there is no guarantee of investment performance
- might not be enough funds in portfolio to cover all educational costs

This strategy can be a beneficial strategy in more then one way, and would also give the child a headstart on insurance protection for when he/she is older. However, as any other strategy, it must be used wisely and funded properly for it to work efficiently. This would be a great strategy to use in unison with another form of planning.

Example:

Contributing $2500 into an RESP per year - this would give an annual grant of the maximum of $500 from the government. Any excess funds can be put into a UL strategy, which would start the child off with insurance from a young age, or the excess funds can be put into another form of investment, such as a non-registered (which will be discussed in the next post).

Before using this strategy, make sure to ask your advisor all questions that you feel need to be asked and know all the ins and outs of the product that your advisor is recommending (most insurance companies have similar products but might have minor differences in some aspects). This strategy is not for everybody and might not make sense in all situations, so consult your advisor before taking this route.

I hope you have picked up some good pointers from this post, and as always, please do not hesitate to contact me with any questions or comments.

Education Savings: Part 1 --> RESPs

Post-Secondary education can be a very stressful and expensive experience for both children and parents alike. These days we're seeing tuition fees increasing year over year, and there doesn't seem to be any end in sight. On top of tuition fees, there are several other expenses which often determine who can, and cannot, afford to get the education they want. Rent, food, transportation, internet, books and phone bills are just some of the additional expenses that get added on top of tuition to make up the total cost of post-secondary education.

Planning for education costs is something that should start soon after the birth of the child, because it can be a very long process. As parents and guardians, we want to see our kids getting the best possible education, but at the same time don't want to have to get a 2nd mortgage on our homes to do so; or even worse, we don't want to have to choose which child goes to post-secondary and which doesn't. Often what we see is the student taking up a part-time job during the school year to help pay for costs; but this usually leads to added stress and also to lower grades due to less time committed for studying.

Just as there are several different options when saving for our own future, there are a few different strategies that can be used to fund the child's post-secondary education. I will discuss just the 4 main strategies that are most often used and discuss the pros and cons of each. The 4 main strategies used are: RESPs, Insurance (Universal Life or Whole Life Policy), Open (Non-Registered Savings) and Trusts. In this post I will discuss the first of the 4.

What is an RESPs?

An RESP is a Registered Education Savings Plan. Similar to the RRSP, it is 'Registered' with the government and there are certain limitations to how it is used and what it can be used for. An RESP is a government sponsored initiative to help families save for post-secondary education. The contributions are made be a subscriber and has one or more beneficiaries designated to it. Here are some of the pros and cons about RESPs:

Pros:

- income earned grows tax-sheltered and tax-deferred
- can designate more then one beneficiary
- can get government sponsored 'bonuses' --> Canada Education Savings Grant (CESG), Canada Learning Bond (CLB), Other provincial sponsored programs
- when funds are withdrawn, it gets taxed at beneficiaries tax rate (I see this as a 'pro', since, in most cases the child's tax rate is very low or even 0)
- You can transfer the RESP from one child to another
- You can carry forward the unused grant room (maximum of $1000 for the next year)
- RESP can be transferred into an RRSP (max of $50,000 -- given that you have room in your RRSP to transfer that much) if it is not used

- No annual contribution limit

Cons:

- Lose any growth and must return grants back to government if child does not go to post-secondary education
- If you invest in the market, there is no guarantee in the amount of return you get
- If you invest in something like a GIC, you might not earn enough return to meet the needs
- RESP plan fees might eat away at your savings and growth
- No tax deductions
- If RESP is not used and there is no room for contribution in your RRSP, then funds are to be withdrawn as INCOME and taxed at MTR (maginal tax rate) [only growth is taxed]
*note: principal invested can be withdrawn at any time without paying taxes because it is invested with after-tax dollars

Other Points:

- Beneficiary must be Canadian resident and have a SIN (Social Insurance Number)
- Maximum lifetime contribution limit of $50,000
- Maximum lifetime CESG of $7,200
- Maximum annual CESG of $500 (20% of contribution up to $2,500)
- RESP can only be used to fund education at a Qualifying Post-Secondary Institution that is approved by the Government of Canada
- CESG stops when child turns 18
- Maximum CLB of $500 initially, and $100/year up to the time child is 15 years of age
- Can only qualify for CLB (Canada Learning Bond) under certain circumstances [must be under National Child Benefit initiative -- i.e. for low-income families]

I know this probably must have confused some of you (although I tried very hard to keep it simple); RESPs do have a lot of rules and regulations about them.

What I would recommend is putting a maximum of $2,500/year into an RESP so you can get the maximum $500 (20% of contribution) grant, and any additional funds to be invested in some other instrument; such as a TFSA or UL policy.

When investing into an RESP, you have 2 main choices in how you go about doing that. You can get a scholarship plan or have a self-directed plan.

Scholarship Plan

Scholarship Trust Funds guarantees that your child will receive specific benefits once the funds are needed. Usually the money is put into GICs or Bonds or the like - the investment decision is completely up to the Company and you have no choice over where the investments are allocated. These are considered 'pooled plans', where all the the investors are pooling their money together into one bucket depending on the birth year of their child (i.e. all children of a certain birth year are placed into one pool). However, if some subscribers leave (stop paying into the plan), they leave most (or all) of their money into that pool, and then the money gets split among the remaining clients. The entire basis of this type of plan is that they know approximately 40% of clients will not live out the full life-time of the plan, thus, being able to split more money among less people.

One of the disadvantages of a scholarship plan is that it offers very little in the way of flexibility. The monthly investment is determined by the company, based on your child’s age. Once committed to a plan, you must meet all monthly payments until your child goes to post-secondary education. If the regular payments are missed, then the plan is terminated and all (or most of the) previous contributions are lost.  Some companies will allow you to start contribution again after you stopped (within a certain timeline - maybe 6-12 months), but they require you to pay back all missed payments + interest.

One big thing to look out for is that some scholarship trust funds do not allow you to choose the university or college; instead they determine from a list of schools where your child can attend and in some cases what expenses will be covered. So, if you are considering to use this type of plan, please make sure you fully understand which schools/institutions your child will be allowed to attend.

Another issue of concern is the drastically high fees that are involved by being with these plans - these fees are actually used to pay the salespersons commission. Usually the first 2 to 2.5 years of your contributions are gone towards covering Membership and/or Administrative fees, and if you were to stop contributing or opt out of the plan, you lose all (or most of) those dollars put in for those fees.

So, if you are considering to go into this plan, you should definitely think twice. The lack of flexibility, lack of transparency and lack of success for most clients are a few reasons people might stay away from this type of plan. You have to ask yourself, if approximately 1 out of every 2 people don't make it all the way through, what are the chances of you making it all the way through?

Self-Directed Plan

In a Self-Directed RESP, the contributor has the flexibility to determine how much to invest and how often. They also have the control to determine how and where the funds are to be invested. If managed properly, the investment can enjoy substantial gains.

With this plan, the student has the option to choose which university or college to attend and has flexibility to determine how to spend the funds on educational related expenses, such as tuition, schoolbooks and even living expense. If the RESP is not used for post-secondary education by the intended child, then it can be used by another member in the family or rolled over into an RRSP (or spousal RRSP), after all grants have been returned back to the government.

With self-directed plans, as compared to scholarship plans, there's generally the opportunity to earn a lot more growth in within the plan, if managed properly. This is where the importance of having a knowledgeable and experienced Advisor by your side comes in.

In contrast to the Scholarship plan, you can start and stop contributions and also increase/decrease contributions as you so choose. There is no penalty for doing these, and no heavy loaded up front fees  (i.e. Membership/Enrollment Fees that Scholarship Plans have) associated with these plans. This means, that all your money will be directly going towards your plan - the only "fee" associated with this plan is the MER (management expense ratio) of the fund that you put it in. This is nothing uncommon from any other mutual fund/seg fund/stock investment that you buy, as every investment you pay some sort of fee -- Scholarship Plans also have an MER associated with the investment within the plan, which is charged on TOP of the Membership/Enrollment Fee.

As you can see, RESPs are not too complicated, but still require a little bit of research before choosing the right one. When thinking about opening an RESP make sure you ask all the necessary questions and have all the information you need to make the right choice for you and your family. The last thing you want is the stress of having a shortfall in your child's future dreams. Make sure you do your homework and be very careful of RESP agents. Many will push the scholarship plan because it pays a LOT more but usually the first 2-2.5 years of your contribution go straight to fees.

I hope you have learned some good things from this post, and please consult your financial advisor before making any decisions on how to invest for the future of your children. If you have any questions, please do not hesitate to contact me!

Investments Part 3: TFSA

As of January 1, 2009, Canadians have another vehicle they can use to invest for their future. The TFSA (Tax Free Savings Account) was introduced as a vehicle that is supposed to help Canadians save. Many investors were getting hit hard with taxes when withdrawing from their RRSPs; many of those because they were not educated properly in regards to the functionality of the RRSP.

First thing I would like to indicate is that the TFSA is supposed to be a mirror image of an RRSP. The two plans are designed to produce the same results. Lets take a look at some of the details of the TFSA.

Pros

- Tax-Free Growth
- Tax-Free withdrawals
- Can withdraw at any time
- Unused balance gets carried forward indefinitely
- Any amount withdrawn gets added to next years contribution limit
- Anybody over 18 with a SIN card can open (does not matter about previous years income, as it would with RRSP)
- No age limit for contributions
- Withdrawals and earnings do not affect government programs such as OAS
- Can contribute in spouse's name without the spouse having to report income
- Transfers to spouse on a tax-free basis upon death (when RRSP transfers to spouse upon death it is also tax-free, but spouse must pay taxes upon withdrawal)

Cons

- Contribution limit
- No tax deductions
- Investing with after-tax dollars
- Cannot re-contribute amount withdrawn until next calendar year
- 1% penalty per month on amount that is over contribution limit
- Cannot be joint or spousal

Many investors were also weary of investing into an RRSP because of the tax consequences upon withdrawal, so the TFSA was started as something to complement the RRSP, and not necessarily compete with it. That being said, there are certain circumstances where one is better then the other. One way of utilizing both vehicles at the same time is by using the money received as the tax refund to fund the TFSA (the same strategy can be used from the tax refund received from an investment loan).

Essentially, I believe the TFSA should be a compliment to either the RRSP, the Non-Registerd vehicle, or both! Lets look at an example of using only TFSA, and using RRSP and TFSA together.

Assumptions:
Annual Pre-Tax Contribution: $5,000
Rate of Return: 8%
Marginal Tax Rate: 40%
Length of Investment (Years): 20

Option #1: TFSA
Total After-Tax Contribution: $60,000.00 ([$5000 x 0.6] x 20 years)
Total Account Value after 20 years: $137,285.89
Net Benefit of Strategy (Growth): $77,285.89

Option #2: RRSP
Total Contribution (Pre-Tax): $100,000
Total Account Value after 20 years: $228,809.82
Net After-Tax Value (40% Tax Rate): $228,809.82 x 0.60 = $137,285.89

As you can see, the after-tax value for both the TFSA and the RRSP are the exact same. This is to prove that the TFSA is designed as a mirror image of the RRSP, because (usually) the money invested into a TFSA is after-tax dollars, whereas the money invested into an RRSP is pre-tax dollar. Let's take a look at using both strategies together.

Option 3: RRSP with TFSA
Total Contributions to RRSP: $100,000
Annual Tax Refund: $2,000 ($5000 x 0.40)
Total Account Value of RRSP after 20 years: $228,809.82
Net After-Tax Value (40% Tax Rate): $228,809.82 x 0.60 = $137,285.89

Tax Refunds invested every year in TFSA: $2,000
Total Contribution to TFSA (20 years): $40,000
Total Account Value of TFSA after 20 years: $91,523.93

Total Combined after-tax Value of the RRSP and TFSA: $137,285.89 + $91,523.93 = $228,809.82

As you can see, using both strategies together results in maximum account value. By using both strategies together, the result is the same as if you were to negate any taxes on the RRSP. So, in essence, both strategies can be benficial.

That being said, in some cases, one strategy is better then the other:

1. If your Marginal Tax Rate is higher at the time of contribution, then the RRSP strategy would make a better choice, because a) you will recieve a larger tax refund, and b) when you withdraw from your RRSP later down the road, you will pay less in taxes.

2. If your Marginal Tax Rate is higher at the time of withdrawal, then the TFSA strategy will be a better choice, because a) when the funds are invested, they are done so with more after-tax dollars, and b) when the funds are withdrawn, they are tax-free.

Lastly, I would like to discuss the investment of funds that are not taxed. For example, we might get a bunch of money for our birthdays, weddings, or just from loving grandparents. These gifts are rarely declared on taxes. Also, there are some professions that work on a cash basis (i.e. taxi drivers, some truck drivers, some labour jobs etc...). In these sort of situations where the cash is not being taxed, then the TFSA will definitely be a better strategy, since the taxation on the invested money is 0. Please note, I think paying taxes is very important, and I am not suggesting that we all try to hide income from the CRA. I think every citizen should pay their share of taxes (but not a penny more!).

Just as every other strategy, this isn't the be-all, end-all of investing. And as well as all other strategies, please consult your financial advisor and do your own homework. If you have any questions, please do not hesitate to contact me!

Investments Part 2: Open [Non-Registered]

The second vehicle that people can use is the Open or "Non-Registered" vehicle. This is pretty much everything that is not within an RRSP or a TFSA.

The basics of the non-registered vehicle are as follows:

Pros

- No limit to amount of contribution
- No witholding tax upon redemption
- Withdrawal amount does not get added to earned income
- You are taxed ONLY on 50% of capital gains (i.e. You invest $100, and it turns into $200, you are only taxed on $50 --> ($200-$100)/2 )
- No age limit

Cons

- No tax deduction for contributions
- You invest with after-tax dollars
- You must declare any distributions as a part of earned income, whether or not you took them in cash

As you can see there aren't as many rules and regulations for the non-registered investment and there are some pros and cons for this vehicle as well.

If we were to do a dollar-for-dollar comparison between RRSP investing and Non-Registered investing - assuming same rate of return, tax brackets, investment timeline etc.. - RRSP will always win because of the tax-sheltering, tax deductions and tax refunds.

Example.

Lets take a look at an investor who's investing $5000/year for 20 years at a rate of return of 10%. Assumed Marginal Tax Rate is 35%. [all values will be rounded to nearest dollar]

RRSP
After 20 years @ 10% return, the investment will become approximately $315,012. When it comes to withdraw the money, the funds will be taxed fully at the MTR (marginal tax rate) of 35%.

$315,012 x 0.35 = $110,254
$315,012 - $110,254 = $204,758

Therefore, after taxes, the investor is left with approximately $204,758.

Non-Registered
After 20 years @ 10% return, invested will become approximately $206,745. When it comes to withdraw the money, the funds will be taxed at the MTR on only HALF the capital gains.

$206,745 - $100,000 [total invested --> 20 years x $5000/yr] = $106,745 --> Capital gains
$106,745 / 2 = $53,373
$53,373 x 0.35 = $18,681
$206,745 - $18,681 = $188,064

(Calculations came from http://www.mackenziefinancial.com/calc/jsp/RegNonReg/rrsp_vs_non_rrsp.jsp)

As you can see, when we compare dollar for dollar investment, then RRSP will beat out non-registered -- in this case, using the RRSP strategy, the investor would have approximately $16,694 more then the Non-Registered Strategy. This is because the RRSP is growing tax-sheltered and the Non-Registered is not; there are taxes paid annually.

Also to note, that the RRSP is getting a tax refund, so if the investor were to contribute the amount they received back from the government, the RRSP would have accumulated a lot more. But there also other strategies you can use for that tax refund, like paying extra on mortgage, or investing that refund into a TFSA (Tax-Free Savings Account - which I will discuss in the next post).

In the previous example we compared dollar for dollar investment. But, is that the only strategy? No, it is not. There is also the concept of 'leveraging' -- borrowing money to invest. The OPM (other peoples money) Strategy is something the wealthy (and all banks and corporations) have been using for years and years.

Leveraging

Pros

- Starting with a larger sum of money
- Money will grow faster
- Can have options to pay 'interest only' on the leverage loan
- Get a tax deduction for the amount paid in interest
- Money is growing as compound interest vs. interest being paid is simple interest
- Can benefit from tax-deferred compound growth

Cons

- If investments tank, you are still liable for the amount of loan that you took
- If interest rates rise, your payment will increase (however, so will your tax deduction)
- If you get a 'margin call' loan, the lending institution can call the loan at any time and you are required to repay it

Leveraging is also more suitable for those who have higher risk tolerance and longer investment horizon (I would say at least 7-10 years).

Example.

Now lets compare RRSP vs Leveraging for Non-Registered. We will use the same RRSP situation as above and assume that on a $100,000 leverage loan @ 5% interest, the interest charges will be $5000 [using round numbers to make calculations easier and more accurate to compare)

RRSP
After 20 years @ 10% return, investing $5000/month, the investment will become approximately $315,012. When it comes to withdraw the money, the funds will be taxed fully at the MTR (marginal tax rate) of 35%.

$315,012 x 0.35 = $110,254
$315,012 - $110,254 = $204,758

Therefore, after taxes, the investor is left with approximately $204,758.

Leveraging
Lets assume that an investor borrowed $100,000 at an interest rate of 5% - this means the interest payment will be $5000/year. At 10% rate of return, the investment will grow to approximately $672,750. Now lets say you are ready to retire and want to pay back the loan.

$672,750 - $100,000 [loan amount] = $572,750 Capital Gain
$572,750 / 2 = $286,375
$286,375 x 0.35 [MTR] = $100,231 [taxes payable]
$572,750 - $100,231 = $472,519

Therefore, after taxes, the investor is left with approximately $472,519.

As you can see, the leveraging strategy works out a lot better then the RRSP strategy; in fact, with leveraging, the investor would have made $267,761 more, then if he would have invested the same amount of money into an RRSP -- that's more then twice the amount of the RRSP!

If we were to put a twist on this, and assumed that the RRSP investor also invested his tax refund of $1750 ($5000 x 0.35) right back into his RRSP, making his annual contribution $6750, the RRSP would grow to approximately $425,267. After taxes, the investor would be left with approximately $276,424, which is still way behind the leveraging strategy.


(Calculations came from http://www.mackenziefinancial.com/calc/jsp/RegNonReg/rrsp_vs_non_rrsp.jsp)

That being said, be very careful with leveraging. It is NOT suitable for everybody. It requires a high risk tolerance and the investor must give time for their investment to compound over and over. Just as the RRSP is not right for everybody, the leveraging strategy is not either. Please consult your financial advisor before making any decision like this.

What might make sense is to do both strategies or mix and match different strategies together.

If you require any more information please do not hesitate to contact me!

Investments Part 1: RRSP

We've already covered few things on the 2 other industries, the Debt(making) Industry, and the Insurance Industry. In this post we'll take a look into the 3rd industry, the Investment/Savings Industry, and more specifically, RRSPs (Registered Retirement Savings Plans).

Essentially, in Canada, we have 3 investment vehicles we can use to accumulate our assets/wealth. We can use RRSPs, Open (Non-registered) Plans, and the newly introduced TFSA (Tax-Free Savings Account). Each one of them has their pros and cons and each must be used according to the clients situation and goals.

What is an RRSP?

An RRSP is an investment vehicle that allows Canadians to grow money tax-deferred (this means you don't pay taxes on the money until it is withdrawn). When a person makes a contribution to their plan, they get a tax deduction for the amount that was contributed. This can be a great thing for those who are in higher tax brackets, and can also help them get into a lower tax bracket.

Any income within the RRSP is not taxable while it is still within the plan and grows tax-free until it is withdrawn. The funds can be withdrawn at any time, but not without any consequence. The withdrawn amount gets added to the persons earned income and can potentially put them into a higher tax bracket. There are also taxes that are witheld at time of withdrawal, which is based on the amount withdrawn.

A person can keep funds within an RRSP until the end of the year in which they turn 71, at which point it must be converted into a RRIF (Registered Retirement Income Fund -- something we will discuss at another point).

Why RRSP?

An RRSP can be a great way to invest for your future, if it is done properly. Lets take a look at a few benefits of the RRSP:

- Tax Deduction
- Tax Deferred Growth
- Possibility of putting you in a lower tax bracket
- You can use funds within an RRSP for First Time Home Buyers plan [HBP] (funds must be repayed within 15 years of withdrawal otherwise they are subject to taxation)
- You can set up a Spousal RRSP to split income (which will be discussed in another post)
- Unused contribution gets carried forward
- You can use funds within an RRSP for Lifelong Learning Plan [LLP] (funds must be repayed within 10 years of withdrawal otherwise they are subject to taxation)
- In the event of death, the RRSP can be transferred to a spouse's or a common-law partner's RRSP tax-free

As you can see, the RRSP can offer several benefits to those, IF it is used properly.

Things to be aware of

Even though there are many benefits to an RRSP, there are also many things to be aware of, that most people are not aware of because they are not told. Some of these things include:

- There is contribution limit (based on previous years income as stated on taxes)

- All growth within the RRSP is considered as "interest income" no matter which type of growth it was (capital gains, dividends, or interest). This means when you withdrawal, you will be taxed at your tax bracket and there are no tax benefits for different types of investments

- You will be taxed on the FULL amount of withdrawal, and not just the growth, within the RRSP

- Once you reach age 71, you MUST either a) transfer the funds into a RRIF (which results in forced withdrawal from the RRSP) b) purchase an annuity or c) withdrawal the amount in full

- You can end up paying more money in taxes in your later years if your income is higher; this could negate any tax deductions you had received in previous years; you can possibly pay more money in taxes in retirement then you saved in the earlier years

- There is a limit that you are able to contribute every year; A Tax of 1% per month applies on the portion of your RRSP contribution that exceeds your RRSP deduction limit and the over-contribution limit of $2000

- Interest on funds borrowed to invest into an RRSP are not tax-deductible (as they would if they were invested into an Open [non-RRSP] Investment)

- If funds are not payed within the specified timelines for the Home Buyers Plan and the Lifelong Learning Plan, you will be subject to taxation

Contribution Limit

The maximum RRSP contribution limit 2012 is $22,970. However, if you did not use all of your RRSP contribution limit for the years 1991-2011, you can carry forward the unused amount to 2012. Therefore, your RRSP contribution limit for 2012 may be more than $22,970.

The maximum RRSP contribution limit for subsequent years is as follows:

• 2012 maximum RRSP contribution limit: $22,970
• 2011 maximum RRSP contribution limit: $22,450
• 2013 maximum RRSP contribution limit: $23,500 plus inflation index amount
• 2014 maximum RRSP contribution limit: Indexed to inflation
• 2015 maximum RRSP contribution limit: Indexed to inflation

(Source: http://www.tax-services.ca/rrsp-canada.html#RRSP_Contribution)

Now, it is evident that there are many things that you should be aware of before using RRSPs as your investment vehicle. Like I said before, they can be a great investment vehicle IF used properly. What I don't like is how they are marketed; they're marketed as the "one size fits all, for everybody, in every situation". The traditional industry (specifically the banks) have done a terrible job in setting up RRSPs and with educating Canadians about all the pros and cons of them.

When using this investment vehicle, do your homework and consult your advisor. Find out everything you think you will need to know about them. I hope this has helped! If you require any more information, please do not hesitate to contact me. Happy investing!