Magic Number – What are some advisor assumptions on how much to save?

How much do I need to save for retirement? It’s the most common question asked of financial planners.

Of course, the response depends on how much you’ve already set aside, how much you need to live on now, and how much you want to (or must) spend in those later years. That’s the core of financial planning, and there’s a lot of information to be gathered, decisions and assumptions to be made, and calculations to be applied to come up with viable options and sound recommendations — and even then, there is still some degree of uncertainty.

This doesn’t mean that you don’t go to the effort, particularly if you are the financial planner tasked to make those recommendations. The critical step of any plan though, is putting it in motion.

Heuristics – The appeal of simplicity

In the face of what may feel like a laborious and elusive task, people often prefer to use a heuristic, for example “save 10 per cent of your income.” This is also known as the 10 per cent rule. Because it is so simple, it may very well get things moving, which in fairness, is a victory in itself.

Once good saving habits are established and experience gained, adjustments can be made that cater to changing circumstances.

Even so, 10 per cent is just a nice, round, but otherwise arbitrary figure. The aura that surrounds it should not be confused with the principled due diligence that informs good financial planning.

Do you apply it before or after…?

If we’re not careful, the apparent simplicity can be misleading. How you apply it is equally and arguably more important than the rate you choose in the first place. Too little and there’s not enough when you need it. Too much and the budget stress could be overwhelming, perhaps leading you to abandon the initiative you have taken. Consider these key tax issues:

Is the 10 per cent set before or after income tax?

In other words, are you applying it to gross income or net income? As a rough example (which varies by province), the average tax rate at $100,000 is about 25 per cent.

So, do you target $10,000 based on the gross, or about $7,500 based on the net? That could hinge on the mechanics of how you save.

If you pre-calculated $10,000 then you could pre-authorize a proportionate dollar amount from each paycheque/auto-deposit.

If instead you took 10 per cent off each deposit after it is in your account, it would come out to $7,500.

Are you saving with before-tax or after-tax dollars?

As compared to the first question, which was about the amount to save, this is about deductibility. Put in more familiar terms, you could make a deductible RRSP contribution, or a non-deductible TFSA deposit.

While you can get more into the RRSP to begin, eventually that is taxed on withdrawal before you can spend. TFSAs face no further tax. You’ll need to look at tax rates now (known) and in retirement (assumed) to properly compare. If you’re doing some of each, the arithmetic is more challenging.

Pre- or post-payroll?

If you contribute to a workplace group RRSP, your employer will generally reduce its withholding tax, as it knows of this deduction. When you contribute to your own RRSP, the annual withholding will likely exceed your actual tax due, resulting in you receiving a tax refund. While you don’t have to, reinvesting the refund effectively boosts your savings rate.

Canada Pension Plan?

The CPP is a savings program, with a base premium of 4.95 per cent. It is withheld by your employer, so most people wouldn’t notice or think of it as saving, per se. But depending on your response on the preceding questions, it could be quietly baked into your savings rate. And with premiums increasing to 5.95 per cent over the next few years, and an additional four per cent premium on higher income levels after that, it warrants a closer look to make sure it dovetails with your intentions.

Housing and mortgage?

What does housing have to do with it? Well, equity in a house is a type of saving, usually by first saving a down payment then servicing a mortgage. As an owner, you defray some of your future shelter costs, whereas otherwise you would need more savings to pay future rent. Whether this is before, after, or part of your 10 per cent depends on your circumstances, which is why a holistic financial plan should underlie your efforts.

Whether interest on T-series distributions is deductible

At issue

Borrowing money for investment is a way to leverage up the amount of capital on which you can generate income. Of course that can also work against you by magnifying losses, but whichever way the performance goes, the interest on that borrowed money is usually tax-deductible.

For a straight buy’n’hold investor, deductibility is in turn straightforward. But when the borrowed money is repositioned in some way – whether by the investor’s actions or by the operation of the investment itself – deductibility can be brought into question.

Mutual funds – return of capital

In Van Steenis v. The Queen, the taxpayer borrowed $300,000 in 2007 to invest in units of a mutual fund.  The fund had the capacity to return capital to investors, a feature often called ‘tax-efficient’ or t-series funds. In this case, the fund returned capital each year up to 2015, to a total of $196,850. Mr. Van Steenis used some of that money to pay down his loan, but the majority was used for personal expenses.

The Canada Revenue Agency reassessed Mr. Van Steenis for his interest expense deductions from 2013 to 2015, denying the portion related to his personal expenses.

Requirements for interest deductibility

As background, there are four requirements for interest deductibility:

  • interest must be paid or payable in the year.
  • it must be pursuant to a legal obligation on the borrower to make the payment,
  • the money must have been borrowed for purpose of earning income from a business or property, and
  • the amount of interest must be reasonable.

Importantly on the third point, it is the current use of borrowed money that is relevant in determining the income-earning purpose. On appeal, Mr. Van Steenis’ position was that he borrowed the money in 2007 to purchase mutual fund units, and that he continued to own those same fund units in the years in question, so therefore he should be entitled to continuing interest deductions.

Furthermore, he had no control over how the fund company characterized the distributions. He argued that though the fund was returning capital from its perspective, that does not necessarily correlate with each unitholder’s actual invested capital, and therefore he should not be bound by that characterization.

Ruling on continuing purpose

The judge did not accept Mr. Van Steenis’ arguments. Almost two-thirds of his capital was returned to him over the years, and more than half of that was used for personal purposes. Returning to that third deductibility requirement, there was no longer a direct link between the borrowed money and investment in the fund units.

In support of this finding, the judge points to the fact that a mutual fund trust is by its nature a flow-through structure. Income that it distributes to unitholders is included in their income and deducted from the fund’s income. By contrast, capital distributions result in a dollar-for-dollar reduction in the unitholder’s adjusted cost base, according to specific provisions of the Income Tax Act.

In sum, a return of capital reduces the amount of the investor’s own money that is in fact invested. If the entire returned capital had been used to reduce the borrowed principal, all ongoing interest charges would have been deductible because all remaining outstanding indebtedness would still be directly connected to the fund units.

As it was, more than half of that money was spent on personal expenses, and you don’t get a deduction for personal spending.

Minister of Revenue confirms the CRA is not going after retail employee discounts

At issue

In the house where I grew up, we bought almost all of our clothing, housewares and other durable goods from one retailer. That’s because it was the company where my dad worked, and part of the employment deal was a discount on purchases.

That’s a common practice for retail employees and restaurant workers, and one that garnered some front page media attention recently. It’s not because of any public uproar as if it was some kind of scandalous abuse. On the contrary, it was prompted by what appeared to be a reversal of the Canada Revenue Agency’s longstanding practice of acknowledging these as non-taxable items.

Is the CRA really intending to begin requiring employers to track the savings each employee receives, and report that as a taxable benefit each year?

Income Tax Act (ITA) Canada

Per paragraph. 6 (1)(a), income from employment includes “benefits of any kind whatever received or enjoyed by the taxpayer …in the course of, or by virtue of the taxpayer’s office or employment”. Some exceptions are allowed in the following subparagraphs, with no mention of discounts.

Income Tax Folio S2-F3-C2, Benefits and Allowances Received from Employment

The CRA has an ongoing multi-year project migrating and consolidating its tax practice guidance from a variety of older formats into the online Folio format. This particular Folio was published in October 2016, but the story hit the headlines in October, 2017.

The Folio states that a discount is generally to be included as an employee benefit under para. 6(1)(a). With the exception of discounts made available to the general public, “the value of the benefit is equal to the fair market value of the merchandise purchased, less the amount paid by the employee.” Responsibility is placed on the employer to “determine the value of the benefit to include in an employee’s income.”

CRA letters 2017-0726641M4 & 2017-0729161M4 – Taxability of employee discounts

An immediate firestorm erupted for the Minister of Revenue Diane Lebouthillier, and within a day she clarified that this was the action of CRA bureaucrats, not the government’s policy intention. One day later, Folio S2-F3-C2 had been taken down from the CRA website, replaced by as a statement that it was “currently under review.”

We now have written affirmation that employee discounts are not on the CRA’s radar. Two letters were published in the last couple of months, from the Minister of Revenue herself. The letters are almost verbatim one another, with one providing a bit of additional reassurance to restaurant employees. The Minister states that the “longstanding administrative policy that employee discounts on merchandise are generally not taxed … is still in place and is explained in Guide T4130.”

T4130 Employers’ Guide – Taxable Benefits and Allowances

This Guide advises an employer that if it sells “merchandise to your employee at a discount, the benefit he or she gets from this is not usually considered a taxable benefit.” If the discount is below the employer’s cost, there would be a taxable benefit for the difference between fair market value and the price paid.

Practice points
  1. Generally, benefits received by an employee from an employer are taxable.
  2. Discounts for an employer’s merchandise and meal discounts for restaurant employees continue to be non-taxable, per the CRA’s longstanding policy.
  3. If a discount is below employer cost then a taxable benefit may still arise.