Tax deferred retirement account (RRSP) for low-income Canadians?

joyfulguyJanuary 30, 2007

If you are near retirement, quite likely using an RRSP is a wise choice, to defer paying tax, then probably pay at a lower rate.

If you have a spouse who's not employed for pay, or is an employee with no/low pension program, likely buying a spousal plan for such a spouse is a wise choice.

Your goal is to provide for more or less equal income for you and the spouse, after retirement, as all or most of the income in one person's hands will be taxed at a higher rate.

If you like to have a substantial portion of your asset in instruments where the number of dollars is "safe", then it would be useful to have such investments in an RRSP.

If you have a company pension plan, it will provide you with some pension (unless the co. goes broke - in which case you'd better hope that the pension plan was carried by an outside carrier, so that the company couldn't raid it).

In that case, you might be wise to do some careful figuring, especially if you have a moderate tolerance for risk.

As you know, many financial agencies offer to lend you the money for your RRSP, if you don't have enough. The interest that you pay is not deductible.

However, should you choose to buy stocks or equity mutual funds outside of an RRSP, the interest on such a loan is deductible.

If you buy Canadian stocks that pay a dividend, such income outside of an RRSP is taxed at a low rate. If you own Canadian stocks inside of an RRSP, there is no tax now - but every dollar is added to taxable income when you withdraw it.

If you own stocks outside of an RRSP, when you sell them (or die) you deduct your cost of purchase, and the remainder is your capital gain. You must pay tax at regular rate on half of it - but you get half of that capital gain free of tax.

Not so if it was held in an RRSP - every dollar withdrawn is added to taxable income.

I bought a Canadian stock 40 years ago for slightly over $4.00 per share. I thought it valuable 40 years ago - and still thought so, 30 years ago, and 20 years ago, and 10 years ago. It's worth about $100.00 now, so I still think it valuable and am not about to sell it. As long as I hold it, I do not have to talk to the Canada Revenue Agency about that increased value, so I avoid paying tax on that asset, so long as I hold it - which is much of the advantage that you gain by using RRSPs.

If I sold it now, I'd get $100. When I deduct the $4.00 that I paid, my capital gain is $96.00, and I have to pay tax on half of that, $48.00 ... but I get $48.00 with no tax to pay on it. That's over 10 times the amount that I invested originally. Tax-free: nice.

If you have $1,000. to invest and put it into an RRSP, you have $1,000. working for you.

If I, in low tax bracket, pay 25% tax, I have $750. after-tax cash residue to invest.

Many financial advisors say that no matter what I do, I can never overcome the fact that you have 1/3 more than I do, working for you.

Suppose I buy a Canadian stock with my $750. cash, and borrow $400. to buy more Canadian stocks, giving all of the stock certificates to the bank as collateral - about $1,150.00.

When I have good credit, the bank will lend me 1/2 of the value of my securities that they hold, so they'd be willing to lend me up to $575.00, but I *never* would be willing to borrow up near that amount, in case the market went down.

Let's say the market goes down 25%, which it sometimes does, and my stocks went down the same amount - that $1,150. original value shrinks by $345., leaving me with $805.00 current value.

I borrowed $400.00, just barely less than half of that amount.

If the value of my asset goes any lower - the bank will be calling me, wanting a minimum $100., more likely nearly $200. cash, or about $400.00 worth of stock or mutual fund certificates. That's today -- tomorrow at the latest.

I have never had such a margin call, and always have some extra assets that I can use to cover, if need be.

The agreement on my loan was that I pay interest only (currently 6.25%) month by month and I use the dividends (about 3%) paid quarterly, on most of the stocks puchased to pay the interest on the loan.

At tax time, the tax rate on dividends on Canadian stocks is low, and the interest on my loan is deductible.

So the dividends on your stocks in RRSP were added, with no tax cost, and I lost a portion of my dividends - but the loan interest is deductible, so my reduction on value isn't as large as one might think.

The original price of the shares was $4.00 (and change) - and the bank would lend me up to $2.00 - no more.

But when the value per share grew to $40.00, the bank would be willing to lend me up to $20.00, if I chose.

Originally, you had $1,000. working, and I had $750. cash, but $1,150. total.

But if I choose to borrow double that amount, later , when the value of the asset has grown, I have the equivalent of original $1,500. working for me.

I wouldn't want to follow such a procedure with only one stock (suppose the one that I chose was NorTel, which fell from $120. to $0.69) - way too risky.

But you'll be investing in an RRSP next year, and the year after that.

And I'll be buying various stocks, so that if the value of one decreases substantially, I'm not sweating blood, unable to pay much of the loan back using my assets on hand.

And I've been playing these games for nearly 50 years, (though not accepting major risk) and have met monthly for the last 7 years with about 20 people of similar interests.

Some thoughts that you might want to consider, as an alternative method of investing, in place of part of your RRSP program.

Now, nearing 80, I was forced to take money out of my RRIF last year (about 8 - 9% of it, percentage rising annually), though I sold some stocks, developed capital gain, and would have liked to have avoided having that extra income last year, but had no choice.

I saved about 26% going into RRSP - now am paying about 38%, going out.

Good wishes for learning how to deal with your income, plus your assets, wisely.

ole joyful

P.S. From $4.00 to $100.00 is 4.5 doubles, more or less. Divide 40 by 4.5 gives about 8.5 years on average to double. Divide 72 by 8.5 is under 9 - about 8.5: the stock was growing at about 8.5%.

Divide 72 by your rate of growth and the answer is how many years it'll take your money to double.

That's just the growth in value of the underlying asset.

Dividend rate originally was about a nickel or a dime on $4.00 value of the stock. Now each stock pays me $2.80 dividend annually. That's in addition to the growth rate of the asset.

That's one of my better investments - I've had a number of major losers, as well.

Life isn't all peaches and cream.

o j

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Knocking this down . . .

    Bookmark   February 16, 2007 at 10:26PM
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Hi kittlebug,

I'm glad that it wasn't a "knock-down-drag-out" fight that you had in mind!

ole joyful

    Bookmark   March 8, 2007 at 6:19PM
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Greetings everyone ... and Canadians in particular, this time,

As the RRSP season is upon us again, some of you Canadians may find this suggestion worthy of consideratrion.

If any of you have questions, or wish to discuss the issue, I'll be pleased to respond.

To be fair, a high percentage of financial advisors in Canada do not agree with my position, though some do.

As I said ... I saved 26% going in ... now am paying about 38% going out (perhaps a bit less, considering some recent tax cuts).

Furthermore, even in years when I have some capital gain or other additional income to report and would like to avoid receiving income from my RRIF, I don't have that choice. I am required to remove at least a certain percentage each year - which percentage rises annually to 20% annual rate at age 90 and after.

To be fair ... I think that it usually doesn't push me into a higher tax bracket.

And I have been able to arrange things so that I've been paying about 9% of my income as income tax, in recent years.

Also ... with regard to that Canadian bank stock that I bought 41 years ago for $4.00 and change, which had grown to about $100. last year ... well, they've had a substantial double exposure to the big mess in the U.S. over those sub-prime mortgages that many financial institutions issued at low interest rates. Those rates of 1 - 2% or so were operational for a couple of years or so, with the mortgage actually earning about 6%, and the difference being added to the loan balance! When the mortgage rate was adjusted to the actual rate being charged, many buyers could not afford it, and defaulted. So there are large numbers of such houses for sale and the earlier mortgage is more or less junk bond status.

Had I wanted to sell my bank stock at closing this afternoon ... $68.13.

Am I about to sell? No ... give it a while and it'll recover. But I wouldn't want to have used it as collateral for a loan and borrowed anywhere near the full amount available when it was worth $20.00 more.

But at the $68.00 level, the loan available would be $34.00 - which is over 8 times the $4.20 or so that I paid, when my loan limit would have been only $2.00.

Good wishes to you with the hope that you will learn increasingly how to manage your income and assets more effectively ... it's an interesting hobby, that pays well!

ole joyful

    Bookmark   January 29, 2008 at 2:23AM
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Hi again, all you Canadians,

Suppose, when the bank stock was at about $105.00, I'd decided to borrow $40.00 using those certificates as collateral (a lot more that the $4.00 original value!), and having certificates issued for the new shares and giving them to the bank to add to the collateral.

When the original stock dropped to $68, a drop of about 1/3, (thanks almost entirely to that dratted U.S. sub-prime mortgage debacle - smells a lot like a hot shot lender-generated scam, to me) ... that would have been a real "loss" had I lost my nerve and sold it.

If I'd used that $40. to have bought more stock of the same bank (not a good idea - best to own a variety of issues), that $40. stock value bought with the loan, having also declined by 1/3, to $26, would, added to the $68 of the original, produce $92.00 total current value ... more than double the $40.00 that I'd borrowed. So I'd have avoided a margin call on the loan, i.e. bring in some money to reduce the lender's loan to below 50% of total asset value, or more shares to add to the worth of the collateral ... by late today, tomorrow at the latest!

And it would have been a lot wiser had I had stocks in about three not only actual companies, but types of industry, used as the collateral: less risky ... or, rather, spreading the risk over a wider area.

Also, I still owed the bank $40. .. but the asset that it had bought was now worth only $26.

By the way: note this aspect of calculating. The stock price dropped from 105 by a third to 68 ... but it's gotta gain by a half to break even: 68 + 34 = 102.

It's a quality stock - it'll recover.

I've got time to let it happen ... well, if, at 79, I don't, the executor of my will does. Neither of my major beneficiaries are under any more pressure to liquidate under pressure than am I.

The pressure would be to pay income tax, about a year or slightly more later ... and there are other assets at close to real value to take care of that. Or, if everything were undervalued, she could use some of them to borrow to pay the tax, repaying the loan after recovery ... but the trouble with that would be that the loan interest wouldn't be deductible.

Further to the rule of 72.

At the price of $68., the stock price has doubled from the original $4.00 or so about 4 times: 8, 16, 32, 64.

When one divides the 41 year period by the number of doubles, or 4, one gets 10.25, i.e., it took 10.25 years on average to double.

Divide 72 by 10.25, one gets 7.02: the growth rate of the basic asset was about 7%.

On the other hand, if you know the rate of interest that you expect a certain investment to achieve and divide that number into 72, say, 6%, you'll get a result of 12 ... it'll take your investment about 12 years to double (with no allowance for erosion of the income by tax, or of the value of the asset by inflation).

In addition to the approximately 7% growth rate that my bank shares achieved, over the years they paid me about 3% in dividends, for a total growth rate of 10% or so: not too shabby ... especially when it's tax-advantaged, deferred and also tax-advantaged.

And the annual rate of dividend grew since my last report to $3.48, which I think that they will make a strong effort to maintain, despite the drop in value of the stock. If they drop it back somewhat, it'll likely hit the stock price for a while, but I won't cry too hard.

Earlier, at $105., or 4.5 doubles (8, 16, 32, 64, 128), dividing the 40 years by 4.5 gives 8.888, which is the rate of growth that the stock developed.

Add about 3% or a little more of dividends that the shares paid over the years, and you get a total growth rate of close to 12%.

I can handle that ... especially when I remember that I pay a low rate of tax on all of those dividends. I use the full amount earned by the loan-purchased stocks, plus part of that earned by my original cash amount invested to pay the interest on the loan, which interest is deductible (as it would not be were I to borrow to purchase an RRSP) and I think that you may get an idea of the reason that I prefer non-RRSP investing in a number of situations.

Especially since, were I to cash out at either $105. or $68., after I deducted the $4.00 of original investment, I'd get half of the difference with no tax liability.

But every dollar that I withdraw from an RRSP (or successor RRIF after age 69) ... gets added directly to income, and taxed at regular rate.

If you can't avoid tax, defer it.

But if you can pay some tax now and not only arrange for ongoing income to be taxed at a low rate ... but defer a substantial portion ... and then arrange for a major portion of it to be tax-free ... so much the better.

So ... I think that sometimes it makes sense to pay some now, in order to arrange major tax benefits ... not only ongoing ... but later, as well.

Not only that, when you have a major portion of your assets in an RRSP ...

... supposing that you need some money during those years of living and want to ask your lender for a loan.

Can you use your RRSP assets as collateral for a loan?

Officially, no ... unless you have a very accomodating lender, who'll make one without collateral (since they already carry your RRSP).

Some will - some won't. Even so, the rate of interest might be higher.

Good wishes for increasingly effective management of both your income and your assets.

ole joyful

P.S. Have you read my thread somewhere around here that outlines how to borrow to invest at almost no net cost (without making any allowance for possible increase in value of the invested asset)?

Plus another asking which ordinary person/investor gains from the erosion in value of one's investment by inflation?

o j

    Bookmark   February 14, 2008 at 12:02AM
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