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Registered Retirement Savings Plans

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RANGA CHAND
From Ranga Chand's Getting Started with Mutual Funds

Are you concerned about the long-term effects of high government deficits? Worried that government and company pensions will be unable to provide an adequate income in your retirement years? If you answered no, I sincerely hope it's because you are independently wealthy. If you answered yes, welcome to the club. It means you are aware of the potential financial problems that could derail your retirement plans and lifestyle. It probably also means that you are already contributing to a Registered Retirement Savings Plan (RRSP). If you aren't, you should be.

What Is an RRSP?

A Registered Retirement Savings Plan is a tax shelter provided under the Income Tax Act (Canada) to give individuals the incentive to save towards their retirement. By investing carefully and wisely, many Canadians enjoy a comfortable standard of living in their later years. An RRSP in itself, however, does not automatically guarantee this. It merely provides the vehicle.

By contributing to an RRSP, you increase your savings in two ways:

All RRSP contributions are deductible for tax purposes, subject to certain limits. For 1995, the contribution limit is 18% of your previous year's earned income, less any pension adjustment, or the allowed maximum of $14,500 -- whichever is the lesser amount. The limit for 1996 and 1997 is reduced to $13,500. Whatever your eligible 1995 contribution, be it $5,000 or $14,500, this money can be deducted from your total earned income for the year, reducing the amount of tax you pay -- and, more importantly, increasing the amount of money you keep. When you make your RRSP contribution, you will receive a tax receipt, which should be filed with your tax return in order to claim your deduction. Beginning in 1991, if you did not contribute your maximum amount in any one year, you can carry forward the unused portion to subsequent years. Make sure you do not exceed the $2,000 lifetime overcontribution limit. Any amount in excess of this limit carries a penalty of 1% a month until the amount overcontributed is withdrawn. Confirmation of your RRSP contribution limit appears on your previous year's Revenue Canada Notice of Assessment.

Any income earned is not taxed. This means that all monies contributed to and accumulating in an RRSP, including all capital gains and interest income earned, is left untouched by Revenue Canada until withdrawn. All RRSPs must be terminated by the end of the calendar year in which your seventy-first birthday falls. This means that if you turn seventy-one years of age in April, you have until the end of December of that same year to terminate your plan. At termination, the money accumulated in your RRSP can be either transferred to a Registered Retirement Income Fund (RRIF), used to purchase an annuity, or cashed in. You can also choose a combination of these options. The difference between an RRSP and a RRIF is quite simple. RRSPs are set up to accumulate money, whereas a RRIFs function is to pay out money -- with minimum amounts set each year. An annuity typically provides fixed monthly payments for as long as you live. If you decide to cash in your plan, the trustee (bank or trust company) will withhold tax at source before releasing the funds. This amounts to 10% for withdrawals up to $5,000, 20% for amounts up to $15,000, and 30% for higher amounts ( different taxation rates apply in the province of Quebec ). By contrast, if you transfer all monies accumulated in your RRSP to a RRIF and withdraw on a monthly basis what you need, subject to the required minimum amount, then only those amounts over the minimum annual payouts will have tax withheld at source.

Why Contribute to an RRSP?

Trying to save even the smallest of nest eggs outside a registered plan is, for most of us, increasingly difficult. The combined effects of taxation and inflation can eat into returns in a surprisingly rapid manner. Assume that you invest $1,000 of pre-tax income at the beginning of each year for thirty-five years, and that your annual rate of return is 8%. At a marginal tax rate of 45%, you are left with only $550 to invest annually. At the end of thirty-five years, you will have accumulated $46,000. By contrast, the same $1,000 invested in an RRSP will have built savings of $186,000. A difference of $140,000. Even if you withdraw the entire $186,000 from your RRSP at the end of the thirty-fifth year, without taking advantage of any further tax-deferral plans such as a RRIF, you will have $102,000 after tax. That still puts you ahead $56,000.

When to Start

Probably the last thing someone just starting out in the workforce wants to consider is retirement. After all, you are young, and you finally have some money in your pocket and many plans on how to spend it. Retirement is something you intend to worry about later on down the road.

Unfortunately, the further down the road you travel before acting, the more it will cost you. Let's say that at age thirty, you contribute $1,000 --that's less than $90 a month -- at the beginning of each year for thirty-five years, and achieve a very realistic 8% rate of return. By age sixty-five, even if you do absolutely nothing else, you will have accumulated close to $190,000. If, however, you wait until further down the road, say age forty-five, and contribute for only twenty years, you will have less than $50,000 in your plan. A difference of nearly $140,000. Moreover, the longer you wait, the greater the difference.

When to Contribute

Your current year's RRSP contribution must be made on or before March 1, 2001. Many people, however, wait until the last possible moment -- so much so that February is known as the "RRSP season." But by delaying your contribution until this late date, you effectively miss out on fourteen months' income. Another option is to make regular contributions through a pre-authorized investment plan. These plans are offered by most financial institutions and major fund companies. All you have to do is decide how much and how often, and your contributions will be automatically deducted from your bank account and invested into the mutual fund of your choice. Whether or not you choose a pre-authorized investment plan, don't forget to name a beneficiary when you open your RRSP, to avoid probate fees.

If you have fallen into the bad habit of putting off making your contribution until the last possible moment, you should strive to correct this. Try to contribute as early as possible, each and every year. It could make a significant difference to your retirement income.

Retirement Goals

You should define all investment goals, including retirement. Fuzzy thinking is not the way to go. Here are some questions to get you started. Turn to Chapter 15 for more on investment objectives.

When would you like to retire? In five years or twenty? Where will you live? Mortgage-free home or rental? How much annual income will you need? More or less than your current income? What sources of income can you expect? Government or company pension plan?

Most banks, trust companies, brokers, and financial planners have information kits or can personally help you plan your RRSP portfolio. Many financial institutions also offer free RRSP seminars, investment workshops, or videos. Take advantage of any additional help you can get. By taking the time now, you can enjoy the benefits later.

Spousal RRSPs

You may invest all or a portion of your own maximum allowable RRSP contribution to a plan in your husband's or wife's name. Assume your allowable contribution is $12,500. If you decide to contribute $7,000 to your own plan, then you will be able to contribute the difference of $5,500 to a spousal RRSP. This contribution is deductible from your taxable income, but the plan belongs to your spouse and the amount contributed by you will not affect his or her yearly limit. Because a spousal RRSP belongs to the person in whose name the plan is registered, only that individual can make any withdrawals or changes to the investments held in the plan.

Although only the planholder can withdraw funds from a spousal RRSP, the withdrawals will be taxed in one of the following two ways. These rules cease to apply, however, if you and your spouse are living separately at the time of withdrawal.

Any amounts withdrawn will be taxed in the planholder's name, provided the contributing spouse has not made any contributions in the year of withdrawal or the two preceding years. If the contributing spouse has made contributions during the year of withdrawal or the two preceding years, the amount withdrawn, up to the amount of such contributions, will be included in the contributing spouse's income.

The advantages of a spousal RRSP are more significant when one partner earns a significantly higher current income (or is the sole wage earner) and expects to receive a higher retirement income. Contributions to a spousal RRSP can mean two lower tax brackets at retirement instead of one higher one. Provided you have earned income, you can still contribute to a spousal RRSP until your husband or wife reaches age seventy-one -- even if you yourself are over seventy-one.

Self-Directed RRSPs

This kind of plan gives you much broader investment options, including a more diversified choice of mutual funds, term certificates from a wide range of issuers, Canadian and foreign stocks and bonds, or even your own mortgage. This wide range of investment alternatives makes a self-directed RRSP attractive to many investors. You do not have to be an investment guru to manage this type of plan. As you accumulate your funds within a regular RRSP, however, your aim should also be to accumulate investment knowledge. This will put you in a favourable position to consolidate your RRSPs into a single self-directed plan at a later stage.

One of the benefits of this kind of plan is that you can contribute investments you already hold. If you find yourself short of cash one year, you can instead contribute any Canada Savings Bonds or stocks that you hold. A self-directed plan also allows for easier record keeping, and transferring to an annuity or RRIF will be simpler.

The Foreign-Content Limit

Although the foreign-content allowance for an RRSP is 20%, many financial planners advise allocating only about 15% or 17% of the book value (the original price you paid) of your total holdings. This gives you a cushion for future gains without exceeding the limits set by Revenue Canada. Wealthier and more aggressive investors can also boost their international content by investing in Canadian-based mutual funds that invest up to 20% of their funds in international securities. In this way, the total foreign-content limit can be increased to a maximum of 36%. ( Please note that foreign content limits have increased to 30% as of January 1, 2001 )

Let's suppose you have $10,000 to invest. You can purchase $2,000 worth of international funds on your 20% foreign-content limit. But if you invest the remaining 80%, or $8,000, in Canadian mutual funds that also take advantage of the 20% foreign-content limit, you boost your total foreign holdings by another $1,600 (20% of $8,000). This gives you a total foreign content of 36%, or $3,600.

Most financial institutions and brokers will monitor the foreign-content portion of your RRSP. The bottom line, however, is that it is your responsibility, and if you do go over the limits set, you will end up paying a 1% monthly tax penalty on any amount over the 30% foreign-content limit.

You may also find when you switch funds that the foreign-content limit has changed to reflect the current market value, not the price you originally paid. It is important to keep your original records of purchase in a safe place, in case you need to produce them later on for tax purposes.

Many financial experts recommend putting aside four to six months' living expenses as emergency money. In the real world, that's not always possible. If you have to withdraw any money for emergencies from your RRSP, try to keep it to a minimum. If you own units in different funds, seek advice as to which should be redeemed. Depending on the prevailing economic climate, redeeming units in, for example, a bond fund may make less of a negative impact than cashing in units in an equity fund.

A Final Word

Rushing out at the last minute and buying units in the first available mutual fund is definitely not the way to go. If your quality of life in retirement will depend to a large extent on how much you have accumulated within your RRSP, you should be prepared to do a little homework. If you end up with poorly performing funds in your RRSP, it could be a case of what you gain on the swings (tax deferrals), you lose on the roundabout (low retums).

Key Points to Remember

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