Chapter 6: Tax and Retirement Planning

Career Average Plan

- pension is calculated as a percentage of an employee's earnings over the course of her career (while in the plan) - employees may contribute a fixed percentage of their salary (such as 5%) to this type of plan - employer contributions required to fund the defi ned benefit vary according to factors such as investment yield, mortality and employee turnover

Name three advantages of contributing to an RRSP.

- provides a medium for investment of, and a compounding return on, taxsheltered dollars - provides a vehicle for regular saving to build up a larger retirement income and a larger estate through the compounding of tax-deferred income and capital gains - avoids the complicated task of bookkeeping regarding the investment income and capital gains earned by the assets of the plan over its life - not affected by a job transfer or the loss of employment to the same degree as many company pension plans. With increased job mobility and portable pensions not in universal use, many taxpayers lose the benefits of one or more private company pension plans as job changes are made over the years - builds up and provides additional funds for an early retirement or an extended period of absence from work - defers income tax to later years when the plan holder has presumably a lower marginal tax rate - provides an opportunity to split retirement income (using both contributor and spousal RRSPs) and reduce the effective tax rate on the combined income

Dividend Tax Credit (DTC)

- refers to the preferential tax treatment granted to dividend income (common & preferred) received from taxable Canadian corporations - dividend is grossed up by 38% and the tax credit of 15.02% is calculated based on this amount

Capital Loss

- selling a security for less than its purchase price - capital losses can only be applied against capital gains. Surplus losses can be carried forward indefinitely and used against future capital gains - only 50% of the loss can be used to offset any taxable capital loss

When a person turns 71, what must be done with his or her RRSP assets?

- terminate all RRSPs and receive a lump sum - use the proceeds to purchase a fixed term annuity which provides benefits to a specified age - purchase a life annuity, with or without a guaranteed period. These are offered by life insurance companies - transfer RRSP funds into an RRIF - or a combo of the above

Life Income Fund

- termination option available to holders of locked-in pension funds such as a LIRA - a LIF is similar to a RRIF but it has both a minimum and a maximum annual withdrawal requirement - funds from a standard RRSP are not transferable to a LIF

Four General Types of Income

- Employment income - Capital property income (income from stocks/bonds etc) - Business income (profit from selling g/s & self-employed) - Capital gains and losses (gain or loss resulting from the sale of capital property)

Tax-Free Savings Account (TFSA)

- Government sponsored saving plan where investment income earned in the TFSA is tax free ($5500 annual limit)

Three different forms of revenues that can be generated from mutual funds.

- Interest income (from fixed income securities)/highest tax - Dividends (from preferred/common shares) /grossed up by 38% on statements and then fed tax rate is 29%, 26%, 22% or 15% (DTC is 15.02%) - Capital gains (when mutual fund/security in it is sold for more than costs) - Dividends offer the most tax-efficient investment income for lower federal tax brackets. For higher tax brackets, the efficiency of capital gains outweighs dividend income.

Describe the features of registered education savings plans (RESPs) and explain how RESPs can be enhanced with Canada Education Savings Grants (CESGs).

- RESPs are tax-deferred savings plans intended to help pay for the post-secondary education of a beneficiary - contributions to a plan are not tax-deductible, there is a tax-deferral opportunity, since the income accumulates tax-deferred within the plan - on withdrawal, the portion of the payments that were not original capital are taxable in the hands of the beneficiary or benefi ciaries, provided they are enrolled in qualifying or specified educational programs - there is no max amount that can be contributed in a single calendar year for each beneficiary - there is a lifetime maximum of $50,000 per beneficiary - contributions can be made for up to 31 years, but the plan must be collapsed within 35 years of its starting date - under CESGs, the fed gov makes a matching grant of at least 20% of the first $2,500 contributed each year to the RESP of a child under 18

What are the major differences between an RRIF and an annuity?

- RRIF's are like RRSP's in that you can control how the money is invested - RRIF's have mandatory minimum withdrawal features - annuities are contracts issued by insurance companies - you provide them with the money and they pay out capital and interest income over a specified period of time - you have few options when deciding how your funds in an annuity are invested & generally receive an interest rate return from this type of investment vehicle

Pooled Registered Pension Plan (PRPP)

- a trust registered with Canada Revenue Agency and established by an employer to provide pension benefits for employees when they retire - both employer and employee may contribute to the plan and contributions are tax-deductible

Registered Pension Plan (RPP)

- a trust, registered with Canada Revenue Agency (CRA) or the appropriate provincial agency, established by a company to provide pension benefits for its employees when they retire - both employer and employee contributions to the plan are taxdeductible (defined benefit plans (DBP) and defined contribution plans (DCP))

Registered Retirement Savings Plan (RRSP)

- allows contributors to save some of their annual earned income, up to allowable limits, while deferring income taxes on the contributions - any earnings held within the plan are sheltered from taxes but, upon withdrawal, are taxed as regular income regardless of their source (e.g., dividends, capital gains or interest) - Single Vendor RRSPs and Self-Directed RRSPs

Describe the features of registered retirement savings plans (RRSP) and calculate the annual contribution limit to an RRSP.

- an RRSP is an investment vehicle that allows you to defer tax and save for retirement - annual contributions are tax deductible up to allowable limits - RRSPs only defer the payment of taxes and eventually all funds contributed to, and earned within, RRSPs will be taxed - advantage of an RRSP is that a retiree will likely pay income taxes on RRSP funds at a lower tax rate than would have been paid at the time of contribution - contributions can be made up to and including the year in which you turn 71. At the end of that calendar year, you must terminate all RRSPs - no limit to the number of RRSPs an individual may own, however, there is a limit on the amount per year that you can contribute to an RRSP - maximum annual tax deductible contributions to RRSPs an individual can make is the lesser of 18% of the previous year's earned income; and the RRSP dollar limit for the year - a RRIF is one of the tax deferral vehicles available to RRSP holders who wish to continue the tax sheltering of their plans

Registered Retirement Income Fund (RRIF)

- an RRSP termination option that allows the investor to retain the same investments as were held in the RRSP - RRIF requires minimum annual withdrawals which must begin by the end of the second calendar year following the plan's initiation - like RRSPs, RRIFs are transferable between financial institutions and an investor may have more than one

Flat Benefit Plan

- an employee's monthly pension is a specified number of dollars for each year of service (simplest) - different earnings don't make different amounts - pension needs to be renegotiated often due to inflation - paid in addition to OAS and CPP/QPP - normally funded entirely by employer

Over-Contribution

- an investment into an RRSP that exceeds the allowed amount of contribution - the over-contribution is not tax deductible, and the individual may be subject to a penalty if the over-contribution exceeds a cumulative lifetime over-contribution limit of $2000

Final Average Plan

- bases the pension on an employee's length of service and average earnings over a stated period of time - often this is the average of the best 5 consecutive years of earnings in the last 10 years of employment, or the average of the best 3 consecutive years of earnings over the last 5 years of employment

Fiscal Year

- company's accounting year - due to the nature of particular businesses, some companies do not use the calendar year for their bookkeeping - typical example is the department store that finds December 31 too early a date to close its books after the Christmas rush and so ends its fiscal year on January 31

Carrying Costs

- deductible annually against investment income that is reported annually - interest on funds borrowed to earn taxable income - investment counselling fees for non-registered investments - trustee, administration and safe-keeping costs for non-registered assets - accounting and tax reporting expenses

The most advantageous ways to minimize tax are:

- deducting amounts from taxable income - sheltering income from taxation - deferring the payment from a high marginal tax rate to a lower marginal tax rate - splitting (transferring or sharing) income with a family member at a lower marginal tax rate

What is the purpose of the Pension Adjustment (PA)?

- designed to equalize the ability to save for retirement between people with pension plans and people without - if you have a company pension plan, you have a retirement income opportunity through earning a pension benefit that is unavailable to taxpayers who do not have a company pension plan - Canadians are able to save for retirement through RRSPs, and receive a tax-deduction for eligible contributions as well as earning tax-sheltered income - if a taxpayer is already contributing to a company pension plan (contributions to the plan are also tax-deductible and tax-sheltered), the government calculates a PA - the amount of this PA reduces the amount of tax-deductible contributions the taxpayer can make to an RRSP meaning individuals with a company pension plan cannot contribute as much to an RRSP as those who do not have one (makes it fairer for taxpayers in terms of opportunities to save for retirement)

List and describe the features of tax free savings accounts (TFSA).

- introduced in 2009 - income earned within a TFSA will not be taxed in any way throughout an individual's lifetime - there are no restrictions on the timing or amount of withdrawals from a TFSA, and the money withdrawn can be used for any purpose - contributions were limited to $5,000 a year - after 2009, that amount was indexed to inflation and rounded to the nearest $500 making the current annual contribution limit is $5,500 - withdrawals can be made from a TFSA at any time

Describe and differentiate between the most common employer-sponsored registered pension plans.

- employer-sponsored plans are called registered pension plans (RPPs) and include both defined benefit and defined contribution plans - a RPP is a trust, registered w/ CRA or the appropriate provincial agency, established by a company to provide pension benefits for its employees when they retire - in a defined benefit plan (DBP) the benefits are predetermined based on a formula including years of service, income level and other variables, and the contributions are designed to match the predetermined plan benefits - in a defined contribution plan (DCP) the contributions to the plan are predetermined and the benefits, at retirement, will depend on how the contributions were invested - in a flat benefit plan, the monthly pension is a specified dollar amount of pension for each year of service - in a career average plan, the pension is calculated as a percentage of an employee's earnings over the course of her career (while in the plan) - in a final average plan, the pension is based on an employee's length of service and average earnings. Rather than basing the earnings over the lifetime of service, however, final average plans use a stated period of time

Identify and describe the features of the government pension plans available to Canadians citizens.

- gov pension plans include the Canada & Québec pension plans and Old Age Security - contributions to CPP or QPP are automatic and the right to a pension based on years of contribution is irrevocable and is paid out even if the contributor leaves Canada - OAS is payable at age 65 to all Canadian citizens and legal residents, including landed immigrants - a provision exists in the Income Tax Act (ITA) for higher income Canadians to repay all or part of the social benefits they receive in any year - this repayment is referred to as a "clawback", and OAS payments are a social benefit that falls into this category

Canada Pension Plan (CPP)

- government sponsored pension plan to which all employed residents in Canada (except Québec) contribute - contribution to the plans is automatic. Starting from age 65, pensioners receive a modest monthly amount

Self-Directed Plans

- holders invest funds or contribute certain acceptable assets such as securities directly into a registered plan - the plans are usually administered for a fee by a Canadian financial services company - investors can make all investment decisions - a full range of securities may be held in these plans, including GICs, money market instruments, bonds, equities and mutual funds and FDIs

Contribution Room

- if you do not contribute the maximum allowable amount to your RRSP in a year, you can carry forward the unused contribution indefinitely to future years - the contribution room is the annual unused contribution carried forward

Single Vendor Plans

- in these plans, the holder invests in one or more of a variety of GICs, segregated pooled funds or mutual funds - the investments are held in trust under the plan by a particular issuer, bank, insurance company, credit union or trust company - no day-to-day investment decisions are required to be made by the holder - there may be a trustee fee charged for this type of plan in addition to any costs incurred for purchasing the investments themselves

Differentiate among the ways that interest income, foreign dividends, Canadian-source dividends and capital gains are taxed.

- interest income is treated the same way for tax purposes as income from employment: there is no special treatment for interest income, and investors pay taxes on interest income at their marginal tax rate - dividends from taxable Canadian corporations receive preferential tax treatment in the form of the dividend tax credit (DTC) - eligible Canadian dividends are grossed-up by 38% and then the taxpayer receives a fed dividend tax credit in the amount of 15.02% - dividends from foreign corporations do not qualify for tax credit - capital gain is the result of selling a security for more than its purchase price - only 50% of capital gains is taxed; the other 50% of a capital gain is tax free - capital loss is the result of selling a security for less than its purchase price - capital losses cannot be applied to reduce other sources of income like dividends, interests or employment income

Québec Pension Plan (QPP)

- mandatory contributory pension plan designed to provide monthly retirement, disability and survivor benefi ts for all Quebec residents - employers & employees make equal contributions

Identify the sources of earned income for the purpose of calculating RRSP contributions.

- total employment income (less any union or professional dues) - net rental income - net income from self-employment - royalties from a published work or invention - research grants - some alimony or maintenance payments ordered by a court - disability payments from CPP or QPP - Supplementary Employment Insurance Benefits (SEIB), such as top-up payments made by the employer to an employee who is temporarily unable to work (for parental or adoption leave, for example), but not the Employment Insurance (EI) benefits paid by Human Resources and Social Development Canada

Contribution In Kind

- transferring securities into an RRSP - the general rules are that when an asset is transferred there is a deemed disposition - any capital gain would be reported and taxes paid - any capital losses that result cannot be claimed

Money Purchase Plan

- type of Registered Pension Plan; also called a Defined Contribution Plan - in this plan, the annual payout is based on the contributions to the plan and the amounts those contributions have earned over the years preceding retirement - in other words, the benefits are not known but the contributions are

Defined Benefit Plan

- type of employer-sponsored pension plan that allows the employee to determine the amount of the eventual pension benefits with relative accuracy - generally, the benefits are a given percentage of the employee's salary and are often based on the number of years of service - flat benefit plans, career average plans, final average plans (you know how much in advance your pension will be at retirement)

Defined Contribution (Money Purchase) Plan

- type of employer-sponsored pension plan that does not allow the employee to determine the amount of the eventual pension benefi ts in advance - the benefits received depend on how successfully the contributions have been invested over the years - employee and the employer both contribute to the plan

Registered Education Savings Plan (RESP)

- type of tax deferred savings plan that allows usually parents or grandparents to save for a child's education - unlike RRSP contributions, annual RESP contributions are not tax deductible

Locked-In Retirement Account (LIRA)

- when a registered pension plan is terminated prior to retirement (e.g. when an individual changes employers), plan funds may be transferred to a LIRA - funds cannot be withdrawn before the holder reaches a designated age

Capital Gain

- when an investor sells an asset for more than its purchase price, a capital gain is realized - only 50% of capital gains is taxable; 50% remains tax free

The fundamental steps of correctly calculating the tax due are:

1. Calculating and adding up all sources of income from employment, business activity and investments 2. Subtracting all allowable deductions from total income to arrive at taxable income 3. Calculating the basic tax due on taxable income 4. Claiming non-refundable and refundable tax credits to calculate the net tax due

Why can't an investor deduct interest on borrowed funds that were used to purchase RRSP investments?

Money contributed to your RRSP is deducted from your income so that tax isn't paid on the contribution. The investment then accumulates tax free, potentially for decades. Since the RRSP investment isn't subjected to tax in the immediate term, you won't be able to deduct interest on funds borrowed to make RRSP contributions.

Annuity

a fixed sum of money paid to someone annually

Life Annuity

an annuity whose payments are guaranteed as long as the investor lives

Canada Education Savings Grants (CESG)

an incentive program for those investing in a RESP whereby the fed gov will make a matching grant of a max of $500 to $600 per year of the first $2,500 contributed each year to the RESP of a child under age 18

Earned Income

for an individual, it includes all income from employment but it excludes income from investments and any pension or unemployment benefits received

Locked-In RRSP

holder of a locked-in plan cannot withdraw any of the money until the holder reaches a particular age depending upon the province of residence

Carry Forward

in the case of RRSPs, it refers to unused contribution room that can be used to reduce taxable income in future periods

Old Age Security (OAS)

pension is payable at age 65 to all Canadian citizens and legal residents including landed immigrants and those with visitors' permits

Marginal Tax Rate

the tax rate that would have to be paid on any additional dollars of taxable income earned

Spousal RRSP

type of plan allows a couple to divide the ultimate retirement income between them

Deemed Disposition

under certain circumstances, taxation rules state that a transfer of property has occurred, even without a purchase or sale, e.g., there is a deemed disposition on death or emigration from Canada