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Post  Max Mon Feb 27, 2012 9:46 pm

Was sure I posted this before, but just in case I am posting again.

For the purposes of this discussion, we will assume an income tax rate of 30% even though it can range from 21.05% to 46.41% (in Ontario in 2008) depending on the amount of income earned.

Not all income you earn is taxed the same. There are the following basic categories:

Employment Income - This is the income you earn from your job. Typically, it is earned on a regular basis (bi-weekly/monthly) as long as you remain employed. It is 100% taxable, which means that if you earn $39,000, you will pay $39,000 x 100% x 30% in tax. This is taxable when the income is received.

Interest Income – This is income earned from the bank, bonds, or GICs. This is the amount paid to you in exchange for loaning your money to the bank or bond issuer. This is also 100% taxable, which means that if you earn $1,000, you will pay $1,000 x 100% x 30% in tax. This is taxable when the interest is received.

Dividend Income – This is a specific kind of income earned from stock. Since when you invest in stock, you are loaning the company your money, the company will use your money to earn income of its own. When the company earns more money than it can use, it will issue a dividend to stockholders (owners). Since the company will pay tax on the income it earns before paying the dividend to you, it does not seem fair that you should pay tax too. So for dividends, the idea is to try to give you a refund for the taxes paid by the company, which you then apply against the taxes you owe as an individual. The rules designed to calculate this make the tax rate of the dividend vary, but generally it will be less than 50% taxable when total income from all sources is under $70,000 (At very low income levels, it can actually have a negative income tax rate!!!). For our purposes, lets assume that it is 50% taxable. This means that if you earn $1,000, you will pay $1,000 x 50% x 30% in tax. This is taxable when the dividend is received (reinvested dividends are still considered received).

Capital Gains – This is a specific kind of income earned from stock, real estate, and other investments in assets which are later resold for profit. This is when the value of the asset rises because people are willing to pay more for it now than when you first bought it. Since it is debatable whether this is really income, the government has decided to tax this type of gain at a reduced rate. This type of income is 50% taxable, which means that if you earn $1,000, you will pay $1,000 x 50% x 30% in tax. Like an RRSP, this is taxable only when sold.

Special Categories:

***Registered Retirement Savings Plan (RRSP)***

RRSP Contribution/Withdrawal – The RRSP is a designation which can be used on almost any investment you make. The exact same investment in stocks can be designated as an RRSP contribution or not depending on how you make the investment. The RRSP has several basic tax consequences which differ from normal investments.

1) There is a deduction from income for all contributions. At our assumed rate of 30%, this means that a contribution of $1,000 will reduce your income by $1,000. Since the income was taxed at 30%, this will result in a tax savings of $1,000 x 30%. Think of this deduction as a loan and not as free money, since you will be required to pay it back one day when you withdraw from your RRSP (see point #3).

2) The income on the investment accumulates without immediate tax consequences. Think of this is a deferral of taxes and not as tax free income (see point #3).

3a) The downside. The entire balance of the RRSP (including the original contributions as well as the income) is 100% taxable when withdrawn. This means that a $1,000 contribution that earns $500 in income (total balance of $1,500) will pay $1,500 x 100% x 30% in tax.

3b) However, you did get a deduction (point #1) for the original contribution of $1,000 x 100% x 30%. So the net result is that only the income earned is taxable resulting in $500 x 100% x 30% in tax. However, if you look at the income classifications above, you can see that an investment earning dividends or capital gains outside of the RRSP would have only paid $500 x 50% x 30% in tax.

This leaves several important factors to consider with the RRSP. The most important factor missing from the calculations above is the value of time.

The benefits:
-Increase in value of original tax deduction (point #1) from the date the money is withdrawn until the original tax deduction is paid back. If I can receive a $300 tax deduction today and do not have to repay it for 30 years, I can earn $450 (@ 5% interest) on that original $300 tax deduction before I have to repay it.
-Potential for different tax rates when the money is withdrawn vs. when you receive the original tax deduction. My tax bracket may be 30% now when I get my tax deduction (point #1), but when I retire I expect that I will not need as much income (my house will be paid off, I have already bought everything I need), so my tax bracket may be only 25%.
-Increase in value of the income because of the deferred tax. If I earn $50 for each of the next 30 years on my investments, I would normally pay 30% tax on this income each year. Since I have invested in an RRSP, this means that I do not pay the 30% tax until it is withdrawn in 30 years, which allows me to use that extra money now to earn even more income before I have to pay the taxes.

The problems:
-You may not be in a lower tax bracket when you retire. You may not have finished paying off the house, your medical expenses will increase, you may want to travel more. Your lifestyle after retirement will likely be no less expensive than it was before retirement. If you want to make large withdrawals from the RRSP, you will increase your tax bracket. You will be restricting your income to low levels in order to get a good tax rate on your withdrawals.
-Income earned through capital gains is also tax deferred, so there is no advantage in the RRSP from deferred taxes on income.
-The income earned from the investments inside the RRSP is 100% taxable (regardless of what it is invested in), where it would only have been 50% taxable if invested outside of the RRSP in stocks.

Bottom Line:
The income earned on the original tax refund (point #1) has to be greater than the increased tax on the income earned inside the RRSP (point #3b) in order for the RRSP to be a good choice. Generally this means that all RRSP refunds must be reinvested in order for you to come out ahead. If you do not do this, then you are better off investing in capital gains outside of the RRSP.

***Tax Free Savings Account (TFSA)***

This is pretty simple. No deduction when you contribute, no tax when you withdraw. All income earned in the TFSA is tax free.

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