Thursday, September 24, 2015

Personal Finance Election Issues

Recently, Mark Seed at My Own Advisor called on Canadians to turn three personal finance issues into election issues. It certainly makes sense to take personal finance policies into account when you vote. Unfortunately, I mostly disagree with Mark on all three of his points.

Here are Mark’s preferences in bold followed by my thoughts.

1. Keep the Tax Free Savings Account (TFSA) contribution limit at $10,000.

On the surface, the choice is between a $5500 TFSA limit and a $10,000 limit. But that misses a crucial point. When the government increased the limit, they eliminated inflation indexing. So, the real choice is between $5500 with automatic cost-of-living increases or a fixed $10,000 limit whose value declines each year with inflation.

It can be difficult to imagine that $10,000 will become a much less valuable amount of money at some point in the future, but it will happen. Just 5 or 6 decades ago, $10,000 could buy a nice house. Now it’s not much of a used car. Far enough into the future, it will be a month’s rent in a typical apartment. Cost of living adjustments matter.

Another thing to consider is that generally only the wealthiest Canadians can afford to put $10,000 annually into their TFSAs today. Don’t be fooled by the many claims that large numbers of low-income Canadians max out their TFSAs. The numbers are very skewed by parents filling up their children’s TFSAs and retired Canadians transferring existing savings into their TFSAs.

So, in the short term, the $10,000 limit benefits wealthier Canadians, and in the long term, the lack of indexing will make the TFSA limit dwindle in real terms. While the $10,000 limit will benefit me, it’s worse for my sons. I prefer to choose a reasonable limit and have it rise automatically with inflation. The old rules of a $5500 limit with indexing make sense to me.

2. Abolish the Registered Retirement Income Fund (RRIF) minimum withdrawal requirements.

This was a big issue before the government made changes to the minimum RRIF withdrawals. It used to be that your RRIF portfolio had to earn a return of 6% over inflation to keep your RRIF payments matching the cost of living. It is unrealistic to expect to earn an average return this high over the years, particularly after accounting for investment costs.

With the latest RRIF changes, you only need to earn a return of about 3% above inflation to keep up with the cost of living. This is much more realistic. Now there is much less need to change RRIF withdrawal rules.

You may ask why we need RRIF withdrawal rules at all. Why not just leave people alone to manage their RRIFs their own way? Let’s look at who benefits if there are no minimum RRIF withdrawals. Lower to middle class Canadians need income from their RRIFs in retirement, so they won’t benefit from scrapping minimum withdrawals.

Middle to upper income Canadians are often better off tax-wise if they start drawing down their RRSPs and RRIFs after retiring rather than waiting until they turn 71. This only leaves people so wealthy that they don’t want to draw down their RRIFs at all. They’d rather defer taxes all their lives. They’d like to pass their RRIFs tax-free to a spouse or even to the next generation if they could.

RRSPs were designed to allow Canadians to defer taxes until they retire. Why should we allow wealthier Canadians to continue deferring taxes throughout their retirements as well? Scrapping the new lower minimum withdrawals will benefit the wealthiest Canadians, and the rest of us will have to make up for the reduced taxes collected by the government.

3. Stop OAS payments entirely to wealthy seniors over the existing “clawback” threshold.

Currently, OAS payments get clawed back by 15% of your income over $72,809. Once your income gets to about $117,000, the entire OAS is clawed back. The suggestion here is to just take all the OAS payments back (or never send them) for those whose incomes are over the $72,809 threshold.

The problem with this proposal is that it creates a huge difference for just an extra dollar of income. Someone making $72,808 gets to keep all of their OAS payments for the year, and someone making a dollar more gets nothing from OAS.

This would lead to tax-planning strategies in retirement where people with high average incomes keep their income to $72,808 or less in most years. If they have to go over the threshold, then they make sure to go over it by a lot, such as by draining a RRIF.

It is much better to have the current smooth tax policies. Once you hit the threshold, the clawback takes 15 cents out of every additional dollar. This is much better than falling off a cliff and having to give back all of the OAS. We can debate whether the threshold should be higher or lower, or whether 15% is the right clawback percentage, but a smooth transition is highly desirable.

Conclusion

Unfortunately, I have to disagree with Mark on all three of his points. The old TFSA limit was better with its automatic inflation increases, and the RRIF minimum withdrawals and OAS clawback rules are just fine as they are.

30 comments:

  1. I love a counter argument!

    I always find it interesting we complain about the higher TFSA, but nobody says anything about the RRSP limit. Most Canadians don't max out that account. :)

    RRIF and LIF minimums still don't make sense to me. Sure, middle or higher-income earners benefit from this but then again, most lower-class Canadians don't need the RRSP anyhow. They are better off with the TFSA, hence point #1.

    Someone needs to explain to me how a senior needs "income security" making over $70k per year.

    I enjoy reading differing views Michael. Aren't there any tax or personal policies you would change?

    Cheers,
    Mark

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    1. @Mark: Most Canadian don't max out either account (RRSP and TFSA). It's a sad state of affairs.

      If we abolish the RRIF withdrawal minimum, wealthy Canadians will pay significantly less tax. Lower income Canadians would need to make up the difference. That's a problem.

      If you want OAS to not be paid to those making $70k/year, you need to start clawing OAS back somewhere in the $30k to $50k range. Otherwise you get the problem of earning a single dollar and losing all your OAS.

      The main policy I would change is the one where almost all governments at all levels fail to fire bad employees. Continuing to employ useless employees costs taxpayers billions of dollars every year.

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    2. I am always surprised that so many folks fail to appreciate the effects of inflation over time. I fear for those that belong to a DB pension plans that have managed over time to weasel out of COLA clauses. Could be some nasty surprises...

      One policy change I would like to see would be to change the eligibility rules for those collecting the GIS. As it stands now, it is perfectly legal for wealthy folks who arrange their income properly to collect. See the article here to see how...

      http://business.financialpost.com/personal-finance/tfsa/even-the-rich-can-qualify-for-guaranteed-income-supplement-heres-how?__lsa=b227-d2f7

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    3. @Garth: I discussed this problem back in 2008:

      http://www.michaeljamesonmoney.com/2008/04/secondary-effects-of-tfsas.html

      I think it is likely that changes will be made to GIS eligibility as TFSA balances become large.

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    4. I have heard of seniors who invest most of their wealth into their (multi million) main residence, and the rest in a low yielding checking account to live off of. They then collect the GIS from age 65 up until their deferred CPP and RRIFs kick in. Cash in the residence and go merrily on their way. No TFSAs required...totally legal but morally wrong IMHO. Maybe the means test will have to look at net worth...

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    5. @Garth: I've heard such stories as well, but I prefer to react to real statistics. If some actual stats showed that significant numbers of seniors were gaming the GIS system, I'd be concerned. However, I'm not aware of any such evidence. The truth is that it's much better to earn investment income and forgo the GIS than it is to leave money in a chequing account. I'm suspicious about claims that significant numbers of seniors are acting against their own interests just to abuse the GIS.

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  2. re: "Most Canadian don't max out either account (RRSP and TFSA). It's a sad state of affairs."

    Do most Canadians earn enough to max out either/both?

    You've got my vote for changing the bad employee policy! I've experienced it first hard for a decade and it is stunning. Perhaps the worst part is that the bad/useless employee will collect a (tax-payer partially funded) pension in exchange for having contributed very little or no value besides simply putting in time.

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    1. @SST: RRSP room is scaled to income (18% up to a maximum). SO, by definition everyone earns enough income to max out their RRSPs. Certainly many Canadians don't earn enough to max out their TFSAs.

      Yes, the real pay of many government employees is much higher than their nominal pay because the pension and other benefits are so valuable.

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    2. The RRSP favours wealthier people, by giving them more contribution room. The TFSA puts everyone on an equal footing.

      People who eventually sell their home will be able to shelter the proceeds into their accumulated TFSA contribution room, if they had not already filled it. So, the TFSA is a better program for them than the RRSP. The $10,000 limit is just OK and should be indexed to inflation.

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    3. @Anonymous: The $10,000 limit, if indexed, would benefit me personally, but I think it is too high for the country. It will allow well-to-do people to avoid taxes on substantial investment income.

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    4. Yet, you don't think that it is too high for the country that well-to-do people get an RRSP limit of near $25,000.

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    5. @Anonymous: I'm not sure if I've ever commented on whether RRSP contribution limits are too high. So, I'm not sure why you think you know my opinion about RRSP limits. In any case, TFSA contribution room is much more valuable than RRSP contribution room because it involves after tax dollars and TFSA contributions don't have to be withdrawn starting at age 71.

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  3. RRIF minimums (somewhat) help to prevent wealthy people from manipulating their incomes in order to maximize OAS (or even GIS!) income.

    Agreed that OAS should start to claw back at lower incomes (~$50K). Retirees with incomes greater than the median worker income should not have their incomes subsidized by tax dollars.

    I think the TFSA limit should be determined based on what is appropriate today. Although the $10K limit is not indexed to inflation, a future government would eventually raise the limit again, or index it to inflation at that time.

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    1. @Justin: I agree that the TFSA limit should be set based on what is appropriate today. It should also be indexed. However, I don't think $10,000 per year with indexing is sustainable. Responsible future governments will either cut the limit, or more likely, allow it to erode with inflation for a long time.

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    2. What would be an acceptable TFSA limit, then, Michael?

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    3. @R: I haven't done any deep analysis, but I think the original $5000 (now $5500 with inflation made sense). There are a couple of reasons why TFSA room is more costly to governments tax-wise than RRSPs. The first is that TFSAs hold after-tax dollars. For someone at a 50% marginal tax rate, a dollar of TFSA room is worth twice as much as a dollar of RRSP room. The second reason is that TFSA holdings can remain sheltered from tax your whole life, but RRSP holdings have to start getting taxed at age 71.

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  4. Thanks for this, I was going to point out the need for a smooth taper on Mark's post, but didn't have the time yet. I agree that the thresholds could be shifted down (e.g. to make the last dollar of OAS in the ~$70k range vs the first clawback). Given the talk about the importance of inflation to the TFSA, perhaps just stop adjusting the OAS claw-back threshold for inflation?

    IMHO, GIS could also use a more gradual taper (~30 cents for each dollar vs 50 cents? Hard to say exactly what to make it but that "feels" more right to me), perhaps starting a touch earlier to balance that out.

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    1. @Potato: The question of when to clawback OAS is difficult because I think it should be different for individuals and couples. $70k may seem a lot to young people now, but a widowed senior with an income of $70k might actually need OAS money to stay in the long-time family home. But a couple both earning $70k certainly don't need OAS money.

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  5. What a relief to read a money advisor who has actually thought through BOTH the individual and broader societal implications, rather than a knee jerk reaction either way. Thank you. A breath of fresh air in a very rank environment.

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    1. @Jean: Thanks for the compliment. I'm certainly driven by self-interest, but I try to consider others as well.

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  6. 1. Great blog - thanks for keeping it!
    2. Got to this old post and it's the first one which seems questionable:

    - Not only will it take a long time to inflate 5,500 to 10,000, but there could be a million changes in the intervening years. One of those election years there could be further increases to the TFSA limit.
    - It's irrelevant whether people use up all their room or not. It is relevant that we want to encourage saving, particularly in young people. TFSA is designed for young people (vs RRSP, which is focused on middle-aged).
    - Most people use TFSAs as savings account. This shields current tiny interest gains from the taxman. Otherwise people are forced to let the combined impact of taxes and inflation to erode their capital. I never understood why it was reasonable to tax the part of the interest which compensates for inflation.
    - The logic of increasing TFSA limit is to kill the principle of double taxation. Our money - whether savings or investments are already taxed; typically more than once.

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    1. @BHCh: I'm afraid I don't find these points convincing.
      - I think $5500 in today's dollars is a sensible limit. I prefer to see it indexed for the benefit of my children.
      - Young people are encouraged to save with a $5500 limit. They don't need a higher limit. Increasing the limit would mainly benefit older people who have high incomes or large savings (like myself).
      - We're not talking about taking away the TFSA. People get the benefits you describe. It's only wealthier people who could get even more benefit from a higher limit.
      - Taxing the returns on capital is not "double taxation." The logic of increasing the TFSA limit is to shift more tax burden away from return on capital and toward earned income. I don't think we need more of this.

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    2. - Exactly $5500? Not $3000? Not $5550? The argument about children does not work because of multiple changes which will happen over the next 20 years. Mean time any child hitting 18 in 2016 (like one of my kids) is clearly disadvantaged vs those who hit 18 before him.

      - Let's not talk on behalf of all young people; they are different and some of them may well "need" the extra room. Graduate engineers, accountants, etc... typically get $60-80K. They often try to save for housing, family... Whatever. To be encouraged.

      - Who is "wealthy" is a relative term; crucially there is no economic advantage in discriminating against "wealthier" on principle.
      - Taxing on interest (which is what most people get from TFSA savings) = eroding the actual capital, which was gained on taxed income.
      - Taxing return on capital is bad for Canadian economy in general, which suffers from low productivity and poor investment.
      - "shift more tax burden away from return on capital and toward earned income." Really? No other options? Like consumption taxes or reducing government expenditure?

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  7. @BHCh: Your latest reply is pointlessly argumentative. $10k is higher than it needs to be. $5500 is more reasonable. Missing out on a one-time $4500 contribution is a small matter for anyone who will actually earn enough money to use it.

    Let's look at the top end of the pay range you suggest: $80k. How many people earning $80k will use all $14400 of their RRSP room plus all $5500 of their TFSA room? Not many. Running out of both is a problem for much wealthier people.

    I'd be thrilled to see a reduction in government waste. But I don't see how reducing taxes for the wealthiest Canadians achieves this.

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  8. Most Canadians are wealthy compared to most of the world's population. Being "wealthy" not a good reason to hike taxes.

    In the example I gave it would make no sense for a graduate earning $80K to use up his RRSP room rather than TFSA. His future earnings will be higher; he would likely suffer a net loss to the taxman. Besides, most engineering companies have pension plans, leaving no RRSP room.

    Maybe I didn't make my point very well, but neither $5.5K nor $10K limits make any logical sense. Our economy is starved for investment while public is spending too much leading to excessively high borrowings. Fast increases in cumulative TFSA room remove harmful taxation on people who save and invest.

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    1. @BHCh: The ironic thing about this sort of discussion I've had with a few people is that I don't feel strongly about the TFSA limit change. I lean toward moving it back to $5500, but not strongly. However, I am strongly against nonsense reasons given for not making the change. I've seen many tortured efforts to portray a higher TFSA limit as a benefit to typical members of Canada's middle class. This is nonsense. A higher TFSA limit helps those with significant savings or high income. The idea that this applies to a significant fraction of millennials is laughable. And the few millennials it does apply to don't need the help. There is nothing wrong with arguing that tax breaks can make sense for wealthier people in some cases, but don't pretend that a higher TFSA limit is a benefit to Canada's middle class.

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    2. Don't think either of us mentioned "middle class" up until now. It does not matter whether we call impacted people "poor", "middle", the "1 percent" or whatever. Let's call them "Pete". Increasing taxes on savings and investment as opposed to consumption is bad for those people who are trying to save, and it's bad for the Canadian economy in general.

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    3. Incidentally, pretty much every Canadian believes himself "middle class", which makes the term just as meaningless as "wealthy". The latter stands for "someone who has more money than me". It makes both terms very convenient for politicians, but not particularly helpful when putting forward logical arguments.

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    4. @BHCh: That's a bold point of view. Eliminating taxes on the return on savings (interest, dividends, and capital gains) would be a major departure from current tax laws.

      If all words with imprecise meanings are to be banned from logical argument, I guess you shouldn't have used the words "long", "young", "middle", and several others. I thought you might have had some interesting point to make, but the uninteresting argumentativeness is changing my mind.

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  9. Either that or you missed the point entirely because you are so focused on the rich/poor thing.

    And let's be clear - what you are supporting in this post is the INCREASE in taxes on the capital, savings and investment. Why? Because the government will be so much better at what they call "investment" than individuals.

    Alright, I am done here.

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