Week 8 - RRSPs Part 3

This is going to be a two-post week. I don't know if I'm alone on this one but the Family Day short week kind of threw me off. That, and I think I've watched about a hundred hours of the Olympics. I go to bed and all I think of is the speed skating oval or the downhill race course. It's like when you play too much Tetris and then all you see is the little blocks falling when you're trying to fall asleep. Maybe that's a bit sad, huh? A little FYI about the Canadian team thus far: we have approximately twenty 4th or 5th place finishes; so close and yet, so far... Anyway, my apologies for all of you who are hanging off my every word each week. After all, we know what a riveting topic personal finance can be, right?

This will be the third and final installment on RRSPs, meant to be short and sweet. We've looked at the benefits of contributing to a RRSP, as well as a few different ideas as to what we could do with our contributions. Now we'll look at a few final details around these accounts, in chronological order.

First we open the account, then we contribute each year, hopefully growing our accounts over time to be used for retirement. But there are a few other ways we can use our RRSPs before we retire.

1) First Time Home Buyers Plan. Basically, we are allowed to take money out of our RRSPs to buy our first home. It is a tax-free, interest-free loan that we make to ourselves. We take out the money for our down payment (up to a $25,000 maximum) and then we have 15 years to pay that loan back. Here's a good website for all the details of this option: http://www.taxtips.ca/rrsp/homebuyersplan.htm

2) Education. If, down the road, you decide to get back learning but need an investment in yourself to get going, then you might be able to use your RRSP to help fund your education. Like the home buyers plan, you have to repay the money, albeit within ten years of withdrawal. Here is the link for more information: http://www.canlearn.ca/eng/lifelong/llp.shtml

After deciding whether or not to use these options, it's the waiting game. We can take money out of our RRSP whenever we want, although we have to pay income tax on the money when we do it. So unless you aren't paying much tax and need the money desperately, it probably makes sense to let the fund grow until we have to withdraw them in retirement.

Conversion to a RRIF

Unfortunately, even if we don't need the money, we can't keep letting our RRSPs grow indefinitely. In the year we turn 71, we have to convert our RRSPs to Registered Retirement Income Funds (RRIFs). The following year, we will then be required to take out our first annual RRIF payment. This payment is a percentage of the total value of the RRIF, as of December 31st of the previous year. For example, if you turned 71 last year and on December 31st, your RRIF was worth $500,000, then you would use that number to calculate the amount you are required to take out this year. The following link is the percentage table that you use to determine your RRIF payment: http://www.ecgi.ca/rif_schedule.html

As you can see, you can convert your RRSP to a RRIF before age 71, but you need to do it by age 71.

Beneficiaries of your RRIF

A nice feature of any registered account is that you can name a beneficiary that will inherit your account if you die. This way, your account doesn't get left to your estate, which would have left it open to probate fees. Be sure to name a beneficiary on your account when you open it, as long as it's a registered account (RRSP, TFSA, etc). If your spouse is your beneficiary, he or she does not have to pay tax on the account either, when you die; another benefit of the RRSP. However, if you are leaving your RRSP or RRIF to your kids or anyone else, they will have to include that account as income for the year you pass away. Still, they will not have to pay probate fees.

Be sure to keep your beneficiary updated, too. From time to time, family situations change and I suspect you wouldn't necessarily want your ex to still be the beneficiary of your RRSP if you die. If you did, that's your business. Just make sure it's updated if you have a change in your life.

Hopefully, this begins to summarize registered accounts and how they can help us save for retirement. They are useful accounts and as I've mentioned previously, I think they are the only truly effective way to defer income tax. I admit this is just my opinion but I'll stick with it for now. Don't forget to contribute and when you do, you can celebrate with a pint a few weeks later on St. Patrick's Day; one of my favourite days of the year and I'm not even Irish!

Thanks for reading. Now that the RRSP deadline is nearly in our rear-view mirrors, I will switch it up for the next post and talk more about financial planning. Again, this is a topic that requires much attention and detail so it will just be an overview. I will start by trying to explain the difficulty in predicting our future needs and why it might just be better to focus on what we are capable of saving today. More on this in a few days.

Cheers.

Week 7 - RRSPs Part 2

I'm settled in. It's Wednesday night. There's a Raptor game on TV, which is going well. Life's good! Then, someone comes in and wants to watch Cougar Town. Time to post week 7.

Last week, I talked about the benefits of RRSP contributions and went over some strategies to maximize your total return down the road. We looked at the power of compounding rates of return, while being able to defer the taxes until we actually need the money.

This week, I wanted to go over a couple of ideas for how your RRSP could be set up, if you are someone that hasn't found the right advisor to work with yet.

We talked about mutual funds already, which are great investment vehicles if you don't have the expertise to pick stocks. I actually prefer picking stocks - I like the research, following my picks, making changes and trying to maximize returns for me and my clients. I would recommend that my clients do the same, or at least let me do it for them! I truly believe that I can achieve better returns this way, if for no other reason than the fees aren't nearly as much when you buy and sell stocks directly.

If you haven't found the right person to work with yet but still need some advice as to how to set up your RRSP, consider this step by step mutual fund strategy:

1) Look for 4 mutual funds, one in each of the following asset categories;

a) Canadian Equity

b) Canadian Bond/Income

c) Global Equity

d) Emerging Markets Equity

When considering your options, look for funds with good long-term returns (see if their 5-year return is good enough to get a 5-star rating) and look for fund managers that have been working on the fund for a long time.

2) Divide your RRSP equally among the 4 funds.

3) Each year, when you make your new RRSP contribution, add to the funds so that they rebalance back to their 25% weight per fund. Make sense?

Essentially, you are adding to the funds that have underperformed, while taking away (or not adding new money) from the funds that have outperformed. It's an easy way of staying disciplined, even if it's been a bad market for one of the areas. It takes the emotion out of having to make the picks yourself. I'd say this is a great strategy for anyone more than 10 years away from retirement.

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If you are closer than 10 years to retirement, congratulations! That said, it probably doesn't make sense to have 75% of your money invested in equity funds (which could decline in value and leave you needing to wait longer for retirement), especially since most mutual funds don't pay a consistent income. With stocks, you can sometimes keep a high weighting because they often pay dividends that will help support your retirement lifestyle, while still offering the potential for future growth. It's different for everyone, depending on your personal situation.

If you aren't in stocks and want a simple rule, consider the old adage that you should always have your the same percentage as your age invested in bonds. So, if you are 50 years old, then you should be 50% invested in bonds or other fixed income investments. As you get older, you can shift more money into bonds to preserve your capital and increase your income. The only problem with this is that right now, bonds pay a very low income. If you were invested in 10-year bonds right now, your average annual return would probably be about 4%. Yes, some bonds pay better rates but aren't of the same quality as the ones that pay lower rates. You want higher returns? Be prepared to take on more risk. Either way, it's a good starting point for someone looking for very basic guidance on setting up an RRSP asset allocation. Just remember the part about rebalancing every year.

Some of you probably have more than 4 funds in your portfolio already. You don't need them. Just pick 4 funds that have good track records. Between all 4 funds, you will likely have about 200 stocks and bonds, which is more than enough diversification. The only reason you should ever switch out of one of the funds completely is if the manager changes. In that case, all bets on past performance are off.

With a stock portfolio, I would only have up to about 20 stocks and then add bonds as needed. I think this is enough diversification, provided my clients are prepared for the ups and downs of owning stocks.

Another thing to consider is that if you have an RRSP and a non-registered account, keep the stocks in the non-registered account and keep the bonds in the RRSP. The interest created by the bonds is taxed at regular income levels, while dividends and capital gains are taxed at approximately half that rate.

The bottom line is that investments in an RRSP are probably a lot easier than many people would have you believe. I think that if you follow that simple formula, you will be satisfied over the long term. You will also be able to brag to your friends that you actually had the balls to add to your equity funds in years like we had in 2008 and 2009, which is a move that would have nicely paid off if you had done so.

Thanks again for reading. Next week, I will continue with RRSPs for those of you who are left wanting more.

Cheers.

Week 6 - RRSPs Part 1

It's been six weeks and I'm still going strong, despite having to try to explain stocks and bonds using one column each. They are tough columns to write without becoming really boring after a while. Also, finance isn't really something that I can use pictures to describe so the blogs tend to be quite the run-on at times. I'll work at making things break down a bit more by using more point-form. I'll maybe even put a swear word in here and there to keep you on your toes. I also wanted to say thanks for all the great feedback I've been getting on this thing! It's great to hear that people are getting something out of it. The idea is to help so I'm glad it's working.

So this is pretty much the apex of the blog for the Canadian investor; the RRSP Articles! The deadline is exactly a month away as of this entry, so we need to start thinking about what the best strategy is for the RRSP. I'm going to try and spread it out over a few weeks, so we can look at the different features of the RRSP and what the most appropriate investments are for them.

Let's look first at a few points about RRSPs:

- Think of an RRSP as a piggy bank that we put money into. Once the money is in the piggy bank, we can use it to buy investments such as stocks, bonds, GICs and mutual funds, which remain in the piggy bank until we sell them and transfer out the cash again. We do not buy RRSPs; we open them (they are accounts) and then we contribute to them!

- When we put money into an RRSP, we can claim that contribution against any earned income from that calendar year. For example, if your income was $60,000 and you put $10,000 into your RRSP, then your taxable income goes down to $50,000. If you already had the tax taken off of your pay cheque, then you would receive the tax back that would have paid on the last $10,000 of your earned income.

- Here are the marginal tax brackets for Canadians for 2009;

http://www.cra-arc.gc.ca/tx/ndvdls/fq/txrts-eng.html

You may want to think about contributing the right amount to lower your taxable income into the next lowest bracket, rather than making large lump sums all in the same year. More on this later.

- Everyone has a limit to the amount they can contribute to an RRSP in a given year. For the 2009 tax year, that limit is $21,000. If you don't use all of your contribution room, then it carries forward to the following year and gets added to that year's new amount. Also, if you had additional contribution room from past years, then this would be added to your 2009 contribution limit.

- The limit is lowered if you contribute to a registered pension (teachers, nurses, etc.), as registered pension contributions count toward your RRSP contributions.

- You can find your 2009 contribution limit on your Notice of Assessment that you would have received when you filed your 2008 tax return.

- Most of our RRSPs are self-directed, that is, ultimately we decide what the investments are that will be bought in our own accounts.

- If we want to take the money out of our RRSP, that amount gets added to our taxable income for the calendar year in which we take it and we pay tax on it. Also note that if we take money out of our RRSP, we cannot put it back, unless we have additional contribution room. Moral of the story: try to avoid taking money out of your RRSP for as long as you can or at least until you reach a point where you aren't working any more, so your taxable income would otherwise be very low.

- Any investment income, dividends, capital gains is sheltered from tax once it is inside the RRSP. This, in my opinion, is what makes it such an effective investment tool. It, along with the TFSA are the only truly effective tax shelters, in my opinion. There are others but they always seem to come with strings attached.

Let's look at an example of the power of not having to pay tax on your investment gains:

If you had a $10,000 bond that paid you 10% per year which you reinvested into similar bonds, then without paying tax, you would double your money in 7.2 years, to $20,000.

However, if you had to pay tax on your interest income, your annual interest would drop from 10% to 6% (assuming a 40% tax rate). The amount of time it would take for your money to double to $20,000 would skyrocket to 12 years.

By that time, your $10,000 in an RRSP would be worth more than $31,000.

You might be thinking "yeah but what about when I actually want to spend it? I'll pay 40% tax and only have like $18,000." True, but that assumes you just blew the $4,000 tax refund you would have received for contributing to your RRSP in the first place!! If you had invested that amount as well at the taxable rate (assume 6%, as above), then you would be left with a total of about $26,000!! That's a full $6,000 more than if you never contributed in the first place. Ah, the power of the RRSP.

Here's a sweet strategy: Contribute to your RRSP (if you can max it out, all the better) and then with the tax refund you will likely get, contribute up to $5,000 of that amount to your TFSA!!! If you do both those things, you are on your way to success, because that means a huge portion of your invested assets are growing TAX-FREE. Then next year if you can't max out your contributions from your employment income, take the money that is in your TFSA and move it into your RRSP to make up the difference. Then, when you get the refund, put it back into your TFSA. Lather, rinse, repeat.

If you did this just once like the above example with $10,000, you would have $31,000 in your RRSP and $12,500 in your TFSA after the same 12 years. If you wanted all that money at once, you'd still have more than $30,000 after tax, since you don't pay tax to take money out of your TFSA. That compares to having just $20,000 if you kept letting the tax man take his cut each year.

The only trouble with my example is finding good bonds that pay 10%. This ain't 1984, people. If you don't get that joke, then ask your parents how they liked refinancing their mortgages in the early 1980's. In those years, you could actually find government bonds that paid about 15-20% per year, or close to it. Mortgage rates were similar.

I think I'll stop there for this week. It's quite a bit to digest. Please feel free to ask questions. There are no stupid questions; only stupid people. Just kidding. Email me if you don't feel like leaving a comment on here directly. If I get a chance, I'll answer it. If it's about what to buy with your contribution, hold that thought. I will touch more on that next week.

Adios!