For Canadian Investors, TFSA or RRSP?
Which is right for me?
As of January 1, 2009, the Federal government is offering Canadians the opportunity to invest in a new Tax-Free Savings Account (TFSA). This new account may offer significant tax advantages to certain Canadian investors. These new accounts have some similarities with traditional RRSPs but are quite different in other respects. The decision on whether to have a TFSA, an RRSP or both will depend on each investor’s specific circumstances. The following table highlights common questions about the two accounts to help you understand them better. Please speak to your advisor for more details and guidance on which approach is right for you. Both plans are important considerations in any early retirement plan!
| Question | TFSA | RRSP |
| Are there minimum age limitations for having the account? | Yes. To open a TFSA you must be 18 years of age or older, a Canadian resident and have a valid SIN. | No. As long as qualified income was earned in the previous year and a Social Insurance Number is available to register the plan, there is no minimum age restriction. |
| Are there maximum age limitations for having the account? | No. Provided you are a Canadian resident with a valid SIN, you can own and contribute to a TFSA. | Yes. You cannot own an RRSP beyond the end of the year in which you turn 71. |
| Is there a tax deduction for contributions? | No. | Yes. |
| Will the income earned in the account be taxed? | No. Income earned in the TFSA is tax-free. | No. As long as the earned income remains in the account there are no tax implications until withdrawal. |
| How much can be contributed to the account annually? | Maximum annual contributions are $5,000 per year per investor. This limit will be inflation-adjusted upwards after 2009. | For 2009, maximum annual contributions are the lesser of 18% of earned income in 2008 or $21,000. This is scheduled to rise to $22,000 in 2010 and will be inflation adjusted beginning in 2011. |
| Can unused contribution room be ‘carried forward’? | Yes. If you only contributed $2,000 this year, you could contribute $8,000 next year ($5,000 + $3,000 unused). | Yes, unused room can be carried forward indefinitely. |
| If funds are withdrawn, will more contribution room be created? | Yes. Withdrawals will create new room. If you withdrew $4,000 this year you could contribute $9,000 next year ($5,000 + $4,000). | No. Withdrawals do not create additional contribution room. |
| How are withdrawals taxed? | Any withdrawals from the account are received tax-free. | Any withdrawals from the account will be taken into income and be taxed. |
| Which account is better from a tax perspective? | Although withdrawals are tax-free, there is no tax deduction initially. Assuming the marginal tax rate (MTR) remains constant, there is no tax advantage. If the MTR is expected to rise in the future, the TFSA could be preferable to the RRSP. | Although withdrawals are taxed, there is a tax deduction provided initially. Assuming the marginal tax rate (MTR) remains constant, there is no tax advantage. If the MTR is expected to be lower in the future, the RRSP could be preferable to the TFSA. |
| Will withdrawals affect my Federal benefits? | No. Withdrawals are not considered income for federally income-tested benefits such as Old Age Security or Employment Insurance so those benefits will not be reduced. | Yes. RRSP withdrawals are considered income for Federal benefits such as OAS or Employment Insurance so those benefits may be reduced. |
| What are the investment options in the fund? | The investment options are very broad, essentially the same as provided by an RRSP. | There is a wide range of investment choices, such as Money Market, Stocks, Bonds, Mutual Funds, etc. |
| Can the funds be used as collateral for a loan? | Yes, provided certain criteria are met. | No. |
| Can non-residents hold the account? | Yes. | Yes. |
| Can the plan be transferred to my spouse on death? | Yes, the plan can be transferred to your spouse if they are named as the sole successor. | Yes, the plan can be transferred to a spouse on death with no immediate tax implications. |
Your Asset Allocation Strategy
It has been said that asset allocation can account for up to 90% of portfolios variability over time. What I mean by asset allocation is what asset classes you are choosing to invest in within your portfolio such as stocks, bonds and cash.
Since no one has a crystal ball to tell them which asset class will outperform another in any given year it is crucial that investors diversify their portfolio across several different asset classes, otherwise known as not putting all their eggs in one basket.
Asset classes tend to behave differently from one another, going up and down in separate cycles and to varying degrees, meaning their correlation is less than 1. Diversification across asset types allows an investor to capture upside gains in the market no matter which asset class currently is performing best, while simultaneously defending against hitting market bottoms. Thoughtful asset allocation can help you strike the right balance between the volatility of high-return investments and the predictability of lower-return investments.
So what is the right asset allocation? It depends on two issues. First, an investor should design a portfolio so that the expected return satisfies any cash-flow needs today and in the future. Second, any portfolio selected must be within an investor’s tolerance for taking investment risk.
As we learned from Markowitz, investors cannot ignore risk in pursuit of returns. Risk tolerance being the degree of uncertainty that an investor can handle in regard to a negative change in the value of his or her portfolio. It is difficult to predict the level of emotional stress that an investor can endure before making a hasty decision to abandon their long-term investment plan. Each investor’s asset allocation must be within their tolerance for risk to ensure plan integrity and increase their probability of investment success.
Along with risk tolerance another important factor to consider is time horizon. Your time horizon is the amount of time you expect this money to be invested for whether your goal is saving for education, a home or retirement each goal has a horizon. An investor with a longer time horizon may feel more comfortable taking on a riskier, or more volatile, investment because he or she can wait out slow economic cycles and the inevitable ups and downs of our markets. By contrast, an investor saving up for a teenager’s college education would likely take on less risk because he or she has a shorter time horizon.
So once you’ve chosen an asset allocation strategy when should you rebalance? Most people chose to rebalance either based on the calendar or on your investments. Most financial experts recommend that investors rebalance their portfolios on a regular time interval, such as every six or twelve months. The advantage of this method is that the calendar is a reminder of when you should consider rebalancing, this method forces you to be disciplined in your approach.
Other experts recommend rebalancing only when the relative weight of an asset class increases or decreases more than a certain percentage that you’ve identified in advance. The advantage of this method is that your investments tell you when to rebalance again this approach helps you to stay disciplined and to stick to your original asset allocation strategy. In either case, rebalancing tends to work best when done on a relatively infrequent basis.
Filed under asset allocation | Comment (0)Dividend Reinvestment Plans
A good way to add to your positions without incurring trading costs is through a dividend reinvestment plan. DRIP’s should be the foundation of any common stock portfolio, but we often forget their importance. A dividend reinvestment plan or DRIP is an investment program offered to shareholders by some corporate securities issuers. Shareholders who participate in the plan reinvest their cash dividends and purchase additional shares of the company instead of receiving a cash payment. DRIP’s though are best suited for long-term investors as purchase prices are not determined by the investor because transactions are executed on predetermined dates.
Some of the advantages of utilizing a DRIP plan are; DRIP’s facilitate the purchase of shares at regular intervals for little or no commission, DRIP’s enable smaller purchases of shares that would not be cost effective through other means & some DRIP’s offer a discount on shares purchased. A few examples are Bank of Montreal offering a 2% discount, Bank of Nova Scotia offering a 2% discount, Enbridge Inc. offering a 2% discount, Royal Bank of Canada offering a 3% discount.
Regular investments at the same dollar amount ensure that more shares are purchased when the share price is low and fewer are purchased when the share price is high. This approach effectively lowers the average price paid for shares and is known as ‘dollar cost averaging’.
For example
Regular investment Share Price Shares Purchased
$100 $11.00 9.09
$100 $12.50 8.00
$100 $10.75 9.30
$100 $15.60 6.41
$100 $18.35 5.45
Total $500 Total 38.25
The average cost per share acquired is calculated by dividing the total amount invested ($500) by the total number of shares purchased (38.25). Average share cost is therefore equal to $13.07. The average price per share paid by the investor can be calculated by dividing the total of the share prices paid ($68.20) by the total number of share purchases (5). Giving you an average share price of $13.64.
This method ensures you are putting your dividend payments to work for you by forcing you to reinvest the money automatically instead of receiving the cash that could just be spent without notice on everyday life. Any investor in common stock should be utilizing this plan to help them achieve their goal of early retirement!
Filed under dividend reinvestment | Comment (0)