RRSP vs. Tax-free savings Which is best? In an excerpt from The Wealthy Barber Returns author David Chilton looks at which tax-sheltered vehicle is best- your RRSP or tax-free savings account.

RRSP vs. Tax-free savings Which is best?

In an excerpt from The Wealthy Barber Returns author David Chilton looks at which tax-sheltered vehicle is best- your RRSP or tax-free savings account.

In this excerpt from The Wealthy Barber Returns, called the Battle of the Abbreviations, author David Chilton looks at the pros and cons of saving in your RRSP or a tax-free savings account.

Remember when life was simple? You needed to save and invest for retirement, so you opened an RRSP and contributed as much as you could each year.

Sure, the saving part was tough. And, of course, investing always had its challenges. But at least we all knew that an RRSP was the way to go.

Everybody said so. The woman on TV. Your advisor. The Wealthy Barber guy. Even your know-nothin’ cousin.

Then in 2009, along came the TFSA — totally fantastic savings account (or tax-free savings account).

Hmm. Suddenly, a second option to house our retirement dollars. What to do?

Many counsel us to put the maximum allowable amount into both our RRSPs and our TFSAs. For big-income, childless people living rent-free in their parents’ basements, that’s unquestionably solid advice.

The rest of us are probably going to have to prioritize. We need to figure out which vehicle to focus on first.

When you make an RRSP contribution, you get to deduct that amount from your taxable income. The investments inside your RRSP grow free of tax while they stay in the plan. Down the road, however, when money is withdrawn directly from the RRSP or from the registered retirement income fund (RRIF) or annuity to which the RRSP has been converted, it will be taxable.

I’m alarmed by how many Canadians still don’t fully grasp that last point. Over and over again, I see net-worth statements where the full value of an individual’s RRSP is listed on the Assets side, but no corresponding eventual-tax-owing amount is recorded on the Liabilities side.

You may have a $110,000 RRSP but you also have a partner — the government — waiting patiently for its share. Annoying, but true.

In essence, a TFSA is the mirror image of an RRSP. You contribute after-tax dollars. In other words, you don’t get a deduction for your contribution. But once the money is in the plan, it not only grows free of tax, but also comes out free of tax. No tax ever! Fantastico!

If you don’t love TFSAs, sorry, you’re nuts. But that doesn’t necessarily mean you should love them more than RRSPs.

When the federal government introduced TFSAs, it created a chart similar to this one:

I’ve spent almost two full books trying to avoid number-laden charts, but this simple, little table is quite illuminating. It neatly shows how a TFSA contribution is made with after-tax dollars, while withdrawals are tax-free. And an RRSP contribution is made with pre-tax dollars, while withdrawals are taxable. Yes, I’ve already explained that, but I thought it best to repeat.

The chart also demonstrates that if your marginal tax rate at the time of the RRSP contribution is the same as at the time of the withdrawal, TFSAs and RRSPs work out equally well.

Even the numerically challenged can understand that if the marginal tax rate is lower at the time of withdrawal than at the time of contribution, the RRSP will win. Conversely, if the marginal tax rate is higher at the time of withdrawal than at the time of contribution, the TFSA will win.

Easy, right? You just need to guess your marginal tax rate at the time of potential withdrawal and base your decision on that.

I’m so disappointed that it’s not that simple, darn it. I love simple. But sadly, the real world is more complicated than the chart world. Quite a bit more complicated.

In the last chapter, we saw that many of us, if not most of us, contribute to RRSPs with after-tax savings and then spend the refund. I hope the previous chapter changes that, but for right now, that’s the way it is. Heck, having some fun with our refund cheque is like playing this year’s first golf game or gardening on May 24th — it’s an annual Canadian tradition. A rite of spring.

Let’s look at a new chart that reflects that reality:

Holy smokes, the TFSA is kickin’ butt!

“That’s not fair,” you might argue. “You forgot to include the $400 tax refund that the RRSP contribution generates!”

No, I didn’t. It’s a chair now. Or half an iPad. Or a flight to Vegas.

And that’s fine. I’m not saying it was squandered — chairs are important, especially when you’re sitting. But it does mean the $400 won’t help your retirement and, therefore, in this scenario, from a financial-planning perspective, the TFSA is a clear winner.

Even when we assume you’ll follow the first chart’s lead and contribute to an RRSP the pre-tax equivalent of the TFSA contribution ($1,000 to $600), the comparison is still trickier than it first seemed.

Why?

When you withdraw money from your RRSP or RRIF (or receive an income from an annuity to which your RRSP was converted), not only do you have to pay taxes on it, but your increased income could also lead to higher clawbacks of your Old Age Security pension, Guaranteed Income Supplement and other means-tested government benefits.

Yikes, the math here is more complex than the RRSP versus RESP debate. Way more. I don’t even drink and I want a beer.

And talk about assumptions! Oh my. Go ahead: Take your best guess at what your taxable income will be 10, 20 and 30 years down the road. What about future tax rates? Will clawback rules be altered? In retirement, will you be able to income split with your spouse or will your spouse already have split with some of your income?

Wow. Maybe I should make that beer a scotch.

I’ve checked out a dozen analyses on the Internet and all that did was reinforce how challenging this comparison is. For example, very few factored in the effect an RRSP contribution can make on the amount of the Canada Child Tax Benefit (CCTB) parents receive. Also, almost all of the researchers assumed every dollar withdrawn from an RRSP or RRIF will be taxed at the marginal tax rate. Think about that — it’s not always the case. If I have $10,000 in government-pension income and receive a RRIF payment of $53,000, it’s not all going to be taxed at the marginal rate. In some cases, it would be more appropriate to use the average rate of tax on the withdrawal in the calculations.

That’s not nitpicky — points like the last one can’t be ignored. They’re vital parts of the evaluation. Unfortunately.

Wake up! I’m almost done.

Based on the various assumption sets I used, the TFSA won a surprising percentage of the time (though usually not by a wide margin). In fact, for most low-income earners, it was the victor under the majority of scenarios.

That said, I frankly have no idea which way you should go. At the risk of being branded The Wishy-Washy Barber, I think it would be irresponsible to give a definitive “do this.” Sit down with your advisor — he or she will at least have the advantage of being able to customize the assumptions to your situation. Plus, I’m sure there will soon be software or an app developed to help you figure this out. Try to curb your enthusiasm.

My final thought here is important (no, really!). TFSAs are very flexible. You can take money out of one at any time and then put it back in future years. That’s being trumpeted as a huge positive by many financial writers, but it scares the heck out of me.

I’m worried that many Canadians who are using TFSAs as retirement-savings vehicles are going to have trouble avoiding the temptation to raid their plans. Many will rationalize, “I’ll just dip in now to help pay for our trip, but I’ll replace it next year.” Will they? It’s tough enough to save the new contributions each year. Also setting aside the replacement money? Colour me skeptical. The reason I always sound so distrustful of people’s fiscal discipline is that after decades of studying financial plans, I am always distrustful of people’s fiscal discipline. And even if I’m proven wrong and the money is recontributed, what about the sacrificed growth while the money was out of the TFSA? Gone forever.

Reminders: (1) If you go the RRSP route, don’t spend your refund; (2) If you go the TFSA route, don’t spend your TFSA; (3) Whatever route you go, save more!

Excerpted from The Wealthy Barber Returns: Significantly Older and Marginally Wiser, Dave Chilton Offers His Unique Perspectives on the World of Money By David Chilton. Copyright © 2011 by David Barr Chilton.

RRSP vs. Tax-free savings Which is best?

RRSP vs. Tax-free savings Which is best?

In an excerpt from The Wealthy Barber Returns author David Chilton looks at which tax-sheltered vehicle is best- your RRSP or tax-free savings account.

In this excerpt from The Wealthy Barber Returns, called the Battle of the Abbreviations, author David Chilton looks at the pros and cons of saving in your RRSP or a tax-free savings account.

Remember when life was simple? You needed to save and invest for retirement, so you opened an RRSP and contributed as much as you could each year.

Sure, the saving part was tough. And, of course, investing always had its challenges. But at least we all knew that an RRSP was the way to go.

Everybody said so. The woman on TV. Your advisor. The Wealthy Barber guy. Even your know-nothin’ cousin.

Then in 2009, along came the TFSA — totally fantastic savings account (or tax-free savings account).

Hmm. Suddenly, a second option to house our retirement dollars. What to do?

Many counsel us to put the maximum allowable amount into both our RRSPs and our TFSAs. For big-income, childless people living rent-free in their parents’ basements, that’s unquestionably solid advice.

The rest of us are probably going to have to prioritize. We need to figure out which vehicle to focus on first.

When you make an RRSP contribution, you get to deduct that amount from your taxable income. The investments inside your RRSP grow free of tax while they stay in the plan. Down the road, however, when money is withdrawn directly from the RRSP or from the registered retirement income fund (RRIF) or annuity to which the RRSP has been converted, it will be taxable.

I’m alarmed by how many Canadians still don’t fully grasp that last point. Over and over again, I see net-worth statements where the full value of an individual’s RRSP is listed on the Assets side, but no corresponding eventual-tax-owing amount is recorded on the Liabilities side.

You may have a $110,000 RRSP but you also have a partner — the government — waiting patiently for its share. Annoying, but true.

In essence, a TFSA is the mirror image of an RRSP. You contribute after-tax dollars. In other words, you don’t get a deduction for your contribution. But once the money is in the plan, it not only grows free of tax, but also comes out free of tax. No tax ever! Fantastico!

If you don’t love TFSAs, sorry, you’re nuts. But that doesn’t necessarily mean you should love them more than RRSPs.

When the federal government introduced TFSAs, it created a chart similar to this one:

I’ve spent almost two full books trying to avoid number-laden charts, but this simple, little table is quite illuminating. It neatly shows how a TFSA contribution is made with after-tax dollars, while withdrawals are tax-free. And an RRSP contribution is made with pre-tax dollars, while withdrawals are taxable. Yes, I’ve already explained that, but I thought it best to repeat.

The chart also demonstrates that if your marginal tax rate at the time of the RRSP contribution is the same as at the time of the withdrawal, TFSAs and RRSPs work out equally well.

Even the numerically challenged can understand that if the marginal tax rate is lower at the time of withdrawal than at the time of contribution, the RRSP will win. Conversely, if the marginal tax rate is higher at the time of withdrawal than at the time of contribution, the TFSA will win.

Easy, right? You just need to guess your marginal tax rate at the time of potential withdrawal and base your decision on that.

I’m so disappointed that it’s not that simple, darn it. I love simple. But sadly, the real world is more complicated than the chart world. Quite a bit more complicated.

In the last chapter, we saw that many of us, if not most of us, contribute to RRSPs with after-tax savings and then spend the refund. I hope the previous chapter changes that, but for right now, that’s the way it is. Heck, having some fun with our refund cheque is like playing this year’s first golf game or gardening on May 24th — it’s an annual Canadian tradition. A rite of spring.

Let’s look at a new chart that reflects that reality:

Holy smokes, the TFSA is kickin’ butt!

“That’s not fair,” you might argue. “You forgot to include the $400 tax refund that the RRSP contribution generates!”

No, I didn’t. It’s a chair now. Or half an iPad. Or a flight to Vegas.

And that’s fine. I’m not saying it was squandered — chairs are important, especially when you’re sitting. But it does mean the $400 won’t help your retirement and, therefore, in this scenario, from a financial-planning perspective, the TFSA is a clear winner.

Even when we assume you’ll follow the first chart’s lead and contribute to an RRSP the pre-tax equivalent of the TFSA contribution ($1,000 to $600), the comparison is still trickier than it first seemed.

Why?

When you withdraw money from your RRSP or RRIF (or receive an income from an annuity to which your RRSP was converted), not only do you have to pay taxes on it, but your increased income could also lead to higher clawbacks of your Old Age Security pension, Guaranteed Income Supplement and other means-tested government benefits.

Yikes, the math here is more complex than the RRSP versus RESP debate. Way more. I don’t even drink and I want a beer.

And talk about assumptions! Oh my. Go ahead: Take your best guess at what your taxable income will be 10, 20 and 30 years down the road. What about future tax rates? Will clawback rules be altered? In retirement, will you be able to income split with your spouse or will your spouse already have split with some of your income?

Wow. Maybe I should make that beer a scotch.

I’ve checked out a dozen analyses on the Internet and all that did was reinforce how challenging this comparison is. For example, very few factored in the effect an RRSP contribution can make on the amount of the Canada Child Tax Benefit (CCTB) parents receive. Also, almost all of the researchers assumed every dollar withdrawn from an RRSP or RRIF will be taxed at the marginal tax rate. Think about that — it’s not always the case. If I have $10,000 in government-pension income and receive a RRIF payment of $53,000, it’s not all going to be taxed at the marginal rate. In some cases, it would be more appropriate to use the average rate of tax on the withdrawal in the calculations.

That’s not nitpicky — points like the last one can’t be ignored. They’re vital parts of the evaluation. Unfortunately.

Wake up! I’m almost done.

Based on the various assumption sets I used, the TFSA won a surprising percentage of the time (though usually not by a wide margin). In fact, for most low-income earners, it was the victor under the majority of scenarios.

That said, I frankly have no idea which way you should go. At the risk of being branded The Wishy-Washy Barber, I think it would be irresponsible to give a definitive “do this.” Sit down with your advisor — he or she will at least have the advantage of being able to customize the assumptions to your situation. Plus, I’m sure there will soon be software or an app developed to help you figure this out. Try to curb your enthusiasm.

My final thought here is important (no, really!). TFSAs are very flexible. You can take money out of one at any time and then put it back in future years. That’s being trumpeted as a huge positive by many financial writers, but it scares the heck out of me.

I’m worried that many Canadians who are using TFSAs as retirement-savings vehicles are going to have trouble avoiding the temptation to raid their plans. Many will rationalize, “I’ll just dip in now to help pay for our trip, but I’ll replace it next year.” Will they? It’s tough enough to save the new contributions each year. Also setting aside the replacement money? Colour me skeptical. The reason I always sound so distrustful of people’s fiscal discipline is that after decades of studying financial plans, I am always distrustful of people’s fiscal discipline. And even if I’m proven wrong and the money is recontributed, what about the sacrificed growth while the money was out of the TFSA? Gone forever.

Reminders: (1) If you go the RRSP route, don’t spend your refund; (2) If you go the TFSA route, don’t spend your TFSA; (3) Whatever route you go, save more!

Excerpted from The Wealthy Barber Returns: Significantly Older and Marginally Wiser, Dave Chilton Offers His Unique Perspectives on the World of Money By David Chilton. Copyright © 2011 by David Barr Chilton.

Difference Between Residential and Commercial Financing

Peter Kinch explains the difference between residential and commercial financing

Call it Commercial Financing 101. I received a call from a client recently who had just put an offer in on a property and needed a mortgage. They had purchased a four-plex only a few months earlier and wanted to know if they could get the same discounted rate for this purchase.

Normally I'd say, no problem, but upon further examination of their deal, I discovered that the property they were buying was an "eight-plex." What's the big deal you might ask? Well, the problem is that the purchase of the four-plex fell under the definition of "residential" financing, whereas an eight-plex is considered a 'commercial mortgage' and the difference between financing the two is quite significant. This simple misunderstanding is probably one of the most common misconceptions in mortgage financing. Many investors do not realize that there is a major difference between residential and commercial financing and as such, enter into purchase agreements with false expectations and often end up disappointed and frustrated.

Different sandbox = different rules

The frustrating part for most borrowers is a misinterpretation of the definition of 'commercial.' Many investors assume that a commercial property is one that includes a retail unit or business component in the building. The problem is that the definition of 'commercial' can vary depending on who you're asking - your Realtor, your banker or your accountant. For our purposes, we are interested in the banker's definition. From a mortgage perspective, a property may be deemed to be commercial as soon as you get beyond a four-plex. Again, we have to realize that we're in a new sandbox. Not only have the rules changed, but so too have the players. Many of the lenders who are happy to lend in the residential sandbox, have opted out of this 'sandbox' completely, whereas some new players have now entered the fray.

Clear definitions

First off, let's define when a mortgage is deemed to be commercial versus residential.

A single unit, duplex or triplex will always be considered a residential property for mortgage purposes. Virtually every bank will treat a four-plex as a residential mortgage as well, however, this is the cut-off point for some lenders and they may only choose to do a four-plex as a residential mortgage on an exception basis (i.e., application must be strong).

A "five-plex" is completely in the grey-zone - most residential lenders opt out at this point and your broker will have to do some digging to find a lender who will treat this as residential.

A "six-plex" is where 99% of the 'residential' players now opt out. Your broker will be extremely limited in finding a lender who will look at this as a residential deal. There is one lender in Canada who is currently treating up to eight units in a multi-family complex as residential, but they are only doing so in Ontario at this point. Beyond that, you will definitely be dealing in the commercial sandbox. The other obvious clue that makes property residential versus commercial is the zoning. Quite often this comes to light when the broker or banker receives the appraisal.

(*Note: Don't confuse an eight-plex, which has eight separate suites, each having its own entrance and each being fully self-contained, with a residential house that has eight rooms rented out and a hot plate in each room for cooking. The latter is considered a 'rooming house' and the banks will scatter quickly if they read this in an appraisal. Simply put - they don't like them. So if you're buying one, expect even more problems. The same is true for 'student housing,' so again, proceed with caution.)

So what's the big deal?

What difference does it make if a property is considered commercial or residential?

First of all, the entire underwriting process now changes - as you might have guessed, new sandbox, new rules. The simple explanation is that in the residential sandbox, you the borrower, were the main focus and the property was secondary. In the commercial box, the property becomes the focal point and you (the covenant) become secondary - which may come as welcome news for some.

The biggest difference between the two is the cost of doing business. In the residential sandbox, the interest rate was very predictable, there was no lender fee, the appraisal costs were low and the legal fees were standard. All of those change when you buy a multi-family/commercial property. The rates could be higher; the bank charges a fee - as does your broker, the appraisal costs start at $1,200 and can go much higher. The legal and accounting fees will be higher. Your residential home inspector is not the same person you will use for a commercial property inspection (and yes, you guessed it, they don't charge the same) and lastly, the lender will likely ask for a Phase 1 Environmental on the property. Other than that, there's no difference.

Source: Peter Kinch, Mortgage Expert