A Summary of the Rules
The deadline for contributions for the 1997 tax year is Monday, March 2, 1998. Your maximum deductible contribution is 18 per cent of your 1996 earned income to a maximum of $13,500. From this, you must subtract any pension adjustments if you are a member of a pension plan. Flowever, you can add to your contribution any missed contributions from previous years beginning from 1991. If you do not use all your contribution room this year, you can carry it forward indefinitely and get a tax deduction when you make your contribution at some future date.
You can also make your contribution for the 1998 taxation year anytime during 1998 and in the first 60 days of 1999. The maximum contribution continues to be $13,500 based on 18 per cent of 1997's earned income.
The contribution limit is scheduled to rise by $1,000 to $14,500 in 2004, and by another $1,000 the following year to $15,500.
Maximize Your Returns with a SelfDirected Plan
You can have as many RRSPs as you like. But you will likely gain some benefits by holding your RRSP investments within one self-directed plan. You will pay only one trustee fee, so your costs will almost certainly be lower than if you held several plans; your holdings will be shown in one statement, an important consideration if you like to monitor performance and asset mix easily; and you will be able to maximize the foreign investment portion of your RRSP, an important consideration for boosting your returns through international exposure.
A self-directed plan can be looked at as a basket holding several RRSP-eligible investments, or as a single portfolio. You can hold a conservative mix of investments, such as shares of senior public companies, strip bonds and other fixed-income investments, or a mix of mutual funds invested in different segments of the market or with different management styles. Alternatively, you can manage your plan aggressively by concentrating in narrow segments of the market in the hope of getting superlative returns. That, however, can be a dangerous route and is best left for investors who both understand and can tolerate the risks involved.
You can attempt to boost your returns in a self-directed plan by writing call options on certain holdings. And if you are strapped for cash, you can contribute bonds, GICs, shares and other eligible investments to your plan and get a tax deduction equal to their market value.
Check with your adviser before you do this because there may be tax implications. If you contribute shares or mutual funds to your RRSP, you will have to pay tax on any taxable capital gains, just as if you sold the securities. If, however, you contributed securities that cost you more than their current market value, you cannot use your losses to offset any gains. You would be better off selling the securities and contributing the cash to your RRSP. You can also use a self-directed plan to hold your own mortgage.
Every mutual fund management company offers its own self-directed plan to hold various funds within its family, generally charging annual administration fees of about $25 to $35. But anyone who holds funds issued by more than one manager or a variety of securities including stocks, bonds, and mutual funds should opt for a plan that provides for a range of securities.
These are available from virtually every full service and discount investment dealer, mutual fund dealer, trust company and bank. The basic annual cost of most plans
generally falls within the range of $100 to $150 although a few have discounted rates if you hold only mutual funds, Canada savings bonds, guaranteed investment certificates, treasury bills and strip bonds. Some offer the first year for free as an incentive to move from another administrator. You may also face some additional costs, depending on the plan. For instance, most brokerage house plans will not charge you a transaction fee if you trade through them. Some bank plans charge transaction fees of about $50 if you buy a competitor's no-load mutual fund. One trust company whose plan is offered through mutual fund dealers waives transaction fees on electronic transactions, but charges $50 a trade when paperwork is involved. Some plans allow options, others do not. If you intend to hold your mortgage in your selfdirected plan, budget $200 for the annual administration fee as well as hefty setup, renewal and discharge fees. Most funds provide monthly statements if transactions occur, and quarterly otherwise.
Choose Your Investments Carefully
Make sure you understand which investments qualify for RRSPs. Mutual funds, shares of public companies traded on Canadian exchanges, deposits with Canadian banks, mortgages on Canadian property and federal, provincial, municipal and many corporate bonds are some of the more common qualified investments. Call options on listed shares, warrants to buy listed shares, exchange-listed limited partnership units and royalty trust units qualify as well. You can even hold foreign government bonds within what is called the 20-per-cent foreign property limit provided the bonds have an investment grade rating from a bond-rating agency.
Investments that are not qualified include gold and silver bullion or certificates, commodities futures, real estate, put options and shares of private corporations, although mutual fund trusts that hold real estate or gold and silver are eligible investments. If your RRSP acquires a non-qualified investment, its value must be added to your taxable income. Flowever, when your plan disposes of that non-qualified investment, you can claim a deduction of the lower of market value or the amount previously included in income. If an investment in an RRSP becomes non-qualified, the plan is subject to a tax of one per cent a month on the value of that investment as long as it is held. Moreover, the plan must pay tax on any income earned on the non-qualified investment. While it is rare for a qualified investment to become non-qualified, it does happen. For example, debt in a private company issued in exchange for shares of a public company would be a non-qualified investment, as would real estate acquired by an RRSP because of a mortgage default. In the latter case, however, you would have a year to dispose of the real estate before the fine would begin kicking in.
A more important concern for most people is the limit on foreign investment. You can hold up to 20 per cent in what Ottawa calls foreign property. The most common types of foreign property are shares of foreign companies traded on certain stock exchanges (including U.S. over-thecounter shares quoted in the Nasdaq listings) and mutual funds that themselves have more than 20per-cent foreign property.
By investing in foreign property, you can participate in industries that are not readily available in Canada, such as certain areas of technology or health care. You can also invest in markets that may be at different stages of the investment cycle than Canada or that offer greater growth potential. The 20per-cent limit applies to each individual plan, not the total value of all your plans. Consequently, by keeping all your investments in one plan you can maximize the dollar amount you can invest in foreign property.
You are responsible for keeping track of your foreign holdings. If you exceed the 20-per-cent limit through purchases, you will be subject to a tax of one per cent a month of the excess value. The limit is based on cost, not market price. So the tax will not apply if your foreign holdings appreciate more than your Canadian holdings boosting the market value of your foreign property to more than 20 per cent of the market value of the plan. To avoid exceeding the limit inadvertently, arrange to have any dividend distributions from foreign property mutual funds paid as cash rather than additional units.
You can, in fact, boost your foreign exposure well beyond 20 per cent without breaking the rules. There are numerous bond funds that invest in foreign currency bonds, but that are 100 per cent RRSP-eligible. They do this by
investing in foreign currency bonds issued by Canadian provinces, banks and corporations or by certain entities such as the International Bank for Reconstruction and Development, which Ottawa considers RRSP-eligible without limit. In addition, several equity mutual funds tie themselves to foreign markets by investing a relatively small part of their portfolio in stock market index futures while keeping more than 80 per cent in Canadian treasury bills.
You Can Hold Your Own Mortgage in Your RRSP
There are some benefits to holding your own mortgage in your RRSP: If you pay the money to yourself, you will not fret too much if you choose a five-year term and rates subsequently drop. Similarly, if you choose a floating rate and interest rates rise, you will not be too upset knowing that the increase in mortgage payments is going towards your retirement.
You can hold your own mortgage in your RRSP provided you follow some very stern rules. The mortgage must be insured under the National Housing Act or through a mortgage insurance company. The mortgage must be administered by a bank or trust company or other approved lender. The interest rate charged must be the same as the rate charged for similar mortgages in the open market. If you default on the mortgage, you will not get special treatment. The bank or trust company will take whatever action is necessary to collect the funds for the benefit of your RRSP.
Holding your mortgage in your RRSP is not cheap either. In addition to the annual fee of $100 to $150 that you pay for a self-directed RRSP, you can expect to pay a setup fee of $100 or more depending on which institution you choose, an insurance premium that will run about $75, and an annual administration fee of $200 or more. In addition, you will have to pay your legal fees-which could top $1,000—and face renewal fees of up to $150 each time the mortgage comes up for renewal.
You normally would not go out and replace your existing mortgage with a mortgage from your RRSP. The costs would outweigh any potential savings. But it is an option if your current mortgage holder decided to withdraw from the market and informed you it would not renew when your mortgage came due. Of course, holding your own mortgage should be compatible with your investment objectives. Your mortgage is a reasonable alternative to fixed-income investments, such as bond and mortgage mutual funds or GICs.
If you do place your mortgage in your RRSP, you must decide how you will invest your monthly payments. Unlike many other RRSP-eligible investments, there is no automatic reinvestment plan available when you hold your own mortgage. You should also realize that you will have a major portion of your RRSP savings in a single asset that cannot be easily liquidated to allow you to go into more promising markets.
Is the Home Buyer's Plan (or You?
If you are planning to buy or build a home this year, you may be eligible to borrow up to $20,000 from your RRSP. Your spouse, if you are married, can withdraw up to $20,000 from his or her RRSP, too, to use towards the same home. You can do this under the Home Buyer's Plan program provided you (or your spouse) did not own a home that you occupied at any time during the period beginning Jan. 1, 1994, and ending 31 days before you
withdraw funds from your RRSP.
You will have to repay the money to your RRSP in 15 equal installments beginning in 2000. If you miss part or all of a payment, Ottawa will simply tax you on the amount owing for that period as if it were income.
Do not make a contribution to an RRSP expecting to pull it out immediately and still get a tax deduction. You will not be able to deduct contributions made to your RRSP during the 89 days before you withdrew funds from your plan, if the money contributed during that 89-day period is part of the money you withdrew towards buying the home.
Û. Should I pay down my mortgage or put the money in my RRSP?
A. There is no simple answer. Your decision should reflect the interest rate you pay on your mortgage, whether you get a significant tax break from making an RRSP contribution and the rate of return you are likely to earn on your RRSP. If your current income level is relatively low, you are probably better off putting the money towards your mortgage and catching up on your retirement savings in the future when your tax savings from RRSP contributions will be greater. Alternatively, contribute to your RRSP now, and use the reduction in taxes to pay down your mortgage.
The Home Buyer's Plan undoubtedly benefits people who would otherwise not have the funds to buy a home. But even temporary withdrawals from an RRSP will almost certainly diminish the overall amount you will accumulate for retirement. Rather than using the full 15 years, you should strive to repay the amount withdrawn as quickly as possible.
You should structure your RRSP portfolio to reflect your anticipated use of the Home Buyer's Plan by moving the money you intend to withdraw into the lowest risk investments possible, such as money market funds.
Cutting Transaction Costs
Small differences in returns over time can have a substantial impact on your retirement income. So it pays to squeeze your transaction costs as much as possible to boost your overall returns on your RRSP capital. Savings of even $500 a year over 10 years will grow to just under $9,000 of additional assets in your plan assuming an average earnings rate of 10 per cent. That is worth at least $1,000 of additional annual income during retirement.
How much you can potentially save depends on the types of assets you trade, their value and, realistically, whether you can afford to give up the advice you are currently getting. If you are truly dependent on a broker's advice for stocks and bonds and are happy with the results you have obtained, cutting costs might be penny-wise but poundfoolish. If, on the other hand, you find that you initiate most transactions, you should consider what your savings would be if you used a discount brokerage house. Savings are generally at least half of a full service dealer's charges, and electronic trading is bringing fees down even more. If you decide that you want to trade through the Internet, play it safe by dealing only with Canadian firms.
Cutting costs when buying mutual funds for your RRSP might be more a matter of negotiation than changing dealers. Unless you deal exclusively in no-load funds, which have no commissions or redemption fees, you buy your funds either with front-end loads-which can be as high as nine per cent but rarely exceed five per cent and which can be negotiated as low as zero-or with deferred declining redemption fees. Redemption fees, depending on the fund family, will be as high as six per cent in the first year, 5.5 per cent in the second year and five per cent in
the third year, falling to zero in the seventh and subsequent years. Redemption fees are more often than not calculated on market value at the time of redemption rather than at cost. As a result, the dollar amount of such fees on a fund that has appreciated substantially can be much greater than the amount that would have been paid if that fund had been purchased with a front-end load.
Buying on deferred declining redemption fee basis is the least expensive route if you intend to remain within the same fund family, because you can switch from one fund to another without triggering a redemption fee. You can also redeem free of change any units you receive as a result of a distribution of income by the fund. If, however, you are an active trader moving from fund to fund and using funds of different families, you are probably better off buying your funds with a small front end load. You can, in fact, buy funds with a zero commission either by negotiating with your mutual fund sales representative or by dealing with one of several firms that advertise zero commission transactions.
Dealers who sell on a front-end load basis earn a trailer commission that is generally half of the management fee, or about one per cent of the value of your assets in the case of equity funds. Trailers paid on units purchased on a redemption fee basis are generally one-quarter of the management fee or about 0.5 per cent for equity funds.
Pay Fees from Your Pocket
The fees you pay for administering your RRSP are not deductible from income for tax purposes. Nevertheless, you should arrange for the trustee to bill you separately and outside your RRSP rather than take the fee directly from your plan. Money in an RRSP grows untaxed and $100 a year of additional funds can grow substantially over a couple of decades.
The Group Plan Alternative
Your employer, industry or professional association may offer you an RRSP alternative called a group plan that can provide you with immediate tax savings, lower management fees or both. Employer plans offer the convenience of payroll deductions with reduced tax withholdings so you do not have to wait to the following year to get a tax refund. Some companies match employee contributions. Industry and professional association plans can often negotiate a sharp reduction in management fees from what you would pay as an individual holding a mutual fund. Many plans offer you a choice of asset mix. A few go so far as to offer you alternative investment managers.
Usually, it is to your financial advantage to join a group plan if available. However, you should still look closely at any potential pitfalls. Make sure that your costs are competitive. Many plans, especially association plans, offer investments on a no-load basis. Others, however, may have acquisition or redemption fees. You should also determine in advance what costs you will face if you change employers or leave the sponsoring group.
How to Shop for the Best Guaranteed Rates
Do not overlook fixed-term deposits for your RRSP. While the interest rates paid are half their levels of a few years ago, they still have certain advantages. Your rate of return is guaranteed by the institution taking your deposit and your principal is generally insured. Minimum deposit rate is $500 at most institutions, but a few require larger amounts.
Most offer terms of six months to five years. Your interest rate is fixed for that period and you generally cannot have access to the funds before the deposit matures. Those that allow access to funds cut the interest rate paid if the deposit is cashed.
At least one major bank offers terms longer than 60 months. However, any deposit with a term longer than 60 months is not covered by deposit insurance. This is unlikely to be a consideration if you are placing your funds with one of the top six financial institutions in the country. But deposit insurance is key for most investors who deal with smaller institutions.
Virtually all banks, trust companies and credit unions pay and compound RRSP interest annually. Usually, interest is reinvested at the initial rate you were offered. So if your deposit is for five years at five per cent, your money will likely be reinvested at five per cent. However, you should read the fine print and ask to see the reinvestment rate spelled out because some institutions reinvest interest at their savings rate, which could be a pittance compared with the rate you think you are being paid.
The banking system is awash with cash so few institutions are willing to pay premium rates to attract cash. Nevertheless, the rates you see posted at the various financial institutions are not necessarily the rates they will pay. Banks and other financial institutions spend a lot of money attracting and maintaining customers. Each branch is a profit centre and has some leeway in what it pays on deposits or charges on loans. What you get above
the posted rate depends on your level or potential level of business with a branch. You can probably get an extra eighth or quarter of a percentage point over the posted rate with little difficulty, particularly if you are transferring funds from another institution.
You can spend a lot of time shopping the market or lining up to make your contribution or renew maturing RRSP deposits. An alternative is to go to a deposit broker who will shop the market for you and get the best rate possible. The institution pays the broker a small fee for bringing it the funds.
David Newman, president of Fiscal Agents of Oakville, Ont., has been operating as a deposit broker for two decades. He deals with about 80 banks and trust companies and attests that he can often get significantly higher rates than individuals. He adds that many people deal with deposit brokers because of the convenience.
Deposit brokers are in a segment of the financial services market that is unregulated. Newman and many of his competitors, however, are regulated by provincial authorities as mutual fund dealers and limited market dealers. Moreover, a number of deposit brokers have banded together to form an industry association, the Federation of Canadian Independent Deposit Brokers. Newman says that "an investor should always make the cheque payable to the financial institution." The broker couriers the cheque to the institution .
For more information contact the Federation of Canadian Independent Deposit Brokers
177 Lakeshore Dr.
Suite 1, Box 59 RR 2
Wheatley, ON NOP 2P0 Telephone: (519) 825-7575 Fax: (519) 825-3676 E-mail: fcidb@MNSi.net
Steven G. Kelman
Steven G. Kelman is the author of RRSPs 1998 and Understanding Mutual Funds, and co-author of Sage Advice: Choosing the best financial adviser for you.