January, 2009
The Second Opinion: Tax Season: Part Two

Introduction

Happy New Year!

By now I am sure that you have heard of the new Tax Free Savings Account (TFSA). However, despite the staggering media attention, there doesn’t appear to be much discussion on how the new account fits into an overall investment strategy.

There are several issues that the new TFSA raises. Most importantly, the old asset location advice of holding interest-bearing securities in your open account and equities in your RRSP—while still correct—now needs to be updated in order to include the TFSA. Second Opinion has put together a detailed response to this issue, which can be found here.

Furthermore, whether you should invest in your TFSA or RRSP or both is another tough question with no quick answer.

In light of the new TFSA we would also like to highlight Warren’s tip #63: Watch for Opportunities to Earn Tax Exempt Income. TFSAs were not around when the tip was written, however the tip does give good advice about other tax free forms of income, including from a universal life policy.

Last but not least, Warren’s latest book is now in book stores and is a must read for retirees and those planning to retire in the next 10 years or so. The book lays out 38 Retirement Rules and, unlike most retirement-focused books, covers both the financial and non-financial aspects of retiring. With the addition of Second Opinion Vice President Ken Hawkins in the writing process, this book may just be even more enjoyable and informative than the last.

To learn more about the new book or to purchase your copy, click here.

By Carlo Palazzo, CIM

Tax Free Savings Accounts

Introduction

The new Tax Free Savings Account (TFSA) is now in effect. This presents an opportunity for Canadians to invest their money without worrying about the tax bite. However, the TFSA also raises some questions. For those who cannot afford to max out both their RRSP and TFSA, what is better? Max out the RRSP and ignore the TFSA? Max out the TFSA and ignore the RRSP? Or max out neither, putting a small amount of savings in each?

For those who can max out both the TFSA and RRSP (an ideal scenario), what is the appropriate asset location?

Before we tackle these advanced questions, let’s take a look at some of the basic rules of the TFSA.

Basic Rules of TFSA

The rules for the TFSA can be found on the Government of Canada’s TFSA website, found at http://www.tfsa.gc.ca. The main rules of the account are that Canadians 18 years of age or older can open a TFSA and contribute $5,000 to the account. The $5,000 limit is increased with inflation, but rounded to the nearest $500. All investment income earned in the TFSA is tax free, regardless of whether it is interest, dividends, or capital gains. There is no tax deduction for contributions, and no tax paid on withdrawals. Withdrawals do not affect eligibility for government-funded income-tested programs, such as Guaranteed Income Supplement (GIS) or Old Age Security (OAS).

TFSA vs. RRSP

Let’s take the example of a 50 year old worker who plans on retiring at age 60. The maximum he can afford to save each year is $5,000. Should it go in his RRSP or TFSA?

Let’s say that he is in the top marginal tax rate, which is about 45%. If he puts his $5,000 per year into the TFSA and earns 7% per year he will have about $69,000 when he retires at age 60. Assuming he continues to invest this money (at only 5%) and lives to age 90, he can have a tax-free income of about $4,500 per year (which would supplement his RRSP, pension, CPP/OAS, and other income).

However, let’s say he puts his $5,000 per year into his RRSP and gets a tax refund of $2,250, which he also puts into his RRSP for a total contribution of $7,250. Again earning 7% per year, at age 60 he will have about $100,000. Assuming he continues to invest this money (at only 5%) and lives to age 90, he can have a pre-tax income of about $6,500 per year. However, taking away his taxes (at the top marginal rate) he is left with only $3,575, which is nearly $1,000 per year lower than investing in the TFSA. If, however, his retirement income is lower than his pre-retirement income and he is therefore in a lower tax bracket when the money is withdrawn (let’s say 30% instead of 45%), his after tax income is now $4,550 – slightly better than with a TFSA.

Therefore, for those who are in the highest tax bracket now but will be in a lower (but not the lowest) tax bracket in retirement, the RRSP is still the better option. For most other people, the TFSA is the better option. However, after crunching the numbers on more than a dozen different scenarios, I have concluded that the best option is to get a financial plan from your advisor that shows which one is better in your case. In other words, there are no hard and fast rules – it depends too much on your personal situation to use general rules of thumb.

Asset Location

Asset location refers to holding your various types of investments in the most tax efficient manner possible. This has generally always meant holding interest-bearing securities in your RRSP and your equities in your taxable account. With the addition of TFSAs, this advice needs to be modified.

Firstly, there is no point in having a taxable account unless you have maxed out your RRSP and TFSA. So for those who currently have a maxed RRSP and more money left over in their taxable account, it would be wise to open a TFSA and move money from the taxable account into the tax free account (which is quite obvious).

The order of priority for equities is taxable account (only if RRSP and TFSA are both maxed), TFSA, than RRSP. In other words, your RRSP is the last place to hold your equities.

For interest-bearing securities, the order of priority is reversed. It goes RRSP or TFSA, and then taxable. This means that your fixed income should not be in your taxable account, but you are indifferent to whether it goes into your RRSP or TFSA.

By Carlo Palazzo, CIM

Tip #63: Watch for opportunities to Earn Tax Exempt Income

Why this is important: Income tax is one of the biggest expenses we incur during our lifetime, and the amount of tax we pay can be reduced by using the right type of life insurance policy. Although most people only think of the insurance in terms of the tax-free death benefit it can also be a tax-efficient way to save for retirement.

Deferring the tax on investment income is beneficial, but earning investment income that is exempt from tax is even better.

The common investment vehicles that allow you to earn income that under most circumstances is exempt from income tax are whole life insurance and universal life insurance policies. (Note that while the withdrawal of cash from a whole life policy is usually free of tax, a small level of tax may be triggered if the amount withdrawn exceeds the adjusted cost base of the policy.)

In addition to accumulating income that can be withdrawn during your lifetime with little or no income tax cost, insurance policies also provide a tax-free death benefit to the beneficiaries of the policy. Life insurance can help you reduce tax on income earned while you are living and can also, by reducing the tax bite, increase the size of your estate.

Investors often hesitate to consider the possibilities offered by insurance policies. They shy away from what they expect will be the inevitable sales pressure from insurance salespeople. For that reason, potential investors will often skip getting valuable information about the benefits of insurance coverage. This is a mistake and you should think of your insurance advisor as a key member of your team.

Another advantage of whole life or universal life insurance policies is that you are forced to save money. In the long term, the forced savings may be even more important than the life insurance feature.

Bottom line: Life insurance should be a central part of everyone’s strategy for financial security. Life insurance is an effective and proven way to minimize income tax.

What you can do now: Call your life insurance agent and ask for a policy review.