Last week, we listed the main strategic options you have to help build up retirement capital to meet your goals for the future. Today's column has two main purposes: to expand more on those comparisons and to bring you up to date on the latest RRSP rules and deadlines.
By "strategic options," I mean the types of accounts in which you can hold investments. These include non-registered investment accounts, TFSA accounts and RRSP accounts. (Other options would be to invest in private equity or start a business, but we will leave that for another day.)
Investing in a non-registered account simply means opening an investment account with an investment dealer, mutual-fund dealer, bank or credit union, then choosing investments such as stocks, bonds, mutual funds or GICs.
There is no tax benefit for depositing this money. As well, all interest and dividend income is subject to income tax each year. Capital gains are taxable when realized (when investments are sold), but only half of the gain is included in income.
Careful investing can minimize the tax burden along the way and keep it relatively small in retirement. For example, if the investments are in stocks (shares of profitable companies) or mutual funds that invest in stocks, these may grow in value for many years without any tax to be paid on capital gains. This tax deferral can be valuable and can last until death if the stocks or funds are never sold. But eventually, tax will have to be paid on half the gain. With mutual funds, gains are typically realized along the way as the portfolio is gradually turned over.
Dividends are taxed each year, but at a much lower rate than interest income.
Up to $5,000 a year can be invested in a TFSA (tax-free savings account), which has tax benefits and really no drawbacks. There is no tax benefit for putting the money in, as all the investment income earned over the years is tax-free and all withdrawals are tax-free.
If you have money to invest on which you are earning investment income, then definitely maximize your TFSA, subject to your decision about RRSPs. If you can maximize your RRSP and still fund your TFSA, then do both.
Money invested within an RRSP account also grows tax-free, whether invested in GICs, stocks, mutual funds or other investments. However, every dollar withdrawn from an RRSP (or RRIF) is taxable. This is the trade-off for the fact that every dollar contributed to an RRSP (subject to limits and eligibility) reduces the contributor's taxable income. If the contributor is paying income taxes, the taxes are reduced by that person's marginal tax rate multiplied by the contribution.
This means that a $1,000 contribution will save a person $278 if they are in the 27.8 per cent tax bracket. This applies to taxable incomes between $31,000 and $41,600 in Manitoba. The next tax bracket, up to $67,000 taxable income, is taxed at 34.75 per cent. The tax deduction and resulting tax saving is attractive and can multiply the amount you are able to invest if you reinvest the tax saving. The best way is to arrange with your employer for smaller tax withholdings on your paycheque and invest monthly.
If you are in one of the top two tax brackets now (above $83,000 taxable income), then definitely maximize your RRSP contribution. In one of the other tax brackets mentioned above, make the contribution if you will be in the same or lower tax bracket at retirement.
However, if your future retirement income is projected to be above $68,000 and RRSP withdrawals would be on top of that, then think twice. In this case, those withdrawals will cause a clawback of OAS benefits, which is an additional 15 per cent "tax."
In lower retirement tax brackets, RRSP withdrawals can negatively affect income-tested government benefits such as guaranteed income supplement, the age (65) credit and others. TFSA withdrawals will have no such negative effect and are not taxable, making them more attractive at the time of withdrawal.
The deadline for RRSP contributions deductible on your 2011 income taxes is Feb. 29, 2012. Your limit is 18 per cent of your 2010 earned income, reduced by any pension adjustment (for members of registered pension plans), subject to an overall limit of $22,450.
David Christianson is a fee-for-service financial planner with Wellington West Total Wealth Management Inc., a portfolio manager (restricted).