Personal Finances, Explained

2013-01-01

Preamble 36 hours ago I knew nothing whatsoever about personal finances.  I literally did not understand why I couldn’t simply have one pile of money in my name, and contribute to and take from it at my pleasure.  I didn’t understand what a pension was, what tax sheltering was, why banks distinguished between savings and checking accounts, none of it.  I knew RRSP stood for Registered Retirement Savings Plan, but I had no idea what registered meant, what retirement meant (do I have to retire?  Is it based on age?  What if I work part time?), or what a savings plan really is.  Now, it all makes sense to me.  Pensions, retirement savings, income funds, investment income, stocks, bonds, mutual funds, securities, investment portfolios, all these terms have meaning to me now.  And I hope to explain it!

Introduction There are three players here.  The government, the bank, and you.

The government wants you to own a place to live, they want you to invest in Canadian companies, they want you to be educated, and they don’t want you to go broke when you’re old and weak, and have to put you into social assistance programs to keep you alive.  They want you to pay your own way.  And so they force you to contribute money to be given back in your retirement years through the Canadian Pension Plan (CPP), and they encourage you to set aside money voluntarily for education, buying a home, and retirement as well, by delaying when you get taxed on that money through registered savings plans (RSPs).

You want to have money for all these things too, and so if you are making money you can afford to save for specific purposes later, you can take advantage of these government programs, and by keeping your accessible annual income a little flatter this way, you avoid getting heavy income tax on the years when you actually earn your money.

The banks, meanwhile, want to be able to do something useful and lucrative with your money while they have it, and will either pay you simple interest for letting them use your money for their own risky, but overall more rewarding investments, or will let you take the risks directly, and charge you fees for their advice and/or administration of your investments.  Generally the longer you can leave your money with the bank, the more comfortable you should be with volatile investments.

Once you understand everyone’s motivations, things become a lot clearer, at least to me!  In short, though, anything you can spare for retirement you should put in an RRSP, and anything you can spare in the shorter term you should put in a TFSA.  The funds you have there don’t just sit there – you can invest them, and how risky an investment strategy you should choose depends primarily on how long you can let the funds sit there.

Taxation From your perspective, it is all about if and when you will be taxed on various things.  There are several types of accounts you can have, and depending where you put your money, you can be taxed at different times on your original income or on the change in value of your accounts over time (your “investment income”).  In exchange for delaying taxation for you, you agree to use these accounts at certain times and/or for certain purposes, or suffer tax penalties for failing to do so.

The breakdown of options available to you is something like this:

Savings Account Types NRSP (Non-Registered Savings Plan) Basically anything (bank accounts, stocks, bonds, mutual funds, real estate, collectables, homes, etc.) that isn’t registered with the government for any kind of tax deduction purposes.  Everything is taxed normally.

RRSP (Registered Retirement Savings Plan) Anything (stocks, bonds, mutual funds, banknotes, term deposits, etc.) that is registered with the government.  Contributions and investment income aren’t taxed.  Withdrawals are taxed as income in the year they are made.  Pre-retirement withdrawals suffer tax penalties except for funds paid back within a certain number of years, used for either:HBP (Home Buyer’s Plan) – Up to $25,000 as a down payment on your first homeLLP (Lifelong Learning Plan) – Up to $10,000/year to a maximum of $20,000 to pay for education expenses RESP (Registered Education Savings Plan) An account specifically for education purposes, for yourself or another beneficiary.  Contributions are not tax-deductible, but various government bonuses can apply, especially if the beneficiary is your child.  Some RESPs require regular contributions or have other restrictions.  Investment income earned in RESPs is taxed to the beneficiary of the account, and only when withdrawn.  For most students, their net income will fall below minimum levels for income tax anyways, so they won’t pay any tax.

TFSA (Tax-Free Savings Account) Like non-registered savings, except that you do not get charged tax on investment income.  You can only deposit up to $5,500 annually into TFSAs, although any amount you withdraw or don’t use is carried over into future years, so you can make up for lost time if you couldn’t keep up with your maximum allowed contributions the whole time.

DPSP (Deferred Profit Sharing Plan) To help avoid making your income (and income tax bracket) unpredictable, if your employer has a profit sharing program in place, such profit sharing bonuses can be put into a DPSP, and you will only be charged income tax on funds as you withdraw them from this account.

Pensions A pension is a regular payment, usually provided upon retirement.  There are various kinds, managed by different sources and paid for in different ways.

OAS (Old Age Security) You don’t pay for this directly – it’s just a government program that will be there for you when you retire.  You earn 1/40 of your OAS for each year you live in Canada after the age of 18, but your OAS can be reduced if your overall retirement income is high enough.  If your income is too low, you can get a GIS (Guaranteed Income Supplement) in addition to the regular OAS.

CPP (Canadian Pension Plan) This is a mandatory government program, requiring you and your employers to contribute a fixed percentage of your income to finance it.  You are then paid in regular installments upon disability or retirement based on how much you ultimately paid into the plan, and how many years you worked.  This fund doesn’t run out, and can’t be withdrawn from in lump sums.  Upon your death, some additional funds may be granted to your estate, spouse, or children.

RPP (Registered Pension Plan) This is a fund managed by your employer, who will typically match contributions up to a certain percentage of your income.  Within certain limits contributions are tax deductible, and investment income isn’t taxed until withdrawn.  All RPPs have lifetime retirement benefits (regular payments, similar to CPP but can eventually be exhausted when your RPP’s value runs out), and some RPPs can have lump sum payments as well.

LIRA (Locked-In Retirement Account) If you leave your employer but don’t retire, your RPP can be converted to a LIRA (Locked-In Retirement Account), aka a LRSP (Locked-In Retirement Savings Plan) aka Locked-In RRSP.  These accounts are locked and cannot be contributed to or withdrawn from (with some exceptions for financial hardships) until they are converted to a LIF (Life Income Fund).

Income Funds Retirement savings plans and pension plans must be closed by the time you turn 71.  To avoid high income taxation at this time, these funds are typically put into income funds, which ration payouts over time.

RRIF (Registered Retirement Income Fund) RRSPs, other RRIFs and lump sums from RPPs and other employer retirement benefits funds can be put into RRIFs.  Once set up, an RRIF cannot be added to.  Income is taxed as it is withdrawn from an RRIF.  There are required minimum annual withdrawals, but no maximum withdrawals.

LIF (Life Income Fund) Employer-sponsored benefits which are expressly locked in for retirement, including RPPs, LIRAs, and group retirement savings plans (GRSPs – RRSPs managed by your employer) must be converted into LIFs instead of RRIFs.  LIFs are similar, except with a maximum annual withdrawal amount.

Life Annuities Instead of keeping income funds, which can eventually be exhausted, you have the option of purchasing life annuities from insurance companies.  These are insured annual payments, which scale with the size of your purchase, guaranteed to last the remainder of your life.  Of course, the insurance companies have to make a profit, so on average you’ll get less money than you put in, but you don’t risk going broke if you live to be 100.

Investments Your accounts don’t simply have to hold banknotes (cash).  Savings accounts, which are expected to go untouched for extended periods of time, are typically better off being invested.  There is a tradeoff of risk and potential reward with each kind of investment, and the longer your assets can remain in an account, the more that the law of averages can mitigate the risk of short term market fluctuations hurting your investments, probably leaving you with considerably higher investment income than simple interest would have produced.  For a fee, companies can manage investment portfolios for you, geared towards a particular amount of risk/reward.

For example, you might simply invest in a low-risk income fund that chooses appropriate low risk shares and bonds for you, or at the other extreme you may pay a discount brokerage to manually buy and sell shares in companies yourself, at a much higher risk.  In practical terms, a young person with an RRSP they don’t plan to touch for 30 years that doesn’t have time to manage investments themself would be well advised to invest in a higher risk equity-based mutual fund.  As you near retirement years, you’d probably be better advised to migrate towards lower-risk investments.

Types of Investment IncomeInterest income – comes from savings, guaranteed investments, and bonds.  Is fully taxed as income.Dividend income – dividends earned on Canadian stocks qualify for a federal tax creditCapital gains – profits from the sale of an investment (for example, selling shares on the stock market for more than you paid for them).  Taxed at a lower rate than interest income, and reduced by any capital losses you might have. Investment TerminologyBonds – essentially a request for a loan from a corporation or government entity, to be paid back with interest (unless the entity goes bankrupt!).  Reliable, low-risk.Security – a tradable asset of any kind, including banknotes, bonds, sticks, and derivative contractsEquity – shares or any other tradable asset representing ownership in an entity.  Value is tied to the value of that entity.  High risk, high reward.Common Stock – aka shares, the most common type of stock, represents ownership in a company, and the right to vote at company shareholder meetings.  Dividends may be paid, but not necessarily.  If a company goes bankrupt, stock owners may claim company assets, but are last in line behind all other creditors, employees, and preferred stock owners.  Highest risk, highest reward.Preferred Stock – fixed dividend payments, higher priority claim on company assets than with common stock.  Since dividends are predictable, prices are stable.  Similar to a bond, with slightly higher risk/reward.Income Fund – a collection of fixed income securities such as bonds, mortgages, and preferred shares.  Low risk, low reward.Money Market Fund – invests in short-term interest-bearing investments (maturing in