Kicking Financial Ass
Page 17
Tip 1: Many tax deadlines fall at the end of the year, but IRAs are an exception. You can make prior year IRA contributions up until April 15 of each year.
Tip 2: If you move money from one IRA to another, e.g., to switch company’s or consolidate accounts, request a direct transfer from one custodian, or trustee, to the other. There is no limit on direct transfers.
Traditional IRA Roth IRA
2018 contribution limits $5,500; $6,500 if age 50 or over $5,500; $6,500 if age 50 or over
Contributions are Pre-tax Post-tax
Pay taxes at Withdrawal at retirement Time of contribution
Withdrawal rule Withdrawals before the age of 59½ are subject to income tax and a 10% penalty. Withdrawals are penalty-free beginning at age 59½. Withdrawals must begin at age 70½.
Beneficiaries pay taxes on inherited IRAs. Contributions can be withdrawn at any time, tax-free and penalty-free. Five years after your first contribution and age 59½, earnings withdrawals are also tax-free.
No withdrawals are required during the account holder’s life time. Beneficiaries can stretch distributions over many years.
Taxes in account No taxes on dividends, capital gains, or interest. No taxes on dividends, capital gains, or interest.
Extra benefits In some cases, up to $10,000 penalty-free withdrawals to cover homebuyer expenses, but taxes are due. Qualified education and hardship withdrawals are also available. After five years and in some cases, up to $10,000 of earnings can be withdrawn penalty-free to cover homebuyer expenses.
Qualified education and hardship withdrawals may be available without penalty before the age 59½ and the five-year waiting period. These may be taxed.
CHAPTER 11B
CANADIAN ACCOUNTS
In Canada, the two primary investing accounts used for retirement is the RRSP and TFSA. Both can be opened with your investment brokerage and shelter your investments from taxation, allowing your money to grow tax-free using a variety of investment options. In some ways, they are the opposites of each other, but each should be used simultaneously to meet your retirement goals.
•The RRSP, the older of the two, was introduced in 1957. Best to use if you feel your taxation rate will be lower in retirement than it is now to maximize your savings. It is more restrictive regarding withdrawals as you cannot take out money penalty free unless you are buying your first home or education purposes. Some employers offer pension-matching contributions for RRSP contributions, which is a nice benefit.
•The TFSA was introduced in 2009. Best to invest in if you feel your taxation rate will be higher in retirement than it is now to maximize your savings. It is also more flexible, allowing you to withdraw funds at any time, which can be a benefit or hindrance to your long-term retirement savings.
It is ideal to take advantage of both accounts to maintain flexibility and maximize your savings. I go further into detail below.
RRSPS
RRSPs, or Registered Retirement Savings Plans, are a tax-deferred investment vehicle. You do not pay tax on the contributions but do pay tax when the money is withdrawn, typically in retirement. You pay taxes on the withdrawn money as income rather than the more favorable capital gains and dividend tax rates. However, the fact that the money grows tax-free should offset any downside from paying taxes on withdrawals in retirement. You can also invest in many types of investments within an RRSP: cash, stocks, bonds, money market funds, mutual funds, and index funds.
Annual Contributions70
Contribution limits exist with RRSPs. To find out the exact amount you can contribute to your RRSP for the current year, check your most recent Notice of Assessment you received from the Canada Revenue Agency. You may contribute to your RRSP until December 31 of the year in which you turn 71. The following limits and deadlines apply:
Historical RRSP Maximums:
•2013: $23,820
•2014: $24,270
•2015: $24,930
•2016: $25,370
•2017: $26,010
•2018: $26,230
Your allowable RRSP contribution for the current year is the lowest of:
•18% of your earned income from the previous year,
•The maximum annual contribution limit for the taxation year, or
•The remaining limit after any company-sponsored pension plan contributions.
Earned income includes salary or wages, alimony received, and rental income, among other income sources, but does not include investment income.
Company Pension Plan or Deferred Profit Sharing Plan
If you have a company-sponsored pension plan or are part of a deferred profit sharing plan, the amount you can contribute to your RRSP must be reduced by the total value of the pension credits you earned for the year. This amount is referred to as a pension adjustment (PA), and you will find it on the Statement of Remuneration Paid (T4 slip) that you receive from your employer.
Annual Contribution Deadline
To qualify for an RRSP deduction for your current taxation year, you can make contributions any time during the year or up to 60 days into the following year.
Carry-Forwards
If you cannot contribute to your maximum-allowed annual contribution, you can carry the difference forward. The amount of your unused contribution limit is shown on your federal Notice of Assessment. You may also decide to delay claiming your current year’s RRSP tax deduction. To choose to take the deduction in a later year, make sure that your allowable deduction limit has not been reached.
Over Contributing to Your Plan71
Any contributions over your RRSP contribution limit for the year is considered an over contribution with a lifetime allowance of $2,000 without being penalized. However, you cannot claim a deduction for the excess amount, meaning you cannot claim it for a tax refund.
If you over contribute by more than $2,000, you are subject to a 1% penalty tax for each month you are in excess, up to 12% a year. Be careful to not over contribute!
Withdrawing from an RRSP
First, you do not need to start taking money out of your RRSP until the year you turn 72, although many people start withdrawing when they retire.72 Even so, by December 31 of the year you turn 71, you need to decide whether to cash out your RRSP (or wait until you turn 72), purchase an annuity from an insurance company (not recommended), or transfer your RRSP to a registered retirement income fund (RRIF). For young people, RRSP withdrawals typically happen in one of three situations—purchasing a home, withdrawing for education, or financial difficulty. I would highly recommend not withdrawing from your RRSP even if you are facing financial difficulty because you are borrowing from your future and seriously harming your retirement nest egg. That leaves two other reasons for withdrawing early without paying taxes.
Two Reasons to “Borrow” from Your RRSP Tax-Free
1.You can withdraw $25,000 tax-free for a down payment through the first-time home buyer’s plan (HBP) if you have not owned a house in the past four years. You then pay this back to your RRSP over a maximum of 15 years. If you do not follow the repayment plan, then the withdrawals are added back to your income, and you must pay taxes on the money. Note that you must have the funds in your RRSP account for a minimum of 90 days before you can withdraw them under the HBP.
2.You can also withdraw up to $10,000 per year, up to a max of $20,000 total, from your RRSP for education expenses under the Lifelong Learning Plan (LLP). You would pay this back to your RRSP over a maximum period of 10 years. Like the HBP, if you do not follow the repayment plan, then the withdrawals are added back to your income, and you will pay tax on them. The amount you withdraw is not limited to the amount of your tuition or other education expenses. If you meet all the LLP conditions when you make the withdrawal, you can use the funds you withdrew for any purpose. While $20,000 is the total overall limit, once this is completely paid back, you can participate in the LLP again.
Before you decide to borrow from your RRSP, weigh the pros and cons. There is n
o right or wrong answer as it is entirely dependent on your situation. To help with your decision, ask yourself these questions:
•Will you be able to repay the requirement amount back each year?
•Is it the right time to cash out your RRSP? Note, this depends on the investments and rate of return you are getting on your current investment.
•Is it worth forgoing the future tax-sheltered growth potential of your RRSP in favor of reducing the mortgage amount or education expenses?
Outside of withdrawing from your RRSP under the HBP and LLP, if you choose to withdraw from your RRSP early, there are tax consequences.73
1. You Pay a Withholding Tax
For any early withdrawals, your financial institution will hold back the tax on the amount you take out and pay it directly to the government on your behalf. The withholding tax varies between 10% and 30% depending on how much you choose to withdraw from your RRSP. In Quebec, these rates are higher.
If you withdraw: Withholding tax rate outside Quebec Withholding tax rate in Quebec74
Up to $5,000 10% 21%
Between $5,000 and $15,000 20% 26%
More than $15,000 30% 31%
For example, if you withdraw $25,000 from your RRSP early, after the 30% withholding tax ($7,500) is applied, you only end up with $17,500.
2. The Amount You Take Out Is Taxable Income
You must report the amount you take out on your tax return as income. At that time, you may have to pay more tax on the money, on top of the withholding tax. It depends on your total income and tax situation.
RRSP Pros
•You receive a tax refund that you can reinvest in the market.
•RRSPs force you to save for the long term.
•RRSPs are a good investment vehicle for those with high incomes during their working years, assuming they will be in a lower tax bracket during retirement.
•Some employers offer RRSP matching.
RRSP Cons
•If you make more money in your retirement than during your working years, which can happen more easily than you think between receiving your RRSP, Canada Pension Plan, and other income, then your tax bracket in retirement will be higher, and you will pay that tax rate on your withdrawals.
•Your money is locked in until you retire, except for using the Lifelong Learning Plan or Home Buyer’s Plan.
•If you do not earn much money the year you contribute, you will not get much of a tax refund. It is better to use a tax-free savings account (TFSA).
•If you do not reinvest your tax refund, you lose out versus investing in a TFSA.
TFSAS
Tax-Free Savings Accounts (TFSAs) are an amazing investment vehicle, especially if you are young. You contribute after-tax dollars and never pay tax again on the money, regardless of how much it grows. You have the flexibility of withdrawing the money, and then receiving that contribution room back the following year. But be careful! Because of the flexibility of withdrawing funds, people often use this account as a short-term savings account. Treat a TFSA as a retirement account and avoid withdrawals to allow your money to grow tax-free.
Annual Contributions
The contribution room changes every year. Increases are indexed to inflation and rounded to the nearest $500. Your contribution room is made up of:
•Your TFSA dollar limit plus indexation,
•Any unused TFSA contribution room from the previous year, and
•Any withdrawals made from the TFSA during the last year.
Historical TFSA Limits:
Year TFSA Annual Limit TFSA Cumulative Limit
2009 $5,000 $5,000
2010 $5,000 $10,000
2011 $5,000 $15,000
2012 $5,000 $20,000
2013 $5,500 $25,500
2014 $5,500 $31,000
2015 $10,000 $41,000
2016 $5,500 $46,500
2017 $5,500 $52,000
2018 $5,500 $57,500
Every year, the cumulative TFSA contribution limit grows for everyone over the age of 18.
Let’s assume it is 2018, and you just turned 18. If you open a TFSA account today, your contribution limit will be $5,500. If you turned 18 before 2009, your contribution limit is $57,500.
You can invest in any investments with a TFSA, just like with an RRSP. This means cash, stocks, bonds, mutual funds, money market funds, and index funds.
Carry-Forwards
Your unused contribution room can be carried forward indefinitely, and there is no limit on how much contribution room you can accumulate.
Over Contributing to Your Plan
Just like with an RRSP, a penalty will be assessed by the Canada Revenue Agency of 1% per month if you over contribute, up to 12% a year. Ouch! Unlike an RRSP, there is no $2,000 lifetime over contribution limit.
Withdrawing from a TFSA75
Depending on the type of investment held in your TFSA, you can typically withdraw any amount at any time, which makes it way more flexible than an RRSP. All withdrawals are tax-free. Another benefit of tax-free withdrawals is that they have no effect on your eligibility for certain government tax benefits such as Old Age Security (OAS), which can be reduced if you earn higher income levels, including receiving money from your RRSP.
Important to note that when it comes to withdrawing from your TFSA, making a withdrawal does not result in lost contribution room. Any withdrawals you make this year will be added to your unused contribution room next year.
Also, and this is very important, you cannot contribute more than your TFSA contribution room even if you make a withdrawal during the year. The withdrawal does not reset your limit. You must wait until the beginning of the following year when the amount you withdrew is added back to your unused contribution room.
TFSA Withdrawal Example
Date Action Available Contribution Room
January 8, 2017 Claire turns 18 and opens a TFSA $5,500
July 29, 2017 Contributes $3,500 $2,000
August 7, 2017 Withdraws $1,500 $2,000
October 1, 2017 Contributes $1,100 $900
December 3, 2017 Withdraws $500 $900
January 1, 2018 New contribution room available $8,400
In the example above, Claire starts with $5,500 in contribution room because that was the TFSA contribution limit for the year 2017. Notice that as she made contributions to her TFSA throughout the year, her available contribution room decreased by the same amount. However, when she made a withdrawal, the contribution room stayed the same.
In 2018, her contribution room consists of 3 things: The TFSA contribution limit made available to her, her unused contribution room from the year before, and the withdrawals she made in the prior year. Putting these numbers together, she gained $5,500 in contribution room for 2018, had $900 in unused contributions from 2017, and she withdrew a total of $2,000 from her TFSA in 2017. This gives her $8,400 in contribution room for the year 2018.
2018 contribution room=
$5,500 (2018 limit) + $900 (remaining from 2017) + $2,000 (2017 withdrawals)=
$8,400 contribution room for 2018
TFSA Pros
•It is a flexible investment vehicle that allows you to withdraw your money at any time, tax-free, and without penalty.
•When you retire and start withdrawing money from your RRSP and TFSA accounts as well as collect other benefits like CPP and Old Age Security, the government does consider your TFSA withdrawals when “clawing back” Old Age Security payments.
TFSA Cons
•Tax-free savings accounts are misconstrued as being only “savings accounts.” A savings account pays very little interest. You can invest in any number of investments with a TFSA, so use it for this purpose.
•Most people earn more during their working years than during their retirement, which can give an RRSP the edge but only if the tax refund is invested.
•The temptation to withdraw money from your TFSA is real. Making withdrawals will hinder your long-term investment
performance.
TFSAS VS. RRSPS
For example, assume you make $1,000 per year before tax. This table shows how a TFSA contribution is made with after-tax dollars, while withdrawals are tax-free. An RRSP contribution is made with pre-tax dollars, while withdrawals are taxable.
TFSA RRSP
Pre-tax income $1,000 $1,000
Tax (assuming 40%) $400 N/A
Net contribution $600 $1,000
Value 20 years later @ 9.7% growth $3,822 $6,370
Tax upon withdrawal (40%*) N/A $2,548
Net withdrawal $3,822 $3,822
*The marginal tax rate is the rate of tax charged on the last dollar of income.
This also shows that if your marginal tax rate at the time of the RRSP contribution is the same as at the time of the withdrawal, TFSAs and RRSPs work out equally well, if and only if the tax refund from the RRSP is reinvested. But there is one problem, typically most people spend the RRSP refund and do not reinvest it as they should. In that case, the TFSA will almost always be the better choice.
If Your Marginal Tax Rate Is Lower in Retirement
TFSA RRSP
Pre-tax income $1,000 $1,000
Tax (assuming 40%) $400 N/A
Net contribution $600 $1,000*
Value 20 years later @ 9.7% growth $3,822 $6,370
Tax upon withdrawal (25%**) N/A $1,593
Net withdrawal $3,822 $4,777
*Assumes $400 tax refund is reinvested (40% of $1,000).
** Assumes a lower tax rate in retirement.
In the above example, the marginal tax rate in retirement is 25%, less than the initial 40% during the person’s working years. The RRSP comes out ahead when the $400 tax refund is reinvested.
Not Reinvesting the RRSP Refund
TFSA RRSP
Pre-tax income $1,000 $1,000
Tax (assuming 40%) $400 N/A
Net contribution $600 $600*