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How to Choose Between an RRSP or TFSA
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Many investors are torn between contributing to an RRSP and putting funds into a TFSA. Is one plan better than the other? In fact, both vehicles are excellent tax shelters, but each serves a different purpose.

Here’s a look at the differences, and how to make them work for you.

With an RRSP, you have to ask two basic questions: What is my marginal tax rate when I contributed to the RRSP? What will be the marginal tax rate when I plan to withdraw the funds from my RRSP?

In most cases, you will be in a lower tax bracket when you retire. But if you expect to be in a similar or even higher tax bracket, then it might make more sense to load up your Tax-Free Savings Account (TFSA) to the maximum levels each year. That’s because in a TFSA, the money will not be taxed when it is withdrawn from the account.

With an RRSP, you get a tax deduction for the year in which you make contributions. Investments inside the RRSP are sheltered from tax until you withdraw the money, at which point they must be taken into income where they are taxable at your marginal rate at the time of withdrawal. At maturity, you can, of course, roll over your RRSP into an annuity (very low rates at present) or another plan, like a Registered Retirement Income Fund, in which you must withdraw a specified minimum amount each year until the fund is depleted. Withdrawals are taxed as income at your marginal rate.

When withdrawing from an RRSP at retirement, you will want to make sure that you keep your income below the Old Age Security income threshold, or your OAS benefit will be ‘clawed back’.

TFSA benefits

Tax-Free Savings Accounts are a bit different. You can contribute up to a maximum $5,500 annually to a TFSA, and there’s no income or means test involved. There’s also no cutoff date – you can contribute any amount at any time you want through the year, as long as you don’t exceed the maximum in a given calendar year. You have to be over 18 and a have a valid Canadian Social Insurance Number.

Any unused contributions can be carried forward and added to the maximum contribution in a future year. Unlike RRSPs, there’s no tax deduction for contributions, but income generated within the plan – whether interest, dividends, or capital gains – is completely tax-free. As with RRSPs, the benefits of the dividend tax credit, the 50% capital gains exemption, and capital losses are lost within a TFSA.

And as with RRSPs, the rules and regulations for TFSAs can get complicated.

Qualified investments are very much like those allowed for RRSPs: cash, stocks listed on designated exchanges, mutual funds and ETFS, bonds, GICs, and certain shares of small business corporations. Shares traded ‘over-the-counter’ on dealer networks or exchanges are not qualified TFSA investments.

‘In kind’ contributions of qualified investments are also allowed (for example, stocks transferred from a non-registered account). But any in-kind transfer will trigger a deemed disposition of the security at its fair market value, which will be considered as the amount of your contribution. If there’s a capital gain, you will have to take 50% of the gain into income for tax purposes. But if there’s a loss on the disposition, you cannot use it to offset other gains.

Contribution traps

In deciding on RRSPs or TFSAs, one of the most common problems people encounter is running afoul of the rules related to withdrawals and contributions.

This frequently happens for those who use their TFSA like a debit card. This usually results in a confusing cycle of contributions and withdrawals in a calendar year, so that you could end up with so-called ‘excess amounts’ in your TFSA – that is, contributions over and above the $5,500 annual limit for the year.

The CRA levies a tax penalty of 1% per month based on the highest excess TFSA amount in your account for each month in which an excess exists. This means that the 1% tax applies for a particular month even if an excess amount was contributed and withdrawn later during the same month. The excess-amount tax kicks in on the first dollar of excess contributions.

Bottom line

Ideally, you should use both types of plans – but for different purposes. Most commonly, an RRSP is used for long-term retirement savings, allowing money to accumulate and compound on a tax-deferred basis inside the plan for 25 or 30 years or longer. TFSAs tend to be used for shorter-term savings goals over five to 10 years or so, such as a down payment on a home, a new car, vacations, and so on. However, TFSAs are also useful for investing funds that are not required for income needs after retirement.

This post was written by Robyn K. Thompson for Golden Girl Finance.

Comments | Tagged under money, saving, finance
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4 Things You Can Do Right Now to Set Yourself up for Financial Success in 2016
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It’s getting kinda late to set up financial strategies that will have a tax-saving or other impact for 2015, but it’s definitely not too late to set yourself up to start 2016 on the right foot. There are a number of things you can look to before the year is out, including deductible payments, tax-loss selling, portfolio rebalancing, and RRSP maturity options. Here are four things you can do before the new year to get ready for a fresh, financially savvy start to 2016.

1. Deductible payments

A number of payments that you can make before year-end will give you a tax benefit for 2015. These include charitable donations and investment-related expenses used to earn income, like interest payments on money borrowed for investment purposes, investment counselling fees, even safe-deposit box rental fees.

Also, you can make any necessary medical or dental payments for items not covered by provincial health plans. These include such things as glasses, prescription drugs, and hearing aids. Pay before year-end and you can add them to your medical expense deduction for the year.

2. Tax-loss selling

If you’ve lost money on investment assets in your portfolio, consider selling before year-end if you wish to use losses to offset any gains you might have made earlier in the year on other investments. To qualify for a 2015 tax loss, the settlement of the transaction must take place in 2015.

Because it takes three business days to settle a transaction, the last possible day to sell securities to be eligible for a capital loss for the 2015 tax year is Dec. 24 for settlement by Dec. 31, 2015. (This year, Canadian markets are closed Dec. 25 to Dec. 28 inclusive.) For U.S. exchange-traded stocks, different rules apply, and you may have another day’s leeway. But check with your broker or advisor now, while you still have time, to be absolutely sure you can meet the various transaction deadlines.

3. Rebalance portfolios

Throughout the year, as markets fluctuate, assets in your portfolio will gain or lose value, and by the end of the year may have skewed your asset weightings. Perhaps a 50/50 fixed-income/equity split in your balanced portfolio at the start of the year has become a 40/60 split or even a 30/70 fixed-income/equity split at the end of the year. The net effect is that your overall portfolio risk has grown considerably, because your portfolio is now overweighted to stocks, which are considered riskier than fixed-income. If left unattended, this can have a serious impact on your portfolio performance during the next bout of stock market volatility.

So year-end is a great time to review your asset weightings with your advisor, with a view to normalizing allocations and diversification. Trim or switch where necessary, using capital losses to offset gains where available. Don’t forget to apply any unused losses carried forward from previous years.

4. RRSP maturity options

You must collapse your RRSP by the end of the year in which you turn 71. If you haven’t already done so, there are only a couple of weeks left to make some key decisions about the disposition of your RRSP. And you have three choices for what to do with the funds. You can take the entire amount into income (not very tax-effective if the RRSP is one of those big million-dollar ones), purchase an annuity, or convert your RRSP into a Registered Retirement Income Fund (RRIF). Or, what most people in your situation do is to build some combination of these choices to maximize income, security, and tax efficiency.

  • The RRIF alternative. This is a popular choice for many RRSP holders, because a RRIF is much like an RRSP in that investments in the plan continue to grow sheltered from tax. However, you must withdraw a minimum amount from the RRIF every year. That income then becomes taxable at your top marginal rate in the year of withdrawal. The annual minimum withdrawal is calculated by multiplying the market value of your RRSP account on December 31 of the previous year by a percentage pre-set by the government.
  • An annuity contract is designed to provide a guaranteed income stream. Putting it very simply, when you purchase an annuity, you essentially buy an insurance contract under which the issuing company invests the lump sum you provide and guarantees a regular payout over the life of the annuity contract. There are several types of annuities, and these can be complex products. It’s important to understand how interest rates and other factors affect how much income you will receive.
  • ‘Pensionizing’ retirement income can be done with an insurance product that offers a guaranteed income withdrawal feature. This product is similar to an annuity in that it guarantees a specific regular monthly, quarterly, or annual payment until you pass away. But unlike an annuity, you can take the “cash surrender value” if your situation changes dramatically (but this is not recommended). If you’re looking to make last-minute year-end planning decisions that involve larger assets or investments, or decisions that may lock you into contracts like annuities, definitely get the advice of a qualified financial professional first.
Comments | Tagged under money, saving, taxes, finance
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