Marguerite, a 57-year-old manager, is currently maximising her tax breaks by investing in a stock-based registered retirement account. This plan also gives her the option to direct some or all of her savings to a money-market-type fund that offers a guaranteed return of 1.0 per cent per year with a switching feature between the two investments at anytime.
Marguerite recently received a call from the account representative who advised that the fund has been doing better than expected and that she should consider increasing her contributions from $2,000 per month, especially in light of the fact that the tax limit for such plans would be increased from $30,000 to $50,000 annually commencing January 2015.
At 60, the company could either convert all of her savings into a monthly pension for life or refund a quarter of her contributions together with all of her interest/returns as a tax-free lump sum in addition to a reduced taxable pension.The company advised that for planning purposes her pension income could be calculated at an annual investment rate of return of 5.0 per cent.
The representative projected the cash value of her current investment to the end of 2014 (10 years from her first $2,000 payment) to $275,800. Marguerite wants to know how she did as an investor and what her pension and tax position will be when she retires if she increases her contributions as her agent suggests.
Nick's assessment and advice
Pre retirement tax implications
If what we were told is correct: Marguerite's is maximising her tax deductions contributing $2,000 per month to a registered retirement plan. To the end of 2014 the tax deduction limit for such plans inclusive of contributions to employer pensions plans and 70 per cent of NIS–is $30K. Anything above this limit does not make sense as the extra savings will not gain any favourable tax advantage and will be liable to a tax charge at retirement.
From 2004 up to 2009 the tax limit moved between $12K and $25K–it is only from 2010 was the limit increased to $30K–so in Marguerite's case she may have exceeded the limit for some years until 2010. With the new limit of $50K she can now increase her contributions by $20K totaling $44K per year.
Fund performance
Financial institutions often give fund performance figures either from inception, over 5-10 years or even for the last 12 months. As regards to how this affects individual investors it may vary depending on the fund unit price changes, when the client started investing and the charges that the fund is subjected to.
In Marguerite's case she will have invested a total of $240,000 by December 2014 but with a value of $275,800–using time value of money calculations we discover her annualised return was in the vicinity of 2.74 per cent.
So despite the account representative's claim that the fund did better than expected it really did not mean much for Marguerite. You would realise that we were not told what the expected return was in the first place to assess how much better the fund performed. In any event Marguerite needs to determine if this return was commensurate with the extra risk that she undertook.
Investment selection and projection
A good thing about Marguerite's case is the fund-switching feature from the riskier stock market fund to the safer money market based investments. As Marguerite approaches her retirement date she should ideally shift from higher to lower risk investments. Her primary focus at this time is getting the tax break and securing her capital whilst simultaneously realising any gains from the variable stock fund.
If Marguerite switches her $275,800 to the 1.0 per cent money market option come January 2015 and bumps up her contribution to $44,000 per year ($3,667 per month) she can expect a future value of $418,151 in three years.
Retirement options & tax on pension
(Refer Table 1) At retirement the company can take the $418,151 and convert it at 5.0 per cent to a full taxable pension of $20,908 per year ($1,742 per month). She has the other option to take all of her returns and or interest plus 25 per cent of her total contributions as a tax-free lump sum and the remainder of her contributions used to generate a reduced pension.
If the monthly pension calculated here were fully subjected to tax then she would pay less tax if she were to take the lump sum and a reduced pension. As at the last budget, retired persons over the age of 60 will not pay any taxes on the first $6,000 of taxable income, which does not include NIS pension.(Details were modified to protect client's identity)
Nicholas Dean (Cer-Fa) is a financial coach and mentor who is the managing director of the Financial Coaching Centre. He can be contacted at:
nickadvice@gmail.com www.FinancialCoachingCentre.com