Over the last 50 years, the Canadian government has introduced numerous tax sheltered vehicles to help Canadians in our pursuit of a richer retirement, a higher education, and just some plain old tax relief. For those in the upper income tax brackets and with excess cash flow, contributing to all three plans is a no brainer. But for those who fall outside this category, especially successful self-employed individuals who tend to have small salaries and large dividend payments, some of the plans including the RRSP have less benefit than one might think.

Let’s first quickly review the history of each of the three plans:

Registered Retirement Savings Plans (RRSPs) were first introduced in 1957 by the Liberal government to assist the thousands of people without a company sponsored pension plan. Maximum annual contributions were the lesser of $2,000 or 10% of your income which was a lot back then.

Registered Education Savings Plans (RESPs) were technically introduced in 1974 but really only became popular in 1998 after the government added a 20% credit (up to $400) on the first $2,000 contributed to the plan, otherwise known as the Canada Education Savings Plan.

Finally, Tax Free Savings (TFSAs) were introduced last year and allow Canadians to save $5,000 a year in a tax sheltered vehicle where income earned and withdrawals are free from any tax implications.

RRSPs

RRSPs provides two immediate benefits. (1) It provides a tax refund/credit and (2) investment returns are sheltered from tax. But RRSPs have a downside too that many financial advisers neglect. One way or another, the government collects its tax — it’s just a matter of when? Either upon retirement when the individual starts making withdrawals or upon death. Too often I read about financial advisers who make a very simple assumption that individuals will be in a lower tax bracket upon retirement. Unfortunately, this simply is not true. Many individuals and couples are able to build such a large nest egg that they continue to remain in a very high tax bracket. And with that being the case, I often recommend (especially to my self-employed clients) to contribute to a Tax Free Savings Account first (where funds are sheltered from tax forever and ever).

TFSAs

A number of papers have come out showing that individuals making less than $100,000 should probably contribute first to a TFSA and RRSP second even though no tax refund is offered on a TFSA.

Conceptually,this make senses because lower income individuals receive a smaller benefit of any RRSP tax rebate anyway, because they pay less tax in the first place than that of a higher income individual. In fact, a person who pays no tax at all and therefore receives no tax refund from any RRSP contribution, has no reason at all to favour an RRSP over the TFSA.

RESPs

Finally, RESPS are an interesting program, primarily because contributions are made with after-tax dollars but withdrawals are taxed in the child’s hands. One would think that the government should not be taxing RESP withdrawals if only because the dollars deposited into the RESP came from earnings that the parents had already paid tax on.

Hence, the RESP potentially exposes investors to double taxation. So long as the child is in the lowest tax bracket when he/she make withdrawals, there is no double taxation. But if the child is able to earn a university grant or scholarship, or even earns a salary through a part time job, then there is the potential for double taxation.

Where Do you Rank?

Typically, for my higher income clients, I rank RRSPs first, RESPs second (due to the 20% Canada Savings Grants), and TSFAs a close third. But like the TSFA, the onus for investing in an RESP becomes greater as investors fall into a lower tax bracket.

In fact, for some of my wealthy clients whose primary source of income is dividend income from their corporations (as dividends do not generate RRSP contribution room), I often tell them to consider contributing to their TSFA first, RRSP second, and RESP third.

Jeff Kaminker
President, Frontwater Capital

www.fwcapital.ca
www.frontwater.ca

As a derivatives trader, nobody more than myself enjoys coming up with sophisticated investment strategies. Yet, sometimes opportunities presents themselves in ways that don’t require a whole lot of complexity nor hours of research. And while I strongly believe there are no free lunches out there, sometimes you do find a $5 bill or even a $20 bill lying on the street. An insured annuity is one of those very simple, easy to understand products that complement the fixed income portion of one’s portfolio.

So, what is an annuity? It is a contract, usually between an insurance company and an “annuitant” who, for a lump sum payment, will receive from the insurance company, a stream of income for life — very similar to the benefits of owning a long term bond or perpetual preferred share.

So what is an insured annuity? An insured annuity is simply an annuity in combination with a life insurance policy. One of the disadvantages with owning an annuity without the insurance policy is that once you hand over the cheque to the insurance company, you don’t get your money back. An insured annuity solves this problem. Basically upon death, the annuitant’s estate receives the principal amount back — again very much like a bond that upon maturity pays back the principal amount.

Now, there are various types of annuities, and many factors that need to be considered in determining the appropriate type of annuity.

Single Life Annuity

A single life annuity will provide you with an income for as long as you live, ensuring that you will never outlive your money. It can also be guaranteed for a certain number of years. Should a premature death occur, the estate will continue to receive the funds at least up to the guaranteed period.

Joint and Last Survivor Life Annuity

This life annuity is payable while either you or your spouse (or common-law partner) are living. When one spouse dies, the survivor can continue receiving income payments as agreed upon when the annuity contract was established. As with the single life annuity, a guarantee period can be written into the contract.

Term Certain Annuity

This type of annuity can be useful for planning ahead when you will require a specific or additional income for a pre-defined period. A term certain annuity provides you with an income for a set period, or until a certain age.

How Life Annuity Payment Amounts Are Calculated

The life annuity payment amount is fixed and is based on:

• the amount of money used to purchase the annuity,
• the type of life annuity purchased,
• current interest rates,
• the ages of the annuitant and joint annuitant, if any,
• current long-term bond rates.

Tax Efficiency

Perhaps the greatest benefit for considering an annuity is for the tax efficiency of the prescribed annuity when using “non-registered” funds. The CRA recognizes that payments received as income from an annuity include both interest and principal. Since taxes have already been paid on the principal, the annuitant will not be taxed twice.

For example, if one purchases a life annuity for $1,000,000 and receives an annual income of $80,000, the amount that is taxable might be $18,000 (actual income and taxable amount will be based on conditions when an annuity is purchased). That leaves the investor with $62,000 on an after tax basis.

However, in order to complete the financial analysis, we have to factor in the cost of the insurance policy. Again, it will depend on the individual but for this example, let’s assume the cost of the insurance policy was $15,000. This would reduce the investor’s income from $62,000 to $47,000 on an after tax return basis.

In comparison, an affluent, wealthy investor would have to earn at least 8% from his bond portfolio in order to match the after tax return of an insured annuity. Given that most investment grade corporate bonds are paying closer to the 5-6% range, the insured annuity outperforms by a landslide.

In summary here is what an Insured Annuity can do for you?

• Provide a regular, guaranteed income stream for both you and your spouse for as long as both of you live.
• Create a tax advantage
• Ensure your principal is returned to your estate upon death
• Reduce market risk to investable assets by treating an annuity as part of the asset allocation strategy of the portfolio.

Are there any disadvantages to an annuity? It’s a non-cancellable contract, and technically you lose control of those funds. The contractual payments are fixed and will never increase — hence annuities are subject to inflation risk which is why we at Frontwater believe they are a complement to a portfolio weighted towards fixed income.

Certainly, as stated above, if for no other reason than continuing market volatility, and your expectations of a long life, a look at including an annuity within your overall investment strategy might be worth a consideration.

Whenever, I speak about insured annuities, I am reminded of the story with Leonardo da Vinci and the Pope. The story goes that the Pope requested that Leonardo da Vinci submit a piece for a new commission. Leonardo drew, freehand, at arms length, a perfect circle on a sheet of paper and sent it to the Pope, who promptly gave him the commission. For those who don’t know, to draw a perfect circle, freehand and unsupported is one of the hardest things possible to draw — all the more reason to admire beauty in simplicity.

To find out more about insured annuities, please contact Warren Blatt at 416-319-8172.

Author: Jeff Kaminker
www.fwcapital.ca