Posted by Tim Stobbs on March 27, 2008
So far this week we have looked at your yearly spending in retirement (Part I), government programs (Part II) and company pension plans (Part III). Today we are going to look at RRSP’s, taxable investment accounts and Tax Free Saving Accounts (TFSA).
1) RRSP
All of accounts are very similar in the fact they can be just about any investment product. The only real difference is how they are taxed. In a RRSP you get a tax refund on the income tax you originally paid for that money and then that money can grow tax free until you withdraw it (presumably in your retirement).
Despite the almost universal advice that investing in a RRSP is a good thing by most mutual fund companies and banks it actually doesn’t help some people. An RRSP is used to delay the tax not avoid it. So if your in the lowest income bracket already and you expect to be the same in retirement it really doesn’t give you much of a break (a TFSA might actually be a better choice). Yet as you climb tax brackets an RRSP becomes increasingly useful since you hope to avoid the high tax rate now and take it out at a lower tax rate in retirement.
Case in point my wife doesn’t have her own RRSP. Instead we buy her a Spousal RRSP which gives me a tax credit and puts the money in her name. The idea of the this is to split the RRSP’s I would normally buy between two people so when we pull them out in early retirement we can reduce our total tax paid on the money. So for example instead of withdrawing $20,000 a year in my name, we can split the money up and only pay tax on $10,000 each.
But can’t we split pensions now? Yes you can split pensions, but the government never said you could split an RRSP. In fact the only way an RRSP fall under those rules if if you covert it to a RIF and your older than 65. So keep buying those Spousal RRSP for early retirement.
In my case we have around $18,100 in my RRSP (I’m transferring in my old pension from prior to my employer being bought out) and $7900 in my wife’s Spousal RRSP. Using that same calculator from yesterday’s post, I input the following:
My RRSP is at $18,100
Adding $100/month personal plus $225/month from work group RRSP
At 5.5% interest (to keep it in today’s dollars just like yesterday)
For 15 years, I end up with $131,816
Spousal RRSP is at $7900
Adding $100/month personal plus $168.50/month from my work group RRSP
At 5.5% interest
For 15 years, I end up with $92,836So in total we will have $224,652 to help fund our retirement. Note I haven’t put in my tax refund here. I’m going to leave it out for now and see how I do in these calculations.
2) Taxable Investment Accounts
As I mentioned before a taxable account is similar to an RRSP with the choices you have to pick from. The major difference is how you are tax on your gains. You need to understand the differences between interest, dividends and capital gains. For details I suggest reading this. The overall summary is capital gains and dividends are better than interest in a taxable account.
Currently we are investing on average $658.50/month into our taxable accounts. Rather than giving me a headache and try to break out each account separately I’m going to treat them as one single account here.
Starting at $13,029
Adding $658.50/month
At 5.5% interest
For 15 years, I end up with $213,228.
Now out of this amount I’m going to assume I’ve got $50,000 of it producing dividends of $2000 per year when I’m 45. So that leaves $163,228 for general retirement use.
3) TFSA
I’m not how I’m going to work the new TFSA account into my retirement plans. I’m considering for now just letting the contribution room build up until we downsize our current house later in life. That would then allow me a float fund which I could use to cover use in case I’ve made any mistakes during these calculations. Or additionally I might use some of the room to store excess saving so I have the option of either using now or possible extra fun money in retirement. Of course yet one more option is to build up a large cash fund in the account to provide some buffer to my main savings in case we enter a down market as I retire. For now I’m not planning on doing much but move over the high interest savings account to avoid the tax on the interest.
Summary
Alright in total from the above accounts I have $387, 880 to pay for most of my early retirement, plus $2000/year in dividends (which I’m going to assume keep pace with inflation). Tomorrow I’ll try to string this all together to show how I plan to retire at 45 with no where near a million dollars.
Posted by Tim Stobbs on March 26, 2008
Welcome to Part III where we are going to look at pension plans. For your reference in Part I we calculated your yearly spending in retirement, while in Part II we covered government benefits.
Company Pension Plans
Each pension plan is unique to some degree, so it is impossible for me to cover every detail of every pension plan. So if you don’t know the details of your plan get on the phone with your HR department and request the information otherwise it is hard to determine what you are going to get.
Pension plans come in two basic types: defined benefit or defined contribution. Defined benefit used to be the standard of most companies for a number of years. You contributed to the plan during your working life and then once you retired you got a set amount from the plan based on some type of formula. These plans could be very generous. I know one lady who is closing in on retirement that is expecting 70% of her current income (averaged over the last 10 years) in retirement from her plan. The problem with these plans is they are costly to run, so many companies have been shifting over to defined contribution. In a defined contribution plan the company will match a set amount of money you add to the plan. Once you retire you will get a lump some of money that you can buy an annuity with or transfer to a Registered Income Fund (RIF) which is similar to an RRSP, but you have to take out a minimum amount each year based on your age (your options may vary depending on your plan).
Well with my changing jobs over the last few years I’ve been in many different pension plans. First off when I was living in BC I had a defined benefit plan, I’ve cashed that out and transfered that to my LIRA (Lock In Registered Account). Then more recently my employer was bought out last Nov and I got my statement saying my pension amount is small enough I can transfer it to my regular RRSP rather than my LIRA account. Now my new employer pension plan is actually a group RRSP rather than a traditional pension plan which effectively puts my original retirement plans on their head.
Why? Because under my old calculations I was stuck with a large sum of cash I couldn’t use until age 55 because of my employer’s pension plan. Now with the buyout and changing over to a group RRSP I can use some of those funds in my early retirement period (45 to 55). Effectively one of my biggest obstacles to my early retirement has been removed.
So all I have left to estimate is how much my LIRA will grow. To estimate this I’m going to assume a 7% rate of return and reduce that by 1.5% to reflect inflation so I get a number in today’s dollars (if your wondering why I’m using such a low inflation number check out these two posts: #1, #2). Therefore I will use a 5.5% rate of return. I should point out that I’ve been averaging over 8% on these investments, but I’m using a 1% buffer on my calculations to cover years of low performance and general estimating errors.
So if I start off with this calculator and plug in the following values:
Starting Amount $11,300
Then I’m adding around: $0/month (I’m not adding anything to this account)
At a 5.5% rate of return for 30 years (until I turn 60).
I end up with $58,617. I know that is hardly an earth shattering amount, but it will be useful to top up my income during my more normal retirement years. If I assume I want this money to last a while I’ll only be taking out 4% per year or $2344/year
Summary
Therefore if I take that amount and add it to my government benefits I calculated yesterday I should get $2344 + $18,714 = $21,058/year from age 65 onward. So I’m still short of my goal of $26,618/year goal, but I’ve now moved the largest portion of my cash to my RRSP which I’ll cover tomorrow.
Posted by Tim Stobbs on March 25, 2008
In Part I I walked you through how to come up with a yearly income requirement for retirement in today’s dollars. Now today we are going to look at government benefits.
In Canada there are a few different programs you can tap into during your retirement. The most common programs people have to account for is Old Age Security (OAS) (which is vaguely similar to Social Security in the US) and the Canada Pension Plan (CPP).
Both are important to account for in your plans in some form or another. Some people don’t believe the programs will continue when the baby boomers hit retirement. I think you can’t estimate inflation for twenty years either or even tax code changes for next year, but we still try. So for now let’s assume everything is the same and keep them in and we will add some buffer to our calculation later. Also if you really have problems with the OAS program you can drop it out of your calculations entirely, but I would suggest leaving the CPP in as it is a pension plan run by a government. Let’s face it you’ve got a higher risk of your work pension going belly up that the CPP running out of money (after all does anyone recall a company called Enron and their pension plan?).
1) Canada Pension Plan
You’ve seen the deduction on every pay cheque for years and now here is the good news. You get to cash in on some of that forced savings. The earliest you can collect is age 60. Since you don’t know when your going to die I suggest that most people just take the cash and accept that your going to have a pension reduction of 30%. The 30% reduction is worth it when you consider you are being paid for any addition five years. Even if you don’t need it you can always bank it up in a Tax Free Saving Account (TFSA) and pull it out later.
Now normally I don’t suggest people get too involved with understanding how the government calculates your benefits from these programs. All you typically need to know is your benefit amount. Yet in the case of the CPP program and early retirement it is down right critical to understand a few points.
You see your CPP benefit depends on your income from age 18 to 60 (or 65 if you taking it later). The government takes the average over that period and determines your benefits from that (up to the maximum of about $40,000/year). Yet they do give you a break in deducting your lowest 15% of your working years as long as you have contributed for at least 10 years (more if you were raising your children under age 7 and that caused you a lower income for a number of years). So in the typical case (18 to 60) that means you will remove 6.3 years of your lowest earnings using just the 15%. You might notice that if you plan a retirement earlier than 55 you will be adding a several years of potential zero income which will drag down your CPP benefits. So in my case when I retire at 45, I will be adding 15 years of zeros to my average income. I can only offset 6.3 of those, so in total I will be adding 8.7 year of zeros to my average (or about 24% of my calculated earning years). There really isn’t anything you can do about this. If you choose the early retirement path you have to give up some of your CPP benefits. It’s the price of freedom. (With the expection that you want to work in retirement, then you will replace a few zero years with a little work income which will raise your benefit slightly.)
So with that all in mind you have to use the following method to determine you CPP benefits, otherwise it is highly likely you will get a wrong estimate. First you must request a statement of your CPP contributions to date to determine where you currently are. If you take that you can plug it in to this online calculator and get an estimate of what you are going to earn. Also you have the option of adding an age where you stop contribution to simulate early retirement. In my case I got $5460/year for me if I start at age 60 and retire at age 45 and I’ll assume $1200/year for my wife. The reason my wife’s is so low is I’m unsure where she will fall out after the child care drop out so I’m going to play it safe and assume a low number.
I know that doesn’t look like a lot but combined, the $6660/year is still a useful base for your retirement income. The added tax benefit of a CPP pension is income splitting is allowed. Please note that if your from Quebec you fall under the Quebec Pension Plan (see here for information).
2) Old Age Security
Just about everyone qualifies for the OAS. All you have to do is live in Canada for 10 years prior to your retirement but after you turn 18 (and be a Canadian citizen or legal resident). If you’ve lived in Canada for 40 years or more after you turned 18 you will qualify for the full pension. If you are not there I suggest you go read the fine print to find out if you can expect anything or if you qualify for other benefits such as the Guaranteed Income Supplement or the Allowance. Based on the current rates, I expect my wife and I will collect an additional $6027/year each after we turn 65. So that would add another $12,054 to our retirement income.
Summary
Therefore in total OAS and CPP will pay me and my wife $18,714/year of inflated indexed money in today’s dollars. Depending on if required retirement income is fairly modest you might find yourself most of the way towards your goal after you turn 65.
Tomorrow we will continue this series and see how a work place pension and RRSP’s fit into the mix and this is where some of big changes have happened to my plan.
