Section 2.6) Tax and Retirement Planning exam(fully solved).

Types of income 1. Employment (taxed on gross receipt basis) 2. Capital/Property Income (stocks, bonds, mutual funds.. dividends and interest) 3. Business Income (from rendered services) 4. Capital gains and losses Calculating Income Tax Payable On first 43,561 x 15% On portion over 43,561 and up to 87,123 x 22% On portion over 87,123 and up to 135,054 x 26% On portion 135,054 x 29% This is what is considered a Marginal Tax Rate (Tax paid on any additional dollars of taxable income earned.) Different forms of investment income taxation 1. Interest income: From investments such as CSB, GICs, Bonds (M.F.). Taxed as regular income (no preferential tax treatment.) 2. Dividends: From preferred shares/Common Shares that generate a dividend. Grossed up by 38% and taxpayer receives a divident tax credit (DTC) of 15.02% Note: Foreign Dividends do not get preferential treatment; they are taxed as regular income. 3. Capital gains: When M.F. or Security is sold for more than its cost. Only 50% of the gain is taxable. Which type of investment offers the greatest tax advantage for an investor? Dividends offer the most tax-efficient investment income for lower federal tax brackets. For higher tax brackets, the efficiency of capital gains outweighs dividend income. Rebecca, an investor in a 40% marginal tax bracket, receives $1,200 in Canadian dividends eligible for the dividend tax credit. Calculate the dividend tax credit that applies to this income. The taxable amount of the dividend is the income received plus a 38% gross-up amount. Therefore, $1,200 + ($1,200 × 38%) = $1,656. The dividend tax credit is 15.02% of the grossed-up amount, in this example, $1,656 × 15.02% = $248.73. Grossed up Amt (1656) - Grossed up DTC amt (248.73) = $248.73 What are the main pension plans in Canada? Government pension plans include 1. Canada Pension Plan (CPP) 2. Old Age Security (OAS) Employee Pension Plans (Known as Registered Pension Plans, RPPs); Types of RPPs. 1. Defined Benefit Plan (DBP) 2. Defined Contribution Plan (DCP) When can you receive your CPP? May choose to receive monthly retirement pension for life at age of 65. (You can apply to receive at 60, but the amount received is reduced by a certain % for each month by which you are under 65.) - You can also postpone until you're 70 in which case the amount received in increased by a certain % of each month you're over 65.) What is OAS and when can it be received? Payable to all Canadian citizens and landed immigrants who have reached the minimum age. Eligible between ages 65 to 67 In DBP, how are the benefits predetermined? In a DBP the benefits are predetermined based on a formula including years of service, income level and other variables, and the contributions are designed to match the predetermined plan benefits. (You will know in advance how much your pension will be at retirement.) *The full benefit is only available for those who have achieved a minimum level of service of 25 years. (If person leaves before minimum level of service, they receive a lump sum which is transferred to a LIRA) In DCP, how are the benefits predetermined? In a DCP (also known as a money purchase plan) the contributions to the plan are predetermined and the benefits, at retirement, will depend on how the contributions were invested. Employee contributes a % of salary, and employer matches it (Pension is unknown) Harry earns $36,000 in the current year. His employer contributes $1,500 to his defined contribution pension plan. Calculate Harry's maximum contribution to the plan. Remember: The combined employer/employee contributions cannot exceed the lesser of 18% of current year compensation or a fixed dollar amount; ($23,820). In this example, $36,000 × 18% = $6,480. If Harry's employer contributed $1,500, then, Harry could contribute $6,480 - $1,500 = $4,980. What the the three types of DBPs? 1. Flat benefit Plan 2. Career Average Plan 3. Final Average Plan (Only differ in the criteria used to calculate the benefit.) Flat Benefit Plan The flat benefit plan is the simplest type of defined benefit plan. The monthly pension is a specified dollar amount of pension for each year of service. Thus a formula of $15 per month per year of service, after 30 years of service, would produce a pension of $450 per month ($15 × 30 years). Career Average Plans The pension is calculated as a percentage of an employee's earnings over the course of her career (while in the plan). Employees may contribute a fixed percentage of their salary (such as 5%) to this type of plan. Employer contributions required to fund the defined benefit are not fixed: they vary according to factors such as investment yield, mortality and employee turnover. Gareth retired after 20 years of participation in a career average pension plan with a defined pension benefit percentage of 1.5%. His average annual salary, before deductions, was $60,000. Calculate Gareth's annual earned pension. Gareth's annual earned pension would be calculated as $60,000 × 1.5% × 20 = $18,000 Final Average Plans Bases the pension on an employee's length of service and average earnings. Used a stated period of time; often this is the average of the best five consecutive years of earnings in the last 10 years of employment, or the average of the best three consecutive years of earnings over the last five years of employment (BEST PROTECTION AGAINST INFLATION) What are the most common tax deferral plans? RRSP ( are available to individuals to defer tax and save for retirement years. Annual contributions are tax-deductible up to allowable limits. Income earned in the plan accumulates tax-free as long as it remains in the plan) 2 types of RRSP, 1. Single Vendor Plans 2. Self Directed Plans (there are no limit to number of plans can hold) Single Vendor Plans In these plans, the holder invests in one or more of a variety of GICs, segregated pooled funds or mutual funds. The investments are held in trust. To qualify as acceptable investments for an RRSP (either Single Vendor or Self-Directed), In Single Vendor RRSPs (no day-to-day investment decisions are required to be made by the holder.) Self Directed Plans In these, holders invest funds or contribute certain acceptable assets such as securities directly into a registered plan. One advantage of Self-Directed RRSPs is that investors can make all investment decisions. Another advantage is that, while there are rules with respect to allowable content, a full range of securities may be held in these plans. What are special features that an investor should understand about an RRSP account ? 1. RRSP is a trust account designed to benefit the owner at retirement. Withdrawals from an RRSP are subject to a withholding tax and such withdrawals must be included in income in the year withdrawn. 2. An RRSP cannot be used as collateral for loan purposes.