Last week’s federal budget centrepiece was the Tax-Free Savings Account (TFSA), giving investors a new vehicle to save on taxes. As previously reported, the TFSA is scheduled to make its debut in 2009, allowing maximum contributions of up to $5,000 a year.

Although a TFSA is very different from an RRSP, each of these accounts holds an after-tax advantage in returns over a non-registered account. Everyone who is 18 years old and over will be able to contribute to a TFSA, and if you are eligible to make RRSP contributions it will generally be to your advantage to contribute to both.

That, of course, depends on having the money available. According to a national BMO Financial Group/Leger poll released on Feb. 27, more than half of Canadians are not making an RSP contribution this year.

Realistically, for a large number of Canadians who won’t be able to contribute to both a TFSA and an RRSP, the question becomes: Which one of the two will leave me further ahead?

To illustrate the differences between the TFSA, RRSP and non-registered savings, the Finance Department created a table (See below) comparing the three according to one scenario. The example used a $1,000 one-time contribution, held for 20 years by an individual with a 40% marginal tax rate. The assumed return, implying a very conservatively managed portfolio, was a compound annual 5.5%.

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	TFSA	RRSP	Unregistered savings
Tax (40% rate)	400	0	400
Investment income (20 years at 5.5%)	1,151	1,918	707
Tax (40% rate)	0	1,167	0
Net annual after-tax rate of return (%)	5.5	5.5	4.0
Source: Finance Department

The RRSP investor jumps out to an early lead, since there is a tax deduction that leaves this account with the full $1,000 to invest. The TFSA and non-registered accounts, by contrast, start out with only $600, since they must make their contributions with after-tax dollars.Both the TFSA and the RRSP accounts enable income to accumulate tax free, while the holder of the non-registered account gets hit with income tax each year. The RRSP extends its lead, since it started out with a larger amount, while the TSFA ranks second and the non-registered account lags.

By the end of 20 years, the value of the net contribution plus investment income has reached $1,751 for the TFSA, $2,918 for the RRSP, and only $1,307 for the non-registered account. (The government’s example for the non-registered account assumes a tax rate of 28% on investment income, based on portfolio returns that are assumed to be composed of 30% capital gains, 30% Canadian dividends and 40% interest.)

The great equalizer between the TSFA and the RRSP account occurs at the time of withdrawal. The value of the TSFA remains at $1,751, since no taxes are payable on withdrawal of either the original TFSA contribution or any capital gains, dividends or interest earned.

But the $2,918 RRSP is taxable at the highest marginal tax rate at the time of withdrawal, which works out to a tax hit of $1,167. This leaves the RRSP holder with after-tax proceeds of $1,751, thereby finishing in a dead heat with the TFSA holder. (The non-registered account finishes last with $1,307.)

The key variable is how the tax rate at the time of withdrawal compares to the tax rate at the time of the contribution. Here are the three scenarios, and how they may affect your choice of account:

• If the two rates are identical, as in the hypothetical example cited in this article, the TFSA and the RRSP are equally effective tax-savings alternatives.
• If the tax rate at the time of withdrawal is lower than at the time of contribution, the RRSP is the better choice.
• If the tax rate at the time of withdrawal is higher than at the time of contribution, the advantage goes to the TFSA.

In other personal-finance related developments in the budget, there were several changes affecting life-income funds (LIFs) and registered education savings plans (RESPs).

LIFs are locked-in pension accounts. They hold assets that are transferred from a registered pension plan to an individual who would prefer to manage his or her own account rather than remain in the pension plan. LIFs can be created, for instance, when individuals are laid off from an employer.

The budget provides much increased flexibility for LIF holders to gain access to their assets. Individuals who are 55 years or older, and with LIF holdings of up to $22,450, will be able to wind up their accounts and have the option of transferring the assets to an RRSP or a registered retirement income fund (RRIF).

Those 55 and older are also entitled to a one-time conversion of up to 50% of their LIF holdings into an RRSP or RRIF, with no maximum withdrawal limits.

In addition, all individuals facing financial hardship (such as low income, disabilities or medical costs), will be entitled to unlock up to $22,450 from their LIFs.

As for RESPs, the budget proposed changes in the time limits and age limits. The maximum number of contribution years will be increased to 31 years, up from 21 years. The lifetime contribution limit remains at $50,000.

The deadline for terminating an RESP will be extended to the year that includes the 35th anniversary of the plan, up from the current 25th anniversary. If the beneficiary qualifies for the disability tax credit, the deadline is extended to the 40th anniversary year, up from the 30th year.

In terms of age limits, no contributions can currently be made in family plans for beneficiaries who are 21 or older. The budget calls for raising this age threshold to 31 years old.

[Written by Rudy Luukko, MorningStar.com]

Tax Free Savings Accounts (TFSA’s) were just announced in the recent federal budget. At first, it seemed they would be not nearly as useful as RRSP’s since there would be no tax refunds for contributing. However, we are starting to analyze TFSA’s and it seems they beat RRSP’s most of the time. Credit Stephen Harper for implementing what may eventually become the most effective retirement savings vehicle for many (perhaps most?) Canadians, as well as a very useful tax saving tool.

To understand why TFSA’s will beat RRSP’s as a retirement savings vehicle for many Canadians, we first need to understand income tax on seniors.

TFSA’s appear to be almost exactly the same as RRSP’s, except without the tax refund on contributing and tax on withdrawals. Therefore, to determine whether TFSA’s or RRSP’s are better for you depends mainly on your tax bracket when contributing (during your career) vs. your tax bracket when withdrawing in retirement.

A common part of retirement planning and one of the main benefits of RRSP’s includes the assumption that most Canadians will be at lower income tax rates after they retire than they are during their working career. This may sound logical, but it is often not true. In fact, on average, when you include clawbacks on several programs for seniors, income tax rates on seniors are almost 50% higher than on adults under 65!

Our Canadian outlook of always looking after the have-nots has led to quite a few benefits for seniors that are clawed back based on income. The idea is that those with a lot of income do not need the tax relief. The end effect, however, is very high rates of income tax on seniors.

The 3 main Clawbacks that affect seniors are clawbacks on the Guaranteed Income Supplement (GIS), the age credit and on Old Age Security (OAS). GIS is a supplement of up to $7,608 of tax-free income paid to seniors with an income under $15,240. Essentially, for every $2 of taxable income, the GIS is reduced by $1. The age credit is a tax credit of $5,177 that is reduced by 15% for any dollar of income above $30,935. Maximum OAS is a taxable income of $6,028 that is also reduced by 15% for incomes above $63,510. (The OAS clawback is not quite as bad, since we at least get credit for the income tax we would have paid on the OAS.)

There are also clawbacks that apply to adults under 65, such as employment insurance and the child tax benefit, but none of them apply to everyone at any given tax bracket.

When you add the clawbacks that affect seniors, here are the approximate marginal tax brackets in Ontario for adults under 65 vs. seniors. The marginal tax rates apply to everyone, while the tax rates with clawbacks apply specifically to anyone 65 and over.

Note that the average tax rate on seniors up to $121,000 on income (the start of the top tax bracket) is 45%, compared to 32% for adults under 65. This is a difference of 13% of income, or a total of 43% higher tax to pay for seniors!

Note also that seniors making under $15,000 or over $37,000 are almost all taxed higher than the top tax bracket of 46% for non-seniors!

The lowest tax rates for adults under 65 are on eligible dividends. In fact, the tax rates are negative at a few tax rates, but this is now being eliminated by 2010. The latest budget has increased income tax rates on dividends, which appears to increase them to no lower than 0% at any income level. So the marginal tax rates on most dividend income will be a bit higher than on this chart by 2010.

The lowest tax rates for seniors, however, are on capital gains. This is because the clawbacks are on taxable income – which is only 50% of capital gains but is 145% of dividends. For example, for seniors with no other income, the 50% GIS clawback is only a 25% clawback on capital gains income, but is a 73% clawback on dividend income.

Is there logic to these tax rates? Why should dividends have the lowest tax rate for adults under 65 who are building retirement assets, while capital gains have the lowest tax rate for seniors trying to get an income from their investments? It sounds backwards, but there is some logic when you understand the way CRA structures tax on investment income.

Many Canadians, if they have saved a good nest egg or have a decent pension, may be retiring on incomes of 50-70% of their working incomes. For example, an average Canadian may earn $50-60,000/year during their career, which would put them into a marginal tax rate of 31%. When they retire on say $30-40,000, they would be at a marginal tax bracket of 37% - which is higher than during their working career.

Note that many seniors will be at lower tax brackets in retirement, however. This is because most Canadians, if they have only modest savings for retirement, will likely be retiring with incomes of only $15-30,000/year, which would put them in the lower 22% tax bracket.

All of these tax brackets are adjusted for inflation each year. This means that the income amounts for each bracket will be close to double the figures in the above chart in 25 years.

What does all this mean for the usefulness of Tax Free Savings Accounts (TFSA’s)? That will be the subject of our next article.

[Written by Ed Rempel (CFP/CMA) via MillionDollarJourney.com]

For those of you coming here through Google search looking for the RRSP deadline for tax year 2007, the deadline is: Feb 29, 2008.

A reminder for those procrastinators out there, today is the last day for you to contribute to your RRSP’s to make your 2006 tax return! If you’re not sure if RRSPs are right for you, check out my article on “Who Should Contribute to an RRSP?“.

Also note that your RRSP contribution limit should be on your 2005 Notice of Assessment (NOA) or 18% of your 2005 earned income up to a maximum contribution of $18,000.

If you don’t have your 2005 NOA, then you can call Canada Revenue Agency (CRA) and they will determine your limit after a bunch of security questions. CRA also has a free online service that enables you to access your RRSP contribution limit information online. Remember that unused contribution room from previous years can be carried forward.

Here are the RRSP contribution limits for future years:

• 2007 - $19,000
• 2008 - $20,000
• 2009 - $21,000
• 2010 - $22,000

If you want to figure out your tax return based on your RRSP contribution, here is what you do:

1. Go to taxtips.ca and determine your marginal tax rate based on your income and province. For me personally, my marginal tax rate is: 38.16%
2. Multiply your total contribution for the year by your marginal tax rate and voila, you will have your approximate RRSP tax refund. Example: In 2006, I contributed around $6000 to my RRSP, so I should get: $6000 x 38.16% = $2289.60
3. Or, you can forget the math and use the RRSP calculator that is provided on taxtips.ca (select your province first).

Before you go running to the bank, remember, you don’t have to rush into an investment immediately. You can simply deposit money into your RRSP account, and decide which investments to go with later. Now.. run to the bank.

If you’re like most Canadians, you want to retire early and you’re confident you’ll have the means to do it. But chances are you won’t be packing it in as early as you planned to – and you won’t be living in the lap of luxury.

You won’t be stocking up when tins of cat food go on sale, either.

Canada is on the cusp of a retirement revolution. It’s those baby boomers playing their demographic games once again.

Over the next five to 10 years, more Canadians than ever will be in a position to clean out their desks for the last time.

In 1981, there were 4.6 million near-retirees (people between 45 and 64 years old) in Canada. They made up 27.8 per cent of the working-age population. By 2002, that number had grown to 7.6 million – or 35.7 per cent of the working-age population. By 2006, 8.7 million – or 38.8 per cent of the working-age population – will be close enough to the golden handshake to give it serious thought.

Workers per retired person

1991: 3.8 2001: 2.7 2011: 1.8 (projected)

According to the number crunchers at Statistics Canada, a third of them will conclude they haven’t set aside enough to be able to afford to do it.

That same study (the General Social Survey of 2002) asked people who had been retired for a year, how they were faring financially now that they were collecting a pension. Just over a third – 34.1 per cent – said they were worse off. The rest said their situation was about the same – or they were better off.

Here are a few more numbers to ponder:

• The median retirement age fell from 65.1 years in 1976 to 60.6 in 1997. By 2003, it was up again – to 61.8 years.
• Canada/Quebec Pension Plans are designed to provide retirement income of no more than 25 per cent of the average Canadian wage ($41,100 for 2005). Throw in Old Age Security benefits, and you’re up to 40 per cent.
• Most retirement planners say you should have accumulated enough assets to replace 70-80 per cent of your pre-retirement income by the time you stop working.
• Most Canadians retire on far less than that (and don’t have 101 canned tuna recipes).

About 40 per cent of Canadians are currently covered by an employer pension plan. Twenty years ago, more than half were.

Coverage ranges from almost 100 per cent for public sector workers to about 30 per cent for employees of private sector firms. Some of those plans are in deep trouble and may need major overhauls if they’re to provide the benefits promised. In some cases, companies with active pension plans have gone under.

Not all have been as fortunate as former Eaton’s employees. Two of the three pension plans in effect when Eaton’s stopped administering its pension plans on Nov. 18, 1999, had surpluses. Promised benefits have been paid and – in some cases – former employees got a little extra as the surplus was divided among them.

But that was 1999, before the bears chased the bulls off Bay and Wall Streets. The end of double-digit returns forced employers to take a hard look at pension plans.

QUICK FACTS

Two-thirds of Canadians retire before the full Canada Pension Plan/Quebec Pension Plan benefit age of 65, oftentimes involuntarily.

Low interest rates and prolonged market losses meant some pension plans that promised set retirement benefits were running huge deficits. And not just in the private sector.

On February 1, 2005, Nova Scotia teachers narrowly rejected a deal worked out between their union and the province that changes the way pension benefits are indexed to inflation. Under the current rules, benefits are automatically indexed to the inflation rate minus one per cent. But the pension plan is short of money - and the government wanted to tie indexing to the plan’s financial health. The two sides will resume negotiations.

It’s a problem that has dogged Stelco, the giant steel maker in Hamilton, Ont., since Jan. 29, 2004, when the company sought protection from its creditors. At the time, the steel maker cited a looming liquidity crisis and a potential pension shortfall of $1.25 billion. Despite the woes, several interested parties have come forward – especially since Stelco’s liquidity problems were chased away with a profit of more than $100 million in the second and third quarters of 2004.

Many employers are turning to less-expensive pension options that put much more of the burden of saving on the employee.

QUOTE

“It is seldom too late to plan for retirement.” Canada’s Certified General Accountants

But what about the 60 per cent of Canadians who aren’t part of any pension plan? Those who retire today can collect a maximum C/QPP of $828.75 and Old Age Security of $471.76 a month, if they’re 65. That’s a grand total of $15,606.12 a year - assuming those plans will be around when your time comes around.

And if you’ve made it to 65, you’ve got better than even odds of making it past 80, according to the actuaries. You very well might find it tough to have a grand time for 15 years on just 15 grand per.

On the bright side, if you are like most Canadians – and if your health holds up – your lifestyle in retirement will be pretty much what it was while you were working. If you didn’t travel extensively while you were working, you probably won’t morph into Magellan.

So if you prefer taking long walks or hanging out at the library instead of spending afternoons at the club or wintering in Tahiti, you might get by on government benefits.

On the other hand, if you’re looking forward to spending your retirement on golf courses, tennis courts and cruise ships and your retirement savings plan consists of C/QPP contributions – and a lottery ticket every week – you may find yourself spending those golden years sitting in a rocking chair, complaining about the government full time.