In its original form, initiative was an email periodical which had about a 200 word count base text, complemented with a graphic to show connections, flows or other dynamics, including labels and other supplementary text. Those graphics were not compatible with later technology, so only the original base text has been preserved for the present archiving purpose. The material was current to the year and month of issue (Vol#,No#) but is not a legal opinion.
Vol.1. Vol.2. Vol.3. Vol.4. Vol.5. Vol.6. Vol.7.
Volume 7
Client has asked Advisor whether it really makes sense to make his annual RRSP contribution, or if instead he should place his money in a traditional open account designed for dividend income and capital gains. Some considerations:
Investing
Registered – Contributions reduce current income, lead to lower current taxes, and often result in a tax refund
Open – Contributions originate from after-tax money, and have no effect on current income tax reporting
Growth
Registered – There is no tax on growth while funds are within the RRSP, and therefore gross funds are reinvested
Open – Realized income is taxed annually, though capital gains are not realized until disposed (deemed or actual)
Leverage
Registered – Because RRSP growth is tax-sheltered, interest on RRSP loans is not a tax-deductible expense
Open – Interest is generally deductible on loans where the funds are placed into an open investment account
Urgency
Registered – If there is a need for money, fully taxable withdrawals would be required as an RRSP cannot be pledged
Open – To avoid a tax on disposal of an investment, a short- term loan may be used with the account as collateral
Income
Registered – Except for the pension tax credit (worth up to $320 annually), registered source income is fully taxable
Open – Principal is not taxed, and dividends and capital gains are at 1/2 to 2/3 (or less) the rate on regular income
Formality
Registered – Rules prescribe types of investments, maximum deposits and (in later years) minimum withdrawals
Open – Apart from contractual terms with the investment firm, there is a great deal of investment flexibility
Next month: Part 2 – Key questions
Recall that last month Advisor had discussed with Client some comparative features of registered and open investment accounts. Client is now asking what Advisor needs to know to advise how Client might proceed. Some questions that Advisor will want answered:
Employment matters
Has Client’s employer been withholding tax at source?
Is it a group RRSP (with source deduction), or personal RRSP?
Is Client a member of a registered pension plan?
Tax characteristics
What is Client’s marginal tax rate presently? in retirement?
What will Client do with any tax refund received?
Timelines
How many years until Client will begin drawing down funds?
How much and how long will/must Client draw upon the funds?
Investment/financial profile
Does Client have a contingency fund for emergency needs?
What is client’s risk tolerance and rate of return expectation?
What other wealth and savings does Client have presently?
Will Client receive an inheritance from parents or grandparents?
Does Client have investments that may suffer capital losses?
Spouse and family issues
Is Client contributing to a spousal RRSP?
What is spouse’s income and expected retirement income?
Does Client have children who will require support in future?
Last month: Part 1 – Comparative features
Client just opened a Registered Education Savings Plan for her child, and has asked Advisor how much she should be contributing to the program.
While the absolute amount being saved for education will depend on one’s current financial situation and future education expense expectations, there are some tax considerations that may affect how one chooses to save.
Some key benefits of RESPs include:
The earnings in the RESP will be taxed to the child (presumably at a lower rate) when the funds are applied to education in future.
The 20% Canada Education Savings Grant matches contributions up to $2,000 (proposed to go to $2,500 in the March ‘07 budget).
Further financial incentives may also be available for lower-income families.
Beyond the level at which the incentives are available, it may be worth considering other education savings options:
She may simply choose to invest in capital gains directed investments, only half of the growth of which is taxable to her.
She could set up an in-trust account, though according to CRA’s practice any interest and dividends will be taxed to her from year to year, while the capital gains may be taxed to the child.
If a very substantial future need is anticipated, this may warrant the formality and cost of establishing a formal trust so that all of the earnings can be designed to be eventually taxed to the child.
Client is mulling over what to many in the financial advice field is the age-old conundrum: Whether to use his forthcoming tax return to increase the investment in his RRSP or to apply it to reduce the mortgage on his home.
RRSP
The general advantage is the tax-deferred investment growth of the money in the RRSP.
As well, the deposit will reduce his annual reportable earnings, which may in turn result in another tax refund next year.
In the future though, the money withdrawn from the RRSP (or from a follow-up RRIF) will be fully taxable.
Mortgage
An unfortunate drawback of a principle residence is that mortgage interest is not tax-deductible.
By corollary, the effect of the early principal payment is that it reduces the cost of future interest that would otherwise compound against him.
As a final point, due to the principal residence exemption, his expected return is tax-free.
Ultimately, Client would be well served by seeking advice of both his tax advisor and his investment advisor in order to decide which route makes the best sense in his situation.
Client-couple are wondering whether they can declare the cottage as their principal residence in order to capture the galloping growth in the hot recreational real estate market.
While an important consideration in their tax planning, the election to eliminate capital gains using the principal residence exemption really only happens when one disposes of a property. Specifically, one does not choose particular years, but rather decides how many of the ownership years to elect the exemption upon. In fact, one can elect one less year than otherwise required as the calculation is designed to pick up gaps that might result from mid-year transfers.
The reportable capital gain is calculated as (1 + Years elected) / (Years owned)
The exemption is available on traditional houses, condominiums, mobile homes, houseboats, co-op interests and life leases.
Bear in mind that when more than one property is owned in a given tax year, the election to treat a disposed property as a principle residence will limit or preclude such an election on a later disposed property.
If/when Clients sell the house to move to the cottage, they will want to balance the current savings of electing the exemption on the house against potentially larger gains on the eventual sale of the cottage if strong growth continues.
On your recent annual financial check-up with retired Client-spouses, they advised that a major bank recently called asking for payment on a mortgage they knew nothing about. They have lived in their home for over 50 years (having retired their mortgage decades ago) and are therefore wondering … How could this happen?:
A fraudulently executed document transfers the property into the fraud artist’s name
The fraudster then purports to discharge any existing mortgages in order to apply for a mortgage with a new financial institution
The new mortgage is registered on the property
The new financial institution advances the negotiated funds to the fraudster who immediately skips town
Clients now have to engage a lawyer to help clean up a potentially costly problem
While the provincial governments have initiated legislative steps to address some of these problems, an existing homeowner title insurance policy will assure that the costs of such corrective actions are covered:
Such policies are generally retroactive to the original purchase date
Protection can often extend to heirs of the owner
The premium is a one-time cost
Usually there is no deductible if a claim is made
The policy actually covers a large number of potential title problems beyond the fraud concern
Advisor and Client are discussing investment succession issues. Client has a general familiarity with the key rules in the Income Tax Act allowing for spousal rollovers:
Registered (RRSP & RRIF) money can roll to a spouse at death, generally by designating the spouse as beneficiary of the plan
Non-registered capital assets can roll to a spouse during lifetime or at death, though income from the rolled assets is attributed to the transferor (with some exceptions – see initiative Vol.3, No.6)
For insurance-based non-registered money, however, Advisor should pay close attention to the annuitant provisions of the contract. If it does not allow for a successor annuitant, or if a successor is allowed but not elected, the original contract will likely be at a legal end on the death of the original annuitant.
Even if a successor owner is named (even a spouse), tax will be due on any realized capital gain for the original contract, and the successor will own a new contract. Rather than being a rollover of an asset at its cost base, this is essentially passing ownership after an actual capital gain is realized.
Insurance-based investments in registered plans for a spouse beneficiary do not have the same concerns as tax is not payable until money comes out of the RRSP/RRIF.
Client has always been an entrepreneur, having built and sold her first company many years ago to seed her second venture. She was able to escape most of the tax on the sale of her shares in the first transaction by claiming her full $500K lifetime capital gains exemption.
Being an astute (and attentive) business manager, Client’s ears perked up when she heard that that the 2007 federal budget intended to increase the lifetime capital gains exemption from $500K to $750K. She has inquired with Advisor whether she will be able to take advantage of it, perhaps as part of an estate freeze for her current company which has at least another $1M of inherent growth.
While there are some transitional rules for dispositions before and after the March 18, 2007 announcement date, the exemption indeed continues to be available to:
Qualifying small business corporation shares
Qualifying farming property
Qualifying fishing property
As client has used the original $500K, she will have the difference of $250K to employ in the proposed estate freeze – and she will likely be looking for Advisor’s assistance to obtain life insurance coverage to protect against the frozen tax liability in excess of the exempt portion!