Section 2.6) Tax and Retirement Planning
Advantages of RRSPs
1. A reduction in annual taxable income during high taxation years through annual tax-deductible contributions; 2. Shelter of certain lump sum types of income from taxation through tax-free transfer into an RRSP; 3. Accumulation of funds for retirement, or some future time, with the funds compounding earnings on a tax-free basis until withdrawal; 4. Deferral of income taxes until later years when the holder is presumably in a lower tax bracket; 5. Opportunity to split retirement income (using spousal RRSPs) which could result in a lower taxation of the combined income and the opportunity to claim two, $2,000 pension tax credits.
Types of income
1. Employment (taxed on gross receipt basis) 2. Capital/Property Income (stocks, bonds, mutual funds.. dividends and interest) 3. Business Income (from rendered services) 4. Capital gains and losses
What the the three types of DBPs?
1. Flat benefit Plan 2. Career Average Plan 3. Final Average Plan (Only differ in the criteria used to calculate the benefit.)
Disadvantages of RRSPs
1. If funds are withdrawn from an RRSP, the planholder pays income tax (not capital gains tax) on the proceeds withdrawn; 2. The RRSP holder cannot take advantage of the dividend tax credit on eligible shares that are part of an RRSP; 3. If the plan holder dies, all payments out of the RRSP to the planholder's estate are subject to tax as income of the deceased, unless they are to be received by the spouse or, under certain circumstances, a dependent child or grandchild; 4. The assets of an RRSP cannot be used as collateral for a loan.
Different forms of investment income taxation
1. Interest income: From investments such as CSB, GICs, Bonds (M.F.). Taxed as regular income (no preferential tax treatment.) 2. Dividends: From preferred shares/Common Shares that generate a dividend. Grossed up by 38% and taxpayer receives a divident tax credit (DTC) of 15.02% Note: Foreign Dividends do not get preferential treatment; they are taxed as regular income. 3. Capital gains: When M.F. or Security is sold for more than its cost. Only 50% of the gain is taxable.
What are special features that an investor should understand about an RRSP account ?
1. RRSP is a trust account designed to benefit the owner at retirement. Withdrawals from an RRSP are subject to a withholding tax and such withdrawals must be included in income in the year withdrawn. 2. An RRSP cannot be used as collateral for loan purposes.
If OAS candidates did not live in Canada for the last 10 years, they could still qualify for a full pension if:
1. They lived in Canada for the full year immediately before the application was approved 2. They lived or were present in Canada for at least three years for each year of absence during that 10-year period.
If OAS candidates did not live in Canada for the last 10 years, they could still qualify for a full pension if:
1. They lived in Canada for the full year immediately before the application was approved, and; 2. They lived or were present in Canada for at least three years for each year of absence during that 10-year period.
Spousal RRSP
A taxpayer can contribute to a Spousal RRSP only to the extent that the contributor does not use the maximum contribution available for his or her own plan. However, any withdrawals of contributions to a spousal plan claimed as a tax deduction by a contributing spouse made: 1. In the year the contribution is made, or 2.In the two calendar years prior to the year of withdrawal, are taxable to the contributor in the year of withdrawal rather than to the planholder.
Final Average Plans
Bases the pension on an employee's length of service and average earnings. Used a stated period of time; often this is the average of the best five consecutive years of earnings in the last 10 years of employment, or the average of the best three consecutive years of earnings over the last five years of employment (BEST PROTECTION AGAINST INFLATION)
Sally and Anthony Smith do not have any RRSP carry-forward room available. For this year, they can each contribute a maximum of $15,500, based on their current salary levels. So far, Sally has contributed the maximum amount to her RRSP, while Anthony has contributed only $12,500 to his. Under the RRSP guidelines, what are Anthony and Sally allowed to do and why?
Anthony can contribute $3,000 to Sally's spousal RRSP. (Because Anthony has not reached his maximum allowable limit yet of 15,500 he still has $3,000 worth of room. Also remember that a Spousal RRSP and taxpayers RRSP act as two different accounts technically, even though Sally reached her limit on her own.)
Registered Education Savings Plan (RESP)
Are tax-deferred savings plans intended to help pay for the post-secondary education of a beneficiary Max amount of $50,000/beneficiary; if the beneficiary does not attend school, payer can transfer the money to RRSP
Termination options available to holders of a Locked-In Retirement Account (LIRA) at retirement.
At retirement, holders of a LIRA are limited to specific vehicles, 1. Life Income Fund (LIF) or 2. Life Annuity
Termination of RRSP
Can withdraw/de-register at anytime; but mandatory deregistration is required when taxpayer is 71. Taxpayer can transfer proceeds to RRIF, which provides an annual income or just withdraw the lump sum completely.
Locked in Retirement Account (LIRA)
Depending on the plan, employees who leave their employer before the minimum level of service may receive a lump sum that is usually transferred into what is a called a locked-in retirement account or LIRA. Amounts transferred into a LIRA are locked-in and cannot be withdrawn; they can only be used for retirement income.
Which type of investment offers the greatest tax advantage for an investor?
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.
Investment income earned within an RRSP
Investment income earned WITHIN an RRSP like capital gains/dividends for example are not subject to taxation. When they are withdrawn they will be taxed at the marginal rate.
Gareth retired after 20 years of participation in a career average pension plan with a defined pension benefit percentage of 1.5%. His average annual salary, before deductions, was $60,000. Calculate Gareth's annual earned pension.
Gareth's annual earned pension would be calculated as $60,000 × 1.5% × 20 = $18,000
What are the main pension plans in Canada?
Government pension plans include 1. Canada Pension Plan (CPP) 2. Old Age Security (OAS) Employee Pension Plans (Known as Registered Pension Plans, RPPs); Types of RPPs. 1. Defined Benefit Plan (DBP) 2. Defined Contribution Plan (DCP)
In each of six consecutive years, a husband contributes $1,000 to his wife's RRSP, which he claims as tax deductions. In the seventh year there are no contributions, and the wife de-registers the plan. Thus, for the seventh taxation year for the Husband and Wife is ?
Husband: (7th year - nil, 6th year - $1000, 5th year - $1000) Claim $2000 in his taxable income Wife: (4th year - $1000, 3rd year - $1000, 2nd year - $1000, 1st year - $1000) Claim $4000 in her taxable income (notice the year two calendar years prior to the withdrawal rule is applied here.)
Registered Retirement Income Funds (RRIF)
Is one of the tax deferral vehicles available to RRSP holders who wish to continue the tax sheltering of their plans.
In DBP, how are the benefits predetermined?
In a 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. (You will know in advance how much your pension will be at retirement.) *The full benefit is only available for those who have achieved a minimum level of service of 25 years. (If person leaves before minimum level of service, they receive a lump sum which is transferred to a LIRA)
In DCP, how are the benefits predetermined?
In a DCP (also known as a money purchase plan) the contributions to the plan are predetermined and the benefits, at retirement, will depend on how the contributions were invested. Employee contributes a % of salary, and employer matches it (Pension is unknown)
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. To qualify as acceptable investments for an RRSP (either Single Vendor or Self-Directed), In Single Vendor RRSPs (no day-to-day investment decisions are required to be made by the holder.)
Self Directed Plans
In these, holders invest funds or contribute certain acceptable assets such as securities directly into a registered plan. One advantage of Self-Directed RRSPs is that investors can make all investment decisions. Another advantage is that, while there are rules with respect to allowable content, a full range of securities may be held in these plans.
Joanne's earned income last year was $45,000 and her pension adjustment was $2,500. She has $2,000 in carry forward registered retirement savings plan (RRSP) room for the current taxation year. Calculate her maximum tax-deductible RRSP contribution amount for the current year.
Joanne's tax-deductible RRSP contribution room would be calculated as (18% × $45 000) -$2,500 (pens. adjustment) + $2,000 = $7,600.
When can you receive your CPP?
May choose to receive monthly retirement pension for life at age of 65. (You can apply to receive at 60, but the amount received is reduced by a certain % for each month by which you are under 65.) - You can also postpone until you're 70 in which case the amount received in increased by a certain % of each month you're over 65.)
Calculating Income Tax Payable
On first 43,561 x 15% On portion over 43,561 and up to 87,123 x 22% On portion over 87,123 and up to 135,054 x 26% On portion 135,054 x 29% This is what is considered a Marginal Tax Rate (Tax paid on any additional dollars of taxable income earned.)
Over contributions to an RRSP
Over-contributions of up to $2,000 may be made without penalty. A penalty tax of 1% per month is imposed on any portion of over-contribution that exceeds $2,000.
What is OAS and when can it be received?
Payable to all Canadian citizens and landed immigrants who have reached the minimum age. Eligible between ages 65 to 67
Canada Education Savings Grants (CESGs)
Provide further incentive to invest in RESPs. Under this program, the federal government makes a matching grant of 20% of the first $2,500 contributed each year to the RESP of a child under 18
Ryan and Emily are both 35 and employed earning different incomes. They have two children for whom they wish to provide university tuition in the future. Select the most effective income-splitting strategy that would apply to this family's financial situation.
Ryan and Emily are both 35 and employed earning different incomes. They have two children for whom they wish to provide university tuition in the future. Select the most effective income-splitting strategy that would apply to this family's financial situation.
What are the most common tax deferral plans?
RRSP ( are available to individuals to defer tax and save for retirement years. Annual contributions are tax-deductible up to allowable limits. Income earned in the plan accumulates tax-free as long as it remains in the plan) 2 types of RRSP, 1. Single Vendor Plans 2. Self Directed Plans (there are no limit to number of plans can hold)
Harry earns $36,000 in the current year. His employer contributes $1,500 to his defined contribution pension plan. Calculate Harry's maximum contribution to the plan.
Remember: The combined employer/employee contributions cannot exceed the lesser of 18% of current year compensation or a fixed dollar amount; ($23,820). In this example, $36,000 × 18% = $6,480. If Harry's employer contributed $1,500, then, Harry could contribute $6,480 - $1,500 = $4,980.
Marginal Tax Rate
Represents the amount of tax imposed on your next dollar of earned income
Flat Benefit Plan
The flat benefit plan is the simplest type of defined benefit plan. The monthly pension is a specified dollar amount of pension for each year of service. Thus a formula of $15 per month per year of service, after 30 years of service, would produce a pension of $450 per month ($15 × 30 years).
Locked-in RRSP
The holder of a locked-in plan cannot withdraw any of the money until the holder reaches a particular age
Your client, a high income earner in a high marginal tax bracket, is seeking to minimize the amount of tax he pays on investment income while continuing to invest in mutual funds. Choose the mutual fund that would best meet his investment objective.
The most tax-effective would be a Canadian equity fund because it should generate some dividends and some capital gains.
Career Average Plans
The 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 defined benefit are not fixed: they vary according to factors such as investment yield, mortality and employee turnover.
Rebecca, an investor in a 40% marginal tax bracket, receives $1,200 in Canadian dividends eligible for the dividend tax credit. Calculate the dividend tax credit that applies to this income.
The taxable amount of the dividend is the income received plus a 38% gross-up amount. Therefore, $1,200 + ($1,200 × 38%) = $1,656. The dividend tax credit is 15.02% of the grossed-up amount, in this example, $1,656 × 15.02% = $248.73. Grossed up Amt (1656) - Grossed up DTC amt (248.73) = $248.73
Contributions to an RRSP
There is no limit to the number of RRSPs an individual may own. However, there is a restriction on the amount that may be contributed to RRSPs on a per-year basis. The 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.
Maximum allowable RRSP contribution?
Total Income x 18% or the RRSP dollar limit for the year ($23,820)