Category Archives: Mutual funds

RRSP or TFSA?

It’s alphabet soup time out there. Ads everywhere telling you to top up your TFSA overriding the usual February cacophony of RRSP season.

What are you supposed to do? Either ? Both? If you have limited funds which one gets priority?

Many of us are sitting here today looking at RRSP accounts that are still slightly battered from all the recent upheavals, although I think most of us can see the light at the end of the tunnel. But disillusioned by the past year and a half, we ask if we are ready to go down that path again.

At the same time, those near to retirement look at the measly $5,000 annual limit on a TFSA and laugh. There isn’t enough useable space to make a realistic difference in anyone’s immediate plans.

What to choose actually depends on a number of factors; What is your current tax rate? What is the tax rate are you likely to pay in retirement? How old are you? Do you have a pension? What are your current savings? Do you have an emergency fund?

As guidance, I’ll lay out a couple scenarios.

1) 50 year old management type with a good pension and current RRSP holdings, with the house almost paid off.

a) This person is currently in a high tax bracket, and likely to be in a fairly high tax bracket in retirement. Pension income splitting will reduce a couple’s tax burden, and allow them full benefit of their retirement income. Advice – concentrate on the debt, and funnel extra savings to a TFSA which can provide the “fun money” which will make retirement more enjoyable.

b) If you are single or have a spouse who will also have substantial post retirement income, income splitting isn’t likely to help you very much. Advice – forget the RRSPs entirely, they will just create a bigger future tax burden. Pay off the debt, max out TFSAs and if there is still ability to increase savings, investigate unregistered corporate class mutual funds which have a number of tax deferral advantages. Don’t forget the preferential tax status given to Dividend income.

2) 35 years old,with an annual income less than $35,000, no current savings. 20 years left to pay on a 25 year mortgage amortization. A few bucks in an RRSP, no other current savings, no emergency fund.

a) An annual income less than $35,000 is sort of the cut off tax bracket where RRSP contributions are of questionable value. The tax refund you get today, will be pretty well entirely eaten up by the tax you will pay when you start withdrawing the money in retirement. The lower your income the less efficient the RRSP becomes. Advice – get a TFSA to do double duty. Immediate savings can function as an emergency fund because withdrawals will not be penalized. Long term, the TFSA will replace the RRSP for this person, and all income withdrawn from it will be tax free in retirement, which will not affect the person’s eligibility for programs such as OAS. For this person the focus should be on saving, build that nest egg, protect against emergencies. The mortgage, which will pay itself off over time, will be done well before retirement, I wouldn’t worry about it. The trick here is avoiding further debt.

3) Young person, just starting out, lower income, good prospects for the future, no savings, renting. Advice – no question, max out the TFSAs. When the time comes to buy a home, the down payment can be withdrawn from the TFSA without all the headaches of the RSP Homeownership plan. Not only does it not have to be repaid, but you get the available room back the following year, so you are not penalized. During the growing and accumulating years the TFSA can act as an emergency fund, and in the long term will provide tax free income in retirement exactly as above. If this young person does move up in income and tax brackets there may come a day when the tax deduction of an RRSP contribution would be beneficial, however I would continue to advise maxing out the TFSA first.

What to avoid – Tax Free Savings Accounts which are set up like a plain jane savings account, paying pitiful daily or monthly interest. Forget it. At current (and foreseeable likely future) interest rates, these accounts are pointless. The amount of income which could possibly be generated isn’t worth the effort of protecting. We are talking pennies in tax savings here folks. Most of us alive today aren’t likely to live long enough for this to do us any good at all.

What to do – Get a Tax Free Savings Account which is set up like a regular investment account at your local bank, brokerage or investment dealer. Then treat it exactly like you would an RRSP. Same type of investments. GICs, mutual funds, ETFs, stocks, bonds – whatever sets your little heart afire. Think long term, but always keep a little short term money in there on the side in a money market fund or short term GIC, just in case.

 

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Filed under Finance, Investing, Mutual funds, Pensions, Recovery, Saving, Tax Free Savings Accounts

Cashing out Your Pension

I hear it all the time. A person comes to see me, and tells me how someone (perhaps a friend or a so called investment advisor) suggested they cash in their pension when they retire. Oy vey. Please people, stop it already.

I have heard all the arguments why this is such a terrific idea. And I have seen all the tears when things don’t work out according to somebody’s overly optimistic plan. So lets recap.

Yes, when you leave a job, either quitting or retiring, you are often offered the opportunity to convert (or commute) your pension. This is where the first misunderstandings come into play. Yes, you can commute a pension. You can take the money in your company pension account, and put it into a Locked In Retirement Account (LIRA). A LIRA works similar to a RSP, except (1) it is locked in until you turn 55, (2) there are minimums and maximums that you can withdraw each year.

However, there are pitfalls which these so called friends and advisors neglect to either mention or give proper emphasis. Firstly, like an RRSP, your investments will be subject to market forces. So yes, you get to decide how it is invested, in stocks, mutual funds or GICs as you wish. And if they go down in value, like most investments did in 2008, you alone suffer the consequences.

Secondly, in Alberta, BC, Saskatchewan and Quebec, additional voluntary contributions you might have made in the past are not subject to creditor protection, and could be seized if you were ever sued. In Ontario, Quebec, New Brunswick, Manitoba and Saskatchewan locked in accounts are subject to garnishment for child support.

Thirdly, it is possible that not all of the money in your pension plan account will be eligible to be transferred directly to a LIRA. You may find that there will be a cash portion which will be paid directly to you, and you get walloped by income tax deducted from this amount at your top marginal rate. Peachy eh? Especially if you weren’t warned.

One of the things that really has people excited are rule changes in some provinces which will allow you to take up to 50% of your pension money in cash after January 1, 2010. Hooray! The government will then grab taxes from this amount at your top marginal rate. So if you live in Ontario you could lose up to 46.4% right off the top to the government. Dalton McGuinty  and Jim Flaherty will thank you.

My concerns with this whole process are many.

1. Canadian pension plans are generally well funded and regulated, and unless your company goes bankrupt, you will get all the money you are entitled to.

2. Canadian pension plan managers have shown better long term investment returns than the average RRSP investor. Especially Teachers, HHOOP, Hydro and many of the Union plans. Do you really think that you, as an amateur, can do better than the professionals who work in the business all day every day, who are able to utilize economies of scale and instant preferential access to the most up to date information when making their investment decisions?

3. In a defined benefit pension if there is a shortfall, the employer is on the hook to make up the difference. If your LIRA has a bad year, guess who makes up the difference?

4. If you take out 50% of your pension as a lump sum, what are you planning to live on when you retire?

Now, I know that you can never say never, and there are a few people for whom commuting a pension might actually be a good idea. However, they usually fit into certain limited categories.

A. You have multiple tiny pensions which individually will pay very small amounts every month. In this instance you may not suffer any great penalty by combining them and investing them as a unit.

B. You have a diminished life expectancy, no spouse, and wish your pension assets to go to your heirs. If you can make the argument that you will not live long enough, because of a pre-existing illness, to collect the bulk of your pension, then it might make sense to roll it over into a LIRA so that it can become part of your estate. However – big however – this will expose the entire pension to estate and probate taxes.

So exactly why are some people so quick to advise you to commute your pension?

First, is often the friend who read something someplace, and in whose hands a little knowledge is a dangerous thing.

Secondly, and most egregiously, is the so called advisor who assures you that he can put you into investments that will outperform the “pitiful” returns attained by pension plan managers. This guy is solely driven by commissions. Really, really big commissions. Thousands of dollars in commissions. Big, big, fat, juicy, buy a new Cadillac commissions.

Please don’t listen to these people. By the time you come to see me, I can’t fix it. I can’t correct the mess they have made. I can’t restore the long term value that they destroyed.

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Filed under Estate Planning, Investing, Locked in Retirement Accounts, Mutual funds, Pensions, Saving

Getting Paid to Sit and Wait

Many of you have heard me talk about Dividend funds over the past couple years. I am obviously a fan. I can think of nothing better than getting paid to just sit and wait.

There are a few different types of Dividend funds, the tradition Large Cap fund, and the Dividend Growth fund. These can then be broken down into Canadian, US, Global or sector funds. Although they generally hold different types of investments, they basically operate in the same way.

A Large Cap Dividend fund, formerly known as a “Blue Chip” fund, is made up of the big boys of the stock market. Banks, Insurance Companies, Utilities, Pipelines. These companies have a large enough capitalization (number of stocks outstanding) that their price usually doesn’t move a great deal on a daily basis. Their stock price just grows at a rather slow and steady pace over a longer period of time. Boring! And for a long term investor, boring is fabulous.

A Dividend Growth fund is usually made up of a mix of larger and smaller companies, who may have more potential for year over year corporate growth than the big guys. This can provide more capital apreciation than you might get from a Large Cap fund, but because of this, can introduce more volatility, and the price swings of the individual stocks in the fund can be greater. They still pay a dividend every three months, just like the big guys. Not as boring, but it’s still not exciting enough to be a conversational topic at your next dinner party.

So why is boring good? We are interested in the main underlying feature of any Dividend fund, The Dividend. Every three months these companies pay out their corporate profits in a quarterly dividend of cash to their shareholders. In this case, the fund, and and fund holders, you and me.

This is the good part –

At the end of each year, the fund manager takes all those dividends they have collected during the year, and pays them out to the unit holders of the fund (you) in the form of more shares (units) of the fund. So now, not only have the basic underlying stocks in the fund increased in value, and thereby the fund itself has gone up (we hope), but you now have extra units of the fund. So next year your fund will get dividends on the original units you owned, but also on the new ones you just recieved. Which will in turn be used to buy you more units next year.

And the shares go up, and cash rolls in, and you get more units…

And so on, and so on…..

 

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