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© Talbot Stevens The “Hidden Tax” of Clawbacks The Impact on Savers and Retirees by Talbot Stevens Financial Educator, Speaker, and Author of Dispelling the Myths of Borrowing to Invest and Financial Freedom Without Sacrifice
© Talbot Stevens Objectives Understand the impact of the “hidden tax” of clawbacks on savers on retirees Highlight the importance of After-Tax Income analysis, accounting for clawbacks and behavioural parameters Show how advisors can increase their business and benefit clients
© Talbot Stevens Marginal Loss Rates Any clawback of a government benefit is a “hidden tax” Marginal Loss Rate (MLR) The portion of the next dollar earned that is lost to income taxes and all clawbacks Combination of Marginal Tax Rate and Marginal Clawback Rate Defines the disincentive to earn extra money Marginal Loss Rate profile: Marginal Loss Rates for all incomes, for an individual’s unique situation
© Talbot Stevens Marginal Loss Rate Profile CCTB only, Single-Income Family, Ontario, 2004 Source: Talbot’s Finance Maximizer software
© Talbot Stevens Marginal Loss Rates, Single-Income Family, 2003 Source: Finn Poschmann, C.D. Howe Institute
© Talbot Stevens Marginal Loss Rates, Single-Income Senior, 2003 Source: Finn Poschmann, C.D. Howe Institute
© Talbot Stevens Observations Real Marginal Loss Rates do not increase in simple, progressive manner Highest MLR for low-income seniors and moderate- income savers Understanding personal Marginal Loss Rate profile important for making effective decisions Especially corporate business owners, who have flexibility in amount drawn as personal income Industry and public almost totally unaware Most financial planning software does not integrate the impact of clawbacks
© Talbot Stevens Clawed Back Programs Affecting Savers Canada Child Tax Benefit (CCTB) Tax-free benefit clawed back 4% for families with 2 or more children under 18, based on combined income Must apply to get, gone after ~$107,000 income 22-32% clawback for lower-income families Provincial programs Child Benefit supplements Health “premiums”, in Ontario, Alberta, … Many smaller tax credits (eg. GST) Tricky for those 65+, as seniors programs start * 2005 rates
© Talbot Stevens Clawed Back Programs Affecting Retirees National Guaranteed Income Supplement (GIS) Old Age Security (OAS) Age credit Provincial Provincial Seniors Benefit programs Health premiums, co-payments Amount, if any, depends on province
© Talbot Stevens OAS Overview Before-tax payout of $5,680/year (maximum), indexed with CPI 15% before-tax clawback Based on individual income, unlike GIS Clawback starts at $60,806 OAS is all clawed back at income of $98,660 ~5% of seniors have some OAS clawed back ~2% of seniors lose all OAS * 2005 rates
© Talbot Stevens GIS Overview For seniors with little or no income Tax-free payout of $6,750/year, for single seniors, indexed with CPI Must apply to receive, each year 50% after-tax clawback Clawback starts at $0 of combined income Ends at $13,512/year if single, $17,616 for couples (both over 65), not counting OAS 37% of seniors receive GIS, and thus face the 50% after-tax clawback * 2005 rates
© Talbot Stevens Impact of Clawbacks on Savers Benefits of strategies that reduce taxable income (RRSPs, leverage, etc.) are understated Example: Kim is a single parent with 2 children and earns $56K. Contributing $1,000 to an RRSP results in an immediate marginal benefit of 35%, not just the 31% tax savings, since her CCTB increases by 4%. Example: Ted has 3 kids, with a single income of $34K. His MLR is 54.6% (22.1% tax % CCTB clawback). He would have a higher immediate benefit from an RRSP contribution (borrowing if needed).
© Talbot Stevens Impact of Clawbacks on Retirees Determining the best strategy to save for retirement is not as simple as most think Net retirement income, after taxes and clawbacks can be lower than expected Example: Beth, 66, has no pension, and earns $8,000/yr. She faces 22% income taxes and 50% clawback of GIS, for a MLR of 72%. Additional income (part-time job or RRIF withdrawals) would net her 28 cent dollars. Advisors have been sued for not understanding the impact of (GIS) clawbacks on RRSP withdrawals
© Talbot Stevens After-Tax Income is All That Matters All investment goals are to produce a net income, after all costs (taxes, clawbacks, commissions and fees, etc.) A lump-sum goal, like maximizing estate values, is an income goal where the withdrawal period is 1 year Must evaluate all financial strategies in terms of net After-Tax Income (ATI) Accounting for math, taxes, clawbacks, and behavioural parameters Professional advice, with proper tools, is required
© Talbot Stevens Maximizing After-Tax Retirement Income Retirement is the most significant financial goal Maximizing after-tax, after-clawback income during retirement is the real objective Comparing before-tax future values can lead to wrong conclusions Rather have $100K of RRSPs or $70K of unregistered equity funds?
Are RRSPs always best?
© Talbot Stevens Behavioural Parameters Most Important to Financial Success Biggest threat to success is our behaviour and lack of commitment Investor performance more important than investment performance Examples What do most do with RRSP refunds? RRSP vs. pay down mortgage
© Talbot Stevens Refund Strategy Can Increase RRSP Income 22 to 46% or More What you do with RRSP refund is critical Simply reinvesting all of refund increases RRSP retirement income 22 to 46% Benefits investor and advisor by same ratio Refund strategies: spend, reinvest, “gross up” to invest all after-tax dollars Example: In 50% tax bracket, $2,000 in an RRSP equates to $1,000 after-tax. Thus, $1,000 to invest equates to a “grossed up” RRSP contribution of $2,000.
© Talbot Stevens RRSP Refund Strategies $500Spend Reinvest $1,000 (Before-tax) Contrib. Refund Strategy $750 Gross up$1,000 After-tax Net Cost $1,000 $1,500 $2,000 - $1,000 (after-tax) to invest, 50% tax bracket
© Talbot Stevens Factors that Reduce Benefit of RRSPs Not investing all after-tax dollars (using grossed- up contributions) Shorter savings periods Lower returns Rising tax and clawback rates Tax-efficient unregistered returns Taxed later, taxed less, tax deduction? RRSP trustee fees Get unregistered money back tax- and clawback-free
© Talbot Stevens Sample After-Tax Income Results Goal is maximize After-Tax Income over 20-year retirement period 20-year ATI is like an after-tax annuity No “rules of thumb” possible Legend RRSP1: spend refund RRSP2: reinvest refund RRSP3: gross up (invest all after-tax dollars) Equities: 30% of return distributed and taxed annually, 50% of capital gains taxable
© Talbot Stevens Comparing Before-Tax Values Can Be Misleading - Invest $4,500/yr after-tax from age 55 to 65 (10 yrs), 40% tax 9% returns, at 9% interest can borrow $83,333 to invest - Goal to max. After-Tax Income (ATI) over 20 years, 40% tax $4,490 reference $6,290 40% more $7,490 67% more $6,350 42% more $9, % more
© Talbot Stevens Case 1: Seniors Benefit Impact, Invest 5 years, 40% Tax Now, 60% After 65 - Have $1,000 to invest, 5 years from retirement (60-yr old), 40% tax now, 9% returns - Goal to max. 20-yr ATI, facing 40% tax and 20% clawback - 20% (SB) clawback means RRSPs eventually don’t make sense for all equity investors and most fixed-income investors
© Talbot Stevens Case 2: GIS Clawback Impact Invest 5 years, 25% Tax Now, 75% After 65 - Have $1,000 to invest, 5 years from retirement (60-yr old), 25% tax now, 5% (conservative) returns - Goal to max. 20-yr ATI, facing 25% tax and 50% GIS clawback - If going to face GIS clawback, should invest outside of RRSPs. NOTE: ~37% of seniors receive GIS
© Talbot Stevens Case 3: OAS Clawback Impact Invest 5 years, 43% Tax Now, 50% After 65 - Have $1,000 to invest, 5 years from retirement (60-yr old), 43% tax now, 8% returns - 30% of equity returns distributed annually - Goal to max. 20-yr ATI, facing 43% tax and 15% OAS clawback
© Talbot Stevens Minimum Holding Period for RRSPs $1,000 $500 Time INT EQ R1 R2 After- Tax $ R3 Min. Holding Period for Equities if Reinvest All of RRSP Refund EQ, 12%
© Talbot Stevens General After-Tax Income Conclusions Simple before-tax value conclusions of the past are not always valid Professional analysis and advice critical Behavioural parameters most important RRSPs generally produce more ATI, if at least reinvest refunds A minimum holding period is required for RRSPs to be better than unregistered GIS candidates often better to avoid RRSPs
© Talbot Stevens General After-Tax Income Conclusions In some cases, equities can be better unregistered Fixed income generally best inside RRSP Current investment decisions must account for best (total tax) prediction of future High future Marginal Loss Rates can result in RRSPs not making sense RESPs generally produce more 4-year ATI, if child goes to school and has little other income
© Talbot Stevens Summary of Benefits to Advisors Increase the real, after-tax value of own and client accounts Know when equities are better unregistered Increase RRSP business 22 to 46% or more Behaviour and RRSP refund strategies Prove that professional advice is essential To choose best strategy for identified goal To minimize behavioural risks
© Talbot Stevens Summary of Benefits to Advisors What portion of your competitor’s clients would like to have their investment strategies reviewed in terms of producing net after-tax, after- clawback retirement income over years? Instead of the common approach comparing before- tax, lump-sum values Be a leader in advising the best after-tax strategy to max. retirement income or estate to Attract clients away from competition Attract high net worth accounts Get significant referral generation by being unique, valuable, and a leader
© Talbot Stevens Summary of Benefits to Advisors Can quantify benefit of tax-efficient investments/strategies Equities with low-distributions (Spousal) RRSPs TPSPs (Tax-Prepaid Savings Plans)
© Talbot Stevens How to Reconcile ATI Approach With View “RRSPs Always Best” “As a professional financial advisor, I am committed to constantly looking for better ways to add value to my clients and help them achieve their goals. While RRSPs are generally the best way to save for retirement, recently I’ve learned that in certain cases a non-registered approach can produce more after-tax retirement income, particularly for equity investments. If you’ve got 10 minutes, I’d like to explain in simple terms how that is possible. If there was a different approach that could increase your after-tax retirement income by say 20%, would you want to know about it?” Leaders welcome change, or create it
© Talbot Stevens Poll of Views How many … Learned new ideas to benefit clients (and your own finances)? Want to learn more, and how these ideas can help you differentiate and grow your business? Additional (hidden) slides in handouts
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