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Withdrawing From Your RRSP’s

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Besides general questions regarding the meaning of life, whether the Blue Jays have a chance of making the playoffs in 2018 and how to avoid OAS pension clawback, many of my clients most like to talk about the best way of withdrawing money from their RRSPs. The answer is, it depends.  Although this sounds exactly like the sort of non-answer you’d expect from a man with a law degree, this time it is actually the truth. Rather than switching the conversation back to the benefits of meditation or whether Devon Travis will return to man second base next year for the boys in blue, I will explain what I mean and what factors to consider when deciding how to minimize taxes on your RRSP nest egg.  Although your picture may still be a little murky by the time I’m done, I’m hopeful that reading this article and those to follow over the ensuring months will provide you with enough to ultimately guide you towards the answers you seek.

By way of preamble, I have been writing this article in my mind for over a year, ever since getting an email from one reader who’d read one of my RRSP planning articles last year in his local library. He disagreed with a few of my assertions and also generally argued that clients are always better off leaving money in their RRSPs as long as possible. Fortunately, for my clients’ sake and my own self respect as a planner, after reviewing his comments and my article, I was able to quickly find the flaws in his various arguments, reaffirm my own conclusions and then respond to him before returning to my thoughts to OAS pensions and Blue Jays’ baseball. I also planned to write an article showing why it isn’t always such a good idea to keep money growing in your RRSP as long as possible after reviewing his elaborate mathematic calculations that were unfortunately flawed and incomplete.

That day has now finally come. Today’s article focuses on explaining why leaving money in your RRSP as long as humanly possible might be an expensive mistake for some of us, although not always. As the old cliché says, the devil is in the details. There will be other articles in this series to follow that will provide the factors to consider when reviewing your own situation in order to apply these general principals to your own specific situation, but my mission today is to merely set the stage for what is to follow.

Overview

Although tax planners generally love taxation procrastination (i.e. delaying triggering tax bills as long as possible), there are exceptions to this rule. First, it you are in a significantly lower tax bracket now than you expect to be in the future, then it might make sense to take your lumps now if it means avoiding greater pain later.

People who withdraw money from an RRSP ahead of schedule are willing to accept a smaller, nimbler, tax-efficient portfolio in the expectation that it is really worth more to them or their heirs than a larger RRSP or RRIF portfolio that might after taxes, particularly if forced to pay 53.53% in Ontario or 47.7% British Columbia on that money at death if in the highest tax bracket.

When determining whether early withdrawals make sense, you have to accept that you are missing out on the growth on the portion of your RRSP investments you are now paying in taxes that would have otherwise stayed invested and be confident that, although you will now have less total dollars working for you, that the benefits of minimizing the tax hit by triggering a bill earlier than necessary will compensate you for the lost pre-tax compound growth you would have received by putting off your day of reckoning. In other words, you need to be willing to work with a smaller investment portfolio than would have been the case if you’d left things well enough alone in the hopes that it will be worth after tax than if you’d kept your RRSP intact.

On a related note, you need to compare how the portfolio you create when you withdraw money ahead of schedule from your RRSP and reinvest it grows will be taxed going forward compared to your RRSPs. As Canadians know or will find out the hard way, everything inside your RRSPs will be fully taxed upon withdrawal. On the other hand, if the extra money withdrawn from your RRSP is invested in your TFSA or in a non-registered account that pays eligible dividends from Canadian companies or is geared towards capital gains, then your new portfolio will have far less tax drag per dollar than your RRSP. If you invest for capital gains, you will only pay tax on 50% of the growth, compared to 100% if you owned the same investment inside an RRSP.

Continuing with the topic of taxation, eligible dividends can be even more tax efficient for many Canadians when owned in an open account. In Ontario, if your income is below approximately $46,000, you not only don’t pay tax on these dividends; in fact, you actually get money back from the government instead! Moreover, if your income is between about $46,000 and $74,000, then the top tax rate on dividends “soars” to only 6.39%. In comparison, if those dividends were paid inside your RRSP, they will eventually be taxed at 29.65% if withdrawn when in that tax bracket. In other words, if paid inside your RRSP, you could easily be paying more than 4 times as much tax per dividend dollar than if you received the dividend in your non-registered account upon withdrawal. If that money stay put until death, however, that’s when things get really unpleasant. If you are in the top tax bracket at that time, as is not uncommon, that same dividend dollar would be taxed at 53.53%, which means paying more than 8 times more tax than if you’d earned that dividend early in your open account!

Early RRSP Withdrawals – an Example

Here is a very basic example with very approximate numbers. I will use Ontario tax rates. Consider an Ontario investor around 60 years of age with $1,000,000 in his RRSP and about $46,000 in other income, which is enough to satisfy his needs, so that any additional withdrawals can be reinvested in his non-registered account for the future. He earns 6.5% per year on his RRSP investments, 3.75% each in capital gains and eligible dividends and, like many Money Saver investors, plans to buy and hold. He is debating between pulling out $40,000 per year for the next 12 years before he officially must convert his RRSP to a RRIF and commence making withdrawals or, alternatively, leaving things well enough alone until he is forced to start withdrawing RRIF funds.

Assuming he pays 30% tax on the early withdrawals, he would have $28,000 per year left to reinvest if he makes his withdrawals each January 1st,. Focusing first on the 3.75% yearly capital growth he would earn on his yearly $28,000 non-registered contributions, this amounts to$414,739after 12 years, of which $78,739 is unrealized capital gains. This ignores any of the dividends this portfolio generates.

Turning to these dividends payments, each year’s withdrawal would pay dividends at 3.75% going forward (which I show as 3.45% after 8% in taxes) which I assume will be reinvested at no cost, such as through a DRIP, so that each year’s dividend stream increases.

In order to crunch the total value of the dividends and their growth, this required calculating 12 separate income streams, as the first year’s dividends will have another 11 years to grow, while the last won’t grow at all using my calculations. There will also be 3.75% capital growth if these dividends are reinvested. Anyway, for the purposes of this calculation, I will assume that the dividends are worth an additional $85,755 after about 12 years with $10,407 in unrealized capital gains. In other words, after including the $414,739 in capital growth on the non-dividend portion, our client has a total non-registered portfolio worth $500,494. If he died at that time, and was in the highest tax bracket, this would leave him with or $476, 634 after taxes, since the bulk of the portfolio was already taxed along the way.

In addition to the non-registered portfolio our client has created with the early withdrawals, his RRSP is still alive and well. Despite the series of $40,000 in withdrawals, would still have $1,434,267 left 12 years later, as the amount he withdrew was actually less than his portfolio’s annual growth. If he died at that point and forced to pay tax on that balance at 53.53%, he would be left with only $666,503. Accordingly, when adding this amount to the $476,634 after-tax value of his non-registered portfolio, their combined after-tax value is worth $1,134,137.

On the other hand, if he does nothing and let his RRSP grow unchecked for the next 12 years, it would grow to a value of $2,129,096. At first blush, this may seem to be the way to go, as is almost $200,000 more than the pre-tax value of his non-registered portfolio and his smaller RRSP if he went with the early withdrawal option. The after-tax values tell a different story. When decimated by tax at 53.53% at death, his RRSP is only worth $989,380 after taxes, which is actually $144,741 less for his heirs than if he’d started his withdrawals early.

Of course, this is a very specific example and only shows, that in the right circumstances, that withdrawing coins from your RRSP early can mean more dollars in your (or your heirs) back pockets later. For example, if our intrepid investor wasn’t investing as tax efficiently in his non-registered portfolio, such as if he was earning primarily interest or realizing his capital gains more frequently, the numbers won’t be as attractive and he might have been better off keeping the money in his RRSP and delaying his day of reckoning.

As well, if our investor had lived to a ripe old age, he would have had the chance to get more of his RRSP or RRIF money out at rates lower than the maximum, thus improving his result. In the end, this example is merely to show that sometimes withdrawing money from your RRSP early can be a good thing, rather than suggesting that it is always the way to go.

Conclusion

Now that I’ve hopefully shown that sometimes pulling money from your RRSP ahead of schedule can make a huge difference in the right circumstances, my next few articles will help you identify the factors to consider when looking at your own account statements and deciding whether to let your RRSPs grow or to start tapping into your dough. Until then, I’ll direct my thoughts to whether or not the Blue Jays will keep or trade Josh Donaldson.

 

 

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Introduction to Investing Event

Thursday, February 15, 7pm to 9 pm – Curling Club, Hillcrest Community Centre

Free to attend

Looking to learn more about investing in and out of the stock market? Not sure about the best way put aside money for retirement and future goals? Worried that your current investments are underperforming or are inappropriate for your appetite for risk or goals? Attend this free event in order to learn more so you can start answering your own questions.

Whether you don’t know the difference between an “ACB” or an “ATM” or if you’re already a savvy investor, this event it geared towards providing you with general information from a variety of different investment or financial professionals. My goal is for to provide new, want-to-be investors or seasoned investors with the background information on investment basics from people who work in the trenches. This includes learning some basic investment terms and principles, as well as opposing them to a wider range of ways to invest their money rather than just parking them in GICs or higher fee bank mutual funds. As you’ll be hearing from different people with different philosophies and strategies, I hope to provide a more balanced view so you can better compare different ways of investing against each other.

For more seasoned investors, I hope to expose them to different ways of investing or other information they can use to get the most out of their portfolios. There will also be the opportunity to ask whatever burning investment questions come to mind from any of the presenters.

No question is too basic nor is anyone too inexperienced to begin learning – the retirement you save just might be your own!

Each presenter will have about 12 to 15 minutes on their topics, with some time at the end of all presentations for questions.

Rough Agenda

Colin Ritchie, lawyer and financial planner      

  • What are the different types of investment earnings and how are they taxed? What is compounding and why is it so important?

Angela Huck, Vice President – Connor, Clark & Lunn Private Capital Ltd.

  • Understanding an investment statement and terms like “book” and “market value”, “rates of return” and “benchmarks”

Chris Stephenson / Lori Norman – Investor Specialist – Steadyhand Investment Funds Inc.

  • What are ETFS, Mutual Funds, Pooled Funds, Wrap Accounts & their pros and cons

Klint Rodgers,  Branch Manager & Private Market Specialist – Pinnacle Wealth Brokers Inc.

  • What does “diversification” mean and different ways of getting it.

Alan Young, Portfolio Manager – Richardson GMP Limited   

  • What are “time horizons” and “rebalancing” and why are they so important?

Colin Ritchie   

  • How RRSPs, RRIFs, RESPs and TFSAs work.

Thomas Tsiaras, Investment Advisor – Industrial Alliance Securities Inc. 

  • What are “covered calls”, “REITs”, “MICs” and other ways of generating income from your investments?

 

As space is limited, please contact me in advance to reserve a space!

Financial Literacy Seminar – Investing 101

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A huge part of why I write so many blogs and magazine articles is to help people take better control over their own financial affairs by arming them with the information they need to make this happen. As part of this commitment, I am in the process of setting up a 2 hour intro to investing seminar with a bunch of investment advisor colleagues of mine tentatively set for February 8 or 15th in Vancouver. My goal is provide anyone who wants to come out with an overview of basic investment topics so they can get better understand their investments, have a better idea of their choices, ask better questions of their advisors and, ultimately, better protect their financial futures. Here are some of the potential topics:

  • Taxation of Investments and what is a dividend, ROC, interest and capital gains, benefits of compounding.
  • Understanding an investment statement, including book and market values, rates of return, benchmarks.
  • What are ETFs, Mutual Funds, Pooled Funds, Wrap Accounts – pros and cons.
  • Diversification and how to get it.
  • Time horizons, and rebalancing.
  • How RRSPs, RESPs and TFSAs work.
  • Covered calls, REITs and MICs and other types of high income investments.

I am really excited about the quality of the people who have indicated they are interested in presenting and have tried to pick people who are both really good at what they do who offer different perspectives. I am writing this message at this time to get an idea about how many people would be interested in attending, as well as any feedback anyone might have in terms of topics, so please let me know if you have any interest in attending.

Thanks and Happy New Year,

Colin

Investing Inside an Insurance Policy –Part 3 Universal Life Insurance as an Investment

 

Introduction

Think that life insurance is just a tool to make sure that junior gets the university vacation if you die in your 40s, your spouse doesn’t have to worry about mortgage payments if you die in your 60’s or your kids have enough money to pay the final tax bill on the family cottage if you die in your 80’s? Not so fast, says the insurance industry. They are now seeking a place at the table when clients discuss ways of funding their own retirement, particularly for those clients in higher tax brackets and those that have their own corporations.

The first two parts of this series have detailed some of the significant tax advantages enjoyed by life insurance and steps you can take to mitigate risk when looking to invest through life insurance or if you’re already the proud owner of a policy to call your own. To date, I’ve said little about your actual investment options inside an insurance policy, although I’ll focus solely on “Universal Life” or UL Policies, the insurance that most closely resemble traditional investments. For those of who are fans of Participating Whole Life (“Par”) Policies, you’ll unfortunately have to wait until next time. Finally, regardless of whether you’re looking at either of these types of policies or even more basic permanent policies, my (hopefully) final article in this series will hopefully provide you with guidelines to use when measuring life insurance against traditional investments, as any comparison between options is only as accurate as the underlying assumptions.

But, before I go any further, I wish to thank the insurance advisors I’ve canvassed for their insurance investment recommendations: Lee Brooks of View 360 Insurance Advisory (New Westminster, British Columbia), Tyler Eastman, Sun Life Advisor (Terrace, British Columbia), John Ong, Certified Financial Planner (Vancouver, British Columbia) and fellow Money Saver Contributing Editor, Rino Rancanelli, owner of CorporateTaxShelter.ca (Oakville, Ontario).

Setting the Stage

While Par Policies are something of a mysterious black box that spits out policy dividends each year and often offer guaranteed increases in cash value, UL policies are generally more transparent, flexible and multi-purpose creatures. There is a set minimum premium payable monthly or yearly for guaranteed death benefit or “face value” of the policy but extra contributions are allowed into what is called an “accumulating fund” that is essentially a tax-free investment account whose balance at death is paid out tax-free on top of the face value. Each insurer offers its own set of different investment options. Traditionally, this meant predominantly mutual funds, which has often meant more uncertain and volatile returns than Par Policies and some rather steep investment management fees.

Like Par Policies, the greatest risk to owning a UL is having the policy run out of money when the owner doesn’t have extra funds to contribute to the cause. Traditionally, there has been a far greater chance of this happening for UL policies than their Par compatriots for a few reasons:

  • Although a UL policy will offer you far more upside than a Par Policy, it also exposes you to double digit losses in a year if you pick riskier investment options and all does not go well.

 

  • Inability to lock in gains. If you get paid a policy dividend in your Par policy, it gets added to the cash value and the insurance company can’t take it away from you the next year if their investments don’t perform as expected. Accordingly, they invest more conservatively and factor lots of margin for safety when setting premium rates. UL policies give clients the chance for making a lot more profit but don’t generally provide them with this safety net, except for “limited pay” policies that at least ensure that you are no longer responsible for ongoing premium payments after a set period of time even though any additional contributions you’ve invested are still fully at risk. I have listed a few exceptions to the rule later in this article.

 

  • Overly optimistic investment return assumptions. In the 80’s and 90’s, when markets soaring and interest rates were high, UL policies were the policies of choice, while Par Policies were considered yesterday’s news. Although illustrations for both types of policies purchased during this period have not lived up to expectations, UL policies (particularly if invested in mostly equities) took far more of the pain. While Par policies ended up paying less than everyone hoped, at least they continued to pay out policy dividends year over year. In contrast, negative portfolio returns in UL policies meant that the anticipated growth that was supposed to pay future policy premiums was not merely growing slower than expected but was actually shrinking. That meant policies running out of money far sooner.

 

  • Yearly Increases in Premiums. It was common for clients to purchase UL policies that had yearly increases in their insurance costs (sometimes to set ages and sometimes indefinitely) to keep costs low in the early years so they could have more money working for them in their investment fund. The theory was that the opportunity to have more money in the market longer helped clients since the extra profits they would earn on their investments in the early years would pay for the increased insurance costs on the back end. When performance lagged and the clients didn’t continue to contribute fresh funds to keep their UL policies on course, the increases in fees, modest for younger clients but growing significantly for older clients, ultimately made many policies unsustainable. By contrast, Par Policies generally offer a level premium for life so that, even if they weren’t able to be self-funding as early as originally illustrated, the cost of keeping the policy going was not nearly as significant.

On the other hand, life is about learning from one’s mistakes. Just because UL policies have performed badly in the past, doesn’t mean that there is no place for them in your future. The potential tax savings and advantages offered by these policies are real and can still offer significant benefits to the right clients. For the same reason that it can be a mistake for investors to completely shun investing in the stock market just because they’ve been bitten in the past, it may also be a missed opportunity for investors to not investigate using ULs now merely because of past problems. The secret is often to learn from and fix the mistakes of the past rather than abandoning a strategy without a backward glance.

Along those lines, the insurance industry has made some significant changes to their investment offerings and the investment fees charged on these offerings that do a lot to mitigate risk and enhance performance. Moreover, no one is purchasing these policies on the expectation of continuous double-digit returns, which means that it is now a lot easier for ULs to live up to their promises. In defence of insurance advisors past, however, it wasn’t merely the insurance industry that was assuming that investors in that period would continue to enjoy double-digit returns in perpetuity; many investment portfolios burdened by similar unrealistic expectations also floundered and flopped.

Finally, more clients select policies with level premiums, specially designed policies that allow tax sheltering but reduce or even almost eliminate the insurance costs over time, or, if they do choose yearly increases in costs, doing so with a contractual right to switch over to a fixed yearly charge at a later date of their choosing at a predetermined rate. In other words, they can take advantage of the rather significant savings and potentially improved overall results by paying yearly increasing rates for a number of years but preselecting a time to bite the bullet and switch over to level rates based on their age at that time in order to control future costs. In the end, UL policies are a lot like an electric drill– if used in the right situation, in a careful, safe manner and regularly maintained, it just might be the best tool for the right job, although if used inappropriate, there is the chance of pain and shocks.

Changes in UL Investment Options

 In my previous article in these series, I argued that it’s important to manage your UL policy in the same way as the rest of your investments. This means reviewing and potentially rebalancing the investments inside your portfolio at least once a year, changing your holdings if your time horizon and risk tolerance change and getting your insurance advisor to update your policy illustrations every few years so you can make small changes immediately rather than facing large changes later.

Noting all of this, in the end, it still often comes down to investments inside the policy. My personal bias is to use UL policies for the slow and steady portion of your portfolio rather than the “shoot for the moon” component. The less volatile your investments, the less likely things can go wrong. Furthermore, for the same reasons I love investments that pay interest and dividends along the way in order to reduce the need to eat into capital during down markets, I love similar investments inside UL policies in order to generate cash to pay the annual premium costs.

Fortunately, there are an ever-increasing number of investment options. One insurer actually offers more than 200 investment choices for UL investors, although I am not completely convinced that more is always better. Many of these are mutual funds, often the same ones you could select within an RRSP or an open account, but they aren’t the only game in town. Here are a few of the more innovative choices:

A Mortgage Investment Corporation. BMO offers you the chance to invest in a portfolio of mortgages held by a Mortgage Investment Corporation (“MIC”) that would pay around 6% and is a non-stock market investment. Since this is a private investment, this means not having to worry about stock market fluctuations and, despite a low interest rate environment, earning a yield that is probably higher than the one used to illustrate the performance of your UL Policy. It also means that yield should increase relatively quickly when mortgage rates go up, as the mortgages are all two years or less and there are always mortgages coming due and fresh money is being lent at the new market rate.

  • A Stock Market Investment that Guarantees No Losses. BMO offers the “Guaranteed Market Index Account”, which it describes as offering the security of a GIC with exposure to the TSX 60. It’s a simple proposition – you get 50% of the market upside each year but none of the downside. Although this doesn’t eliminate volatility and still means having to eat into capital during a bad year to pay premiums, it does offer some exposure to the market during good times and better protects your capital during the bad ones.

 

  • Absolute Return Funds. Sun Life offers a fund designed to make a yearly profit of 5% more than the overnight lending rate over every 3-year period, regardless of market conditions by using a bunch of strategies, depending on market conditions at that time. Thus, instead of claiming a successful record merely because it has lost less than its competitors, it is only successful if it’s making you the promised profit, regardless of what the market does. Furthermore, they strive to be less than half as volatile as the global stock market.

 

  • Diversified Accounts. Sun Life Offers the Sun Life Diversified Account that reminds me a lot of the investment portfolio you’d receive inside a Par Policy: private mortgages, some private investments, real estate, public bonds and some public equities. It also smooths returns in order to provide less volatility and predictability. At the time of this article, it pays daily interest equal to about 4% per year and guarantees that your yearly return will never drop below 0%.

 

  • Hybrid UL / Par Policies. Industrial Alliance offers a product called the “Equibuild” that is designed to give you the best of both worlds. The basic premiums go into a fund that generates guaranteed cash value like you’d enjoy with a Par Policy and pays policy dividends. Any extra money you contribute can be allocated to Equibuild Fund, which is the Par policy equivalent, or towards more traditional UL investments. There is also even the option to use extra money to buy an additional paid up death benefit each year. As another feature, there is a cash for life feature where the owner is guaranteed payment for life if he wants to use the policy for retirement purposes.

Obviously, there are likely other intriguing insurance investment options out there, as these are only some of the options I’ve discovered on my own and through my cadre of insurance advisor friends. I suggest doing what I do when working with financial planning clients who are potentially interested in life insurance – collaborating with a licensed insurance advisor (which I am not, as my focus is on big picture planning despite owning my Certified Life Underwriter Designation and having spent 15 years advising insurance advisors) who can make specific policy recommendations.

Unless your insurance advisor is experienced in overall financial planning and knows your situation, I strongly suggest getting a financial planner familiar with your overarching financial plan review the size, type and ownership of the policy suggested to ensure that it’s the best possible fit. Think about buying life insurance like shoe shopping – even though you need new runners for an upcoming marathon, if you buy the wrong pair or overpay, you may either not make it across the finish line or, if you do, the resulting discomfort and stress of cramped toes or living outside your budget may ultimately make the experience a lot less enjoyable.

Also, when deciding whether to own the policy personally, corporately, in a trust or as a combination of these choices, it’s important to get it right the first time, as there are often tax costs that can arise if you have to change ownership of a policy later. Unfortunately, I often get involved after the policy is already in place, when options are more limited and changes can be expensive.

Conclusion

Although many clients feel more comfortable with Par Policies (which I will talk about more next time), I still see UL Policies as a strong choice for the right client in the right situation. They offer more flexibility and transparency. For example, some UL policies both allow the entire cash value of the investment account to be withdrawn tax-free during life in the event of a disability and allow you to change your policy investments at your own discretion, which may allow clients to perform better over the long term if they play their cards right.

In the end, each policy has its own advantages – for example, clients planning on borrowing against their policies during retirement are often able to borrow more against the cash value of Par Policies than their UL cousins while someone planning on withdrawing directly from their policy during retirement might be better served with a cheaper UL policy with reducing insurance costs. Ultimately, I believe that insurance can become a valuable tool in many retirement plans and that the type of policy best suited to the purpose depends on the client and situation. In these days of steadily increasing income tax rates, life insurance and all the tax benefits that come with it might be worth a second look when looking to fund your retirement.