We are going to be hosting the Carnival of Personal Finance next Monday so I thought I would like a few suggestions:
Get your picks in early!! The earlier the better!
Be creative.
We are also going to be hosting the Carnival of Money Stories on Tuesday so feel free to get your submissions in.
One of the big benefits of RRSPs is that when you withdraw the money, you don’t necessarily pay the marginal tax on the withdrawals but rather the average tax on the amount you withdraw.
For example if you withdraw $40k from your RRSP and you don’t have any other income source then you will pay only the tax payable on $40k which works out to a lot less than your marginal tax rate. If you have any income such as CPP and OAS – let’s say you get $12k per year from those, then the tax on the rrsp withdrawal will be the taxes payable on your income from $12k to $52k which will be more than the first example but still a lot less than your marginal rate.
What if you make a lot of money from your other income sources? In that case, the taxes due on the rrsp withdrawal might just end up being your marginal rate. If you are withdrawing your rrsp money and it’s all being taxed at or close to your marginal rate, is it still worth it?
You need to look at your own scenario and try to decide if it’s worth while or not.
Two main benefits of RRSPs:
1) The possibility of paying less tax on the withdrawal amount than the tax that was deferred on contribution.
2) No tax drag because of taxes on dividends, capital gains and interest.
Some common situations where RRSPs will probably have lesser value:
Defined benefit pension – if you work for the government or a company that has a good DB pension then the pension will probably put you into a moderately high tax bracket. If that is the case then you aren’t getting as much benefit from the RRSP since the tax you pay on the withdrawal might be the same or even higher than the tax you deferred when you contributed. You will still get some benefit from the fact that there is no tax drag in the rrsp. Another consideration is potential government clawbacks on your OAS (Canadian government benefit). This is one of those situations where you will probably be better off using the new TFSA account.
Low income – This is worth a post of it’s own but if you don’t make much money and can still save then the TFSA is a better choice than the RRSP.
Alternative income – If you have an alternative income planned for retirement such as dividend stocks (Derek Foster method or Smith Maneuver) and/or rental properties or any other income sources then they have to be considered as well. This is similar to a defined benefit pension in that if this money puts you at a reasonably high tax rate then any RRSP withdrawals will be taxed at a high rate and you lose part of the benefits of the RRSP.
Benefits of the Canadian tax free savings account
Tax Free Savings Account (TFSA) Basic information for Canadians
Comparison between Canadian TFSA and American Roth IRA
Tax Free Savings Account refresher for Canada
ING offers TFSA refresher for Canadians
Is the RRSP still worthwhile because of TFSA accounts?
Using the Tax Free Savings Account (TFSA) for Canadians as an emergency fund
This free e-book is the culmination of sixteen different personal finance bloggers who got together and decided to write a financial guidebook that spans an entire lifetime. From the innocent little infant to the older retiree, all the different stages of life are covered here. Whether you are in your 20’s or 30’s or any other age — you can benefit from reading this book.
photo by spine
I realize that a lot of readers of Quest For Four Pillars are financially sophisticated already so those people might not get as much from the book – however I would challenge them to think of a friend or relative who could use a helping hand to guide them into better finances and email the e-book to them.
There was a tremendous amount of positive feedback from the series, (including being featured on MSN Money) so all the bloggers involved agreed to re-distribute the series in the form of a FREE eBook. This way all the articles would be archived for all of eternity, and more importantly, all in one place. I think you’ll find MMFAA is an easy read and a handy reference, no matter what phase of life you’re interested in learning more about.
[download#1#image]
A special thanks to David at My Two Dollars and Pinyo at Moolanomy who worked extra hard to make this e-book happen.
Ok the weight today was….179.5 pounds. This was a big decrease from last weeks bloated 183 pounds so my decision not to eat any food for the last seven days was clearly a good one! 🙂
I wanted to highlight a new Canadian blogger this week, Cheap Canuck who lives in western Canada and has quite a few interesting posts. Check it out!
I haven’t paid tribute to my top fourteen referrers for a while so here they are and thank you very much for the traffic you have sent over the last month.
Canadian Capitalist
Million Dollar Journey
Cheap Canuck
Canadian Dream
The Financial Blogger
Being Frugal
The Dividend Guy
The Money Gardener
My Dollar Plan
Loonies and Sense
Mighty Bargain Hunter
Finance Freelance Life
Carnival of Personal Finance was hosted at Broke Grad Student
Festival of Frugality was hosted at Savvy Frugality
The Canadian government announced the creation a new savings account type (Tax-Free Savings Account) which allows Canadians to contribute after-tax money without any taxes on the earnings within the account (interest, dividends, capital gains) and there will be no withdrawal taxes whatsoever. For any Americans reading, this account will be very similar to your Roth IRA account except there aren’t any restrictions on withdrawals in the TFSA.
While this announcement has generated a lot of excitement in the Canadian blogosphere and for good reason, since it will be very useful financial planning tool, my opinion is that the benefits of this new savings account will be very limited for the average Canadian.
Here is an explanation of the new tax free savings accounts for Canadians.
First of all let’s look at some benefits and uses for this new account.
Saving for large purchases during your working years
In my mind, this is one of the greatest benefits of this new account. If you are saving up for a car, a house down payment, vacations or anything else, this account is the way to do it. Previously, if you wanted to save large amounts of cash then you had to pay your marginal rate on any interest earned which for most people is probably at least 30%. You could mitigate this problem with Canadian dividend stocks which are more lightly taxed, but they are still taxable and then you expose yourself to market risk since the money might not all be there when you need it.
Emergency fund
I wrote recently about how I think having a cash emergency fund is not a good idea for someone with a mortgage, a HELOC and a high marginal tax rate. With this new tax sheltered account, my main argument about paying high taxes on the interest is now a moot point so the remaining issue is the interest rate you can get on the savings account vs. the interest you are paying on the mortgage. Unless you have a huge emergency fund, this small interest rate difference might not be large enough to sway the argument one way or the other.
Retirement planning
A lot of Canadians don’t really understand the benefits of an RRSP account (American translation = 401k) which is unfortunate since it is the best tax planning and retirement tool available to Canadians by far.
TFSA are not as good as RRSPs for retirement planning because RRSPs allow you to defer all the tax payable on the contribution and to pay LESS tax upon withdrawal.
One of the common misconceptions of RRSPs is that you have to be in a lower marginal tax bracket in retirement than when you made the contribution. This is not the case because when you make a contribution, the tax deferral is the marginal tax on the entire contribution ie if you make $100k and contribute $10k of pre-tax income and your marginal rate is 43% then you are deferring $4300 of taxes.
When you withdraw this money in retirement then you are paying the AVERAGE tax rate on the withdrawal – not the marginal rate (assuming no other income). So if someone withdraws from their RRSP in retirement and is at the same marginal tax rate as they were when they made the contribution, they will still save a lot of tax. In reality they will probably be in a lower marginal tax bracket which means they save even more tax.
With the TFSA, you don’t get this benefit since you pay your marginal tax as soon as it is earned.
Non-registered investing
For investors who have money in non-registered accounts either because they have already maxed out their RRSPs or other reasons, this new account is a huge benefit since they can reduce the tax drag on earnings on their investments. Previously dividends and capital gains (if they occurred) had to be paid which affects the long term returns of those investments.
Why the general public won’t benefit
Saving for purchases – I don’t believe very many Canadians save for large purchases. You don’t need 20% to buy a house and things like cars and vacations are so easily bought on credit that most people won’t bother to save. Even if we are savers, most of us don’t appreciate the effects of tax drag so paying taxes on the interests may not bother everyone (like it bothers me!).
Emergency fund – Similar to my previous point, how many Canadians even have an emergency fund? While our high taxes made an emergency fund fairly inefficient, with the TFSA this is not an issue anymore. I doubt it will make any difference for the average Canadian since I don’t think they will consider having an emergency fund.
Retirement Savings – The reality is that there are a lot of Canadians who don’t save enough (or at all) for their retirement so introducing a new method (which isn’t even designed for retirement savings) isn’t going to help them. Since I believe that a lack of understanding of how RRSPs work might discourage some Canadians from using them, I am hopeful maybe some of those people will use a TFSA instead since it’s a lot better than nothing but I doubt that many of them will.
Who will benefit?
Simple – savers. People who save, people who complain because they don’t have enough RRSP room, people who invest outside their RRSP, people who are doing a Derek Foster plan (retire on dividends), geeky personal finance bloggers (I guess I could have omitted the word geeky) 🙂
Tax Free Savings Account (TFSA) Basic information for Canadians
Comparison between Canadian TFSA and American Roth IRA
Tax Free Savings Account refresher for Canada
ING offers TFSA refresher for Canadians
Is the RRSP still worthwhile because of TFSA accounts?
Using the Tax Free Savings Account (TFSA) for Canadians as an emergency fund
The Canadian government recently announced a new type of tax-free savings account (TFSA) available to Canadians which is similar to the Roth IRA account available to Americans. Here are some of the details:
What is the TFSA?
A type of account where you make contributions but don’t get any income tax refund. While the money is in the account there are no taxes applied to any kind of earnings such as interest, dividends, capitals gains. Any withdrawals from the account are not taxable and won’t count against any government programs ie GIS, OAS.
How does the TFSA work?
When can I open up a TFSA account?
January 2, 2009 was the first day you could deposit funds into a TFSA. Most institutions allowed customers to set up accounts prior to this date however.
Why do I want to open a TFSA account?
Any money that you might be saving for emergencies or upcoming large purchases will have a constant tax drag in an non-registered account. With the TFSA, this tax drag no longer exists so you will end up with more money for your purchase or emergency. Here are some more benefits of the Canadian tax free savings account.
Tax Free Savings Account (TFSA) Basic information for Canadians
TFSA Over-Contribution Penalty Fix
Tax Free Savings Account refresher for Canada
ING offers TFSA refresher for Canadians
Using the Tax Free Savings Account (TFSA) for Canadians as an emergency fund
Debt Free Revolution published an interesting post today on why she likes to have a cash emergency fund and hates the idea of using your HELOC for your emergency fund. I thought I better write a post to address this idea since having a cash emergency fund is not always the best way to manage your money.
I use my home equity line of credit (HELOC) as my emergency fund because I believe that having too much cash on hand is not good money management.
Some problems with keeping a cash emergency fund:
Let’s look at an example:
Two homeowners – let’s call them Mike and Ana, both have mortgages of $200,000 at 5.19% and they have $10,000 each in cash. Ana likes the idea of keeping the $10,000 in cash as her emergency fund while Mike prefers to pay down the mortgage with the cash and will use a HELOC if an emergency comes up. Both mortgages have interest-only payments for simplicity.
So we have:
Mike – mortgage = $190,000, cash = $0.
Ana – mortgage = $200,000, cash = $10,000.
Scenario I
An emergency occurs after one year and both home owners have to cough up $10,000. Ana has the cash on hand and Mike borrows $10,000 from his HELOC.
How do the home owners compare in this scenario?
Mike – mortgage = $190,000, HELOC = $10,000, payments = $9861, total debt = $200,000.
Ana – mortgage = $200,000, cash = $280, payments = $10,380, total debt = $200,000.
Both home owners end up owing exactly the same amount however Ana has $280 (net of taxes -30%) of interest on the emergency fund but Mike has paid $519 less in interest which tips the scales to Mike and his HELOC emergency fund.
Scenario II
There is no emergency.
Mike – mortgage = $190,000, HELOC = $0, cash = $0, payments = $9861.
Ana – mortgage = $200,000, cash = $10,280, payments = $10,380.
In this scenario, after one year, Ana has netted $280 in interest but Mike has paid $519 less in interest on the mortgage so Mike comes out ahead.
What does it mean?
From the example above it should be pretty clear that using a HELOC is cheaper than using a cash emergency fund for some situations.
There are factors which should be considered which might make the cash emergency fund a better choice:
Conclusion
There are some situations (like mine) where using your HELOC (or regular line of credit) as an emergency fund is the best way to manage your cash. On the hand there are other scenarios where a cash emergency fund makes more sense. It’s up to you to learn the various pros and cons of both methods and apply one method or a combination of both methods to your situation.
Some other posts on this topic:
Mr. Cheap is a fan of line of credits
The Financial Blogger says that cash emergency funds are wasteful.
The Money Gardener explains why he doesn’t like having cash.
Million Dollar Journey says he relies on a combination of cash and a line of credit in an emergency.
Never one to follow a crowd, Thicken My Wallet likes the cash method for emergencies – the more the better.
Thought I would highlight a few more articles that I enjoyed this week:
My Dollar Plan wrote a great post about the work/life mix.
Canadian Capitalist did a book review on “Worry Free Investing” which takes a too conservative look at retirement planning.
Million Dollar Journey asks if 40 year mortgages are a good idea.
Cash Money Life posted about a moral choice that he made – great story!
Chance Favors talks about the differences between the regular 401k and the Roth 401k – believe it or not I really like reading about different retirement accounts from other countries.
Moolanomy needs help to determine how he should increase his foreign equity (maybe buy more Canadian?).
Finance Freelance Life had an interesting post about talking/advising relatives on their investments.
The Wisdom Journal lists some retail ripoff tactics (by salespeople – not the shoppers!).
Canadian Dream is skeptical that “debt free” is really “debt free” if there is still mortgage debt.
My Two Dollars writes about duct tape and wallets
Plonkee Money shows how couples can live a lot cheaper than singles.
Rocket Finance thinks the new US stimulus package is a crock.
Dough Roller has posted his virtual library which contains a lot of great links to investment resources.
Millionaire Money Habits says that maybe smoking isn’t so bad after all.
Prime Time Money doesn’t invest in single stocks for a good reason.
Remodeling This Life has an emotional post on her family’s past troubles.