The Canadian government recently announced that it would do everything to make sure that retirement plans such as the Old Age Security (OAS) plan and the Canada Pension Plan (CPP) would not disintegrate (a concern of many Canadians who have been banking on these plans). While this is good news for the most part, there is still a large amount of confusion surrounding the two types of retirement plans. Here is some basic information about both OAS and CPP plans that you may find helpful when planning your retirement strategy.

Canada Pension Plan Basics

• Unlike the OAS plan, the CPP plan is open to all Canadians who have contributed to the system through paycheck deductions. As such, the amount of money given through a CPP depends on two factors: the length of time a person was working and how much that person paid into the system throughout working years.
• Requesting to receive CPP funds prior to one’s 65^th birthday will result in a small penalty, though early withdrawal is possible. The penalty in this case is 0.52 percent (at the time of this writing) that will be applied to each month prior to a person’s 65^th birthday (for example, if you start 4 months early, the penalty will be a total of 2.08 percent and so on).
• Anyone who does not request to receive CPP funds on the start of a 65^th birthday will be given increased funds (0.64 percent monthly, at the time of this writing).
• Canadian citizens can apply for the CPP plan at any time, though most people wait to apply for this plan six months prior to the start of CPP payments.
• Contribution-wise, self-employed individuals must add 9.9 percent of business income to a Canadian Pension Plan. Those who are not self-employed will contribute 9.9 percent as well, though half of this amount is paid by an employer. Maximum yearly amounts fluctuate on a yearly basis.
• How much money can you hope to gain from a CPP retirement pension?  The average monthly CPP benefit in 2011 was $512.64. The maximum payment in 2012 is $987.67. On average (according to a Service Canada statement based on 2002 statistics), people who have earned an average wage of $39,100 annually can hope to receive $788 in CPP benefits per month. Annually, that number rounds out to $9,456. Is this a large enough amount for you to retire on?

Old Age Security Basics

• If you have been living in Canada for ten years following your 18^th birthday, you can apply for the OAS plan. Likewise, you can apply for this plan if you currently live outside of Canada but are a Canadian citizen or resident and have spent at least twenty years living in Canada (following the age of 18).
• Full plan: in order to gain full pension plan benefits, you must have lived in Canada for forty years following your 18^th birthday.
• Partial plan: if you did not live in Canada for forty years following your 18^th birthday, you may qualify for a partial pension plan. A partial plan is based on the number of years that you have resided in Canada following your 18^th birthday. A minimum payout equals ¼ of the total (adding up to ten years lived in Canada).
• It is only possible to apply for the OAS plan six months prior to your 65^th birthday.
• Anyone applying after the age of 65 will gain up to eleven months in missed monthly payments retroactively in addition to a payment for the month in which that person has applied.
• Following OAS approval, the amount of OAS pension given will not fluctuate (even if you spend more or less years in Canada).
• According to Service Canada, the average OAS pension payout monthly was $508.35. That monthly amount rounds out to an average of $6,100 per year.

Are Government Plans Sustainable?

Both the CPP plan and the OAS plan seem relatively stable. However, there is some doubt as to whether or not CPP and OAS plans will be sustainable looking towards the future. Given the present state of the unstable economy, many financial forecasters are uncertain as to the future of the CPP and OAS plans.

Some also caution that the number of taxpayers compared to the number of pensioners is not equal, and this could spell certain disaster for those who have not made additional retirement investments.

Based on the information listed above, retirement income from both CPP and OAS plans will, on average, total annually roughly $15,556. Will a yearly income of less than $16, 000 be enough for you to live off of? (especially considering the rising cost of living). And while both the CPP and OAS plans look good on paper, it is wise to seek out additional retirement investments just in case these government plans don’t pan out in the long run.

What does RRSP’s do? The most typical response to this question is that they defer taxes. Should you get that answer as well, then you’ve got it only half right! The part you may have overlooked may be more important to your future than you may realize!

So then, what does RRSP’s really do? The correct response is that they affect you in two ways:

Firstly: They do defer taxes.

Secondly: They also defer the tax calculation.

Your tax bracket plays a very important role in this discussion, and while many Canadians focus only on the tax bracket they are in today, the tax bracket that they will be in when they finally take the money out is of as much importance if not more.

What Tax bracket will you be in when you take this money out?

Let’s assume you are investing money in an RRSP. You probably thought doing so would save you taxes. You may have even received information from tax professionals that you will “save” taxes. The truth is that RRSP’s are not tax savings accounts at all, they are tax deferred savings accounts. That means that you will eventually have to pay the tax.

The pressing question is at what bracket?

If you take the money out when you are in a lower tax bracket from the tax bracket you were when you have put the money in—you win. You saved taxes, but there’s no way of knowing that today.

If you have to take the money out when you are in a higher tax bracket—you lose.

An interesting thought: At the time of “withdrawal”, the Revenue Agency is not going to ask you what was your tax bracket at the time of your contribution; their only concern is at what bracket you are at the time of “withdrawal”.

what will be your tax bracket during retirement? Higher or Lower? Perhaps the same?

Let’s say you wanted to borrow $10,000. You would ask two questions from the lender before you took the money.

1: The first question would be, “how much interest do I have to pay”?

2: The second question would be, “when do I have to pay it back”?

If the lender responded by saying, “Right now we have enough money and don’t demand any payments from you at present, but there will come a time however, when we will need to be reimbursed. At that particular time, we will know exactly how much we need, and only then we’ll be able to determine exactly how much interest we have to charge you to get the required amount”.

Would you cash that check?

Absolutely not; but this is exactly what is being done with RRSP’s.
Keep in mind that the government is not saying you do not owe the tax. They are simply saying you can pay the tax later. At what bracket? That is a good question!

By knowing this, you may realize that it’s impossible for anyone to calculate how much money you will “save” by making a contribution today to an RRSP. It is impossible precisely because you have no idea in what tax bracket you will be at the time of withdrawal.

Let’s Assume that you are now in a 30% tax bracket and you wish to make a contribution of $10,000 to your RRSP. The best assessment of how much the “apparent tax benefit” of making a $10,000 contribution today, would be $3,000.

What many fail to realize is the fact that the $3,000 you “saved” in taxes today will be due with interest in the future. You wrote the check for $10,000 to the plan but you only have $7,000 in the plan. The government has their share ($3,000) in the plan as well. Had you claimed the $10,000 in income you would have paid your tax of $3,000 and received the balance of $7,000.

Just because the government allows you to defer the tax doesn’t mean that you saved the tax. In reality you have not saved any tax at all! You simply did not have to pay it today. The money you think you are saving is actually in your RRSP. They understand opportunity cost as well! They will want their $3,000 back one day with interest. Your share earned interest and so did theirs.

If the account value grew to $1,000,000 your share would be $700,000 and the governments share would be $300,000 assuming a 30% tax bracket.

Should they decide they want more and taxes go up when you start taking the money out, your share goes down.

If you listen to the wisdom of many accountants you will hear that deferring your taxes is a good thing because when you retire you will be in a lower tax bracket. They are not necessarily wrong because many people do retire in a lower tax bracket. The reason is not that taxes are less during their retirement years but rather many Canadians are broke, they cannot afford to retire at the same level of income they were making while working. Sad but true.

While many people do retire in a lower bracket remember that you do not have to be one of the “many”.

Do not misunderstand what we are saying. We are not saying these plans are bad. We are simply helping you understand what they do.

These plans can be a great source for retirement savings and most people who have access to such plans should consider using them, especially if you are getting a company match.

If you are not getting a match what are you getting? Tax deferral? It is better than trying to accumulate money in a taxable environment but do not forget you will pay the tax.

There are many rules that you need to know about access to the money in these plans. For instance one of the rules are that you must start taking out the required minimum distribution at a certain age and pay taxes on it even if you don’t need the money at that time and even if you are in a higher tax bracket at the time and it is not in your best interest to do so. Who is helping you with the rules?

If your thoughts were challenged with this information we would recommend that you sit down with a financial services professional and allow him to help you gain a better understanding on what type of retirement plan fits best for you.

You should understand that with RRSP’s you are not necessarily saving taxes. You are simply deferring them and you will have to pay them at some future time with a tax bracket yet to be determined. Your tax bracket could be higher or lower at that time.

Here is an even more compelling reason to get together with someone who can help you with the rules.

What is your exit strategy? Is your plan to pay all the tax? If there were opportunities to avoid paying some of the taxes would you want to know how to do that?

Assume for a minute that you were an apple tree farmer and had to choose between two alternatives regarding the payment of your taxes.

1. You could pay taxes on the seeds that you plant, or
2. You could pay taxes on your harvest.

Which would you choose?

If you are like most people, you would choose to pay taxes on the seeds. After all, you can harvest apples from an apple tree year after year after year…so why pay taxes on all those apples if you had the chance to just pay taxes once on the few seeds you plant?

When saving for retirement, you have a similar decision to make:

1. You can pay your taxes now on the money you put into your retirement savings (which is like paying taxes on the seeds), or
2. You can pay taxes later…each time you pull money out during your retirement… (That’s like paying taxes on the harvest).

Which of those alternatives are better?

We hope this post made you realize that there is much more you need to know about these types of retirement plans.

Albert Einstein once said that compound interest coupled with time was the most powerful force of all time. He was a pretty smart guy!

Compound interest is really a math concept that shows the power of making interest  not just on your principal but also on the interest. If you have $1000 and you make 5% interest, after the first year, you will have $1050. If you let the interest compound, the second year you will not make $50 of interest again but rather $52.50 of interest because you are making 5% off the $1050. After the second year you will have $1102.50. In the third year, you will have $1157.63

The rule of 72. The rule of 72 is an easy way to estimate the effect of compounding. Basically the rule of 72 works like this. Take an interest rate like 5% and divide this number into 72. 72 divided by 5 equals 14.4. The answer is the number of years it take for money to double. In other words, $1000 at 5% will double to $2000 in 14.4 years. At 6%, it will only take 12 years for money to double in value. A 1% increase in interest rate cuts the time frame by 2.4 years.

Keys to making compound interest work for you:
Time – Investing early is very advantageous because with the math of compound interest it plays a big role in helping you to grow your money. Compound interest and time has sometimes been referred to as the eighth wonder of the world. Let’s show you a quick example of the benefits of starting early.

But first, here is my question to you; If someone would offer you to choose from one of the following two options, he is ready to give either a onetime lump sum of $10,000 OR he can give you for the next 30 days starting today with one penny, tomorrow 2 pennies and will go on to give you every day double the amount of the day before until the 30 days end, which of the 2 choices would you choose?

are you ready for my choice? I would pick the penny doubled every day for 30 days, Why? although that in the first week it does not even reach to be worth one dollar, at day 30 it is already worth more than $5,000,000 and if these 30 days would of started only one week late with the first week missing it would be worth at the end only approximately $100,000 this is the power of time, the power of doing it earlier with 7 days!!!

Cindy Elizabeth is 25 and starts investing $1000 per year right away. She invests $1000 per year for the next 10 years for a total of $10,000 but then gets married, starts having kids and wants to stay home with the kids so she quits work.

Elizabeth’s twin brother late Larry took some time off to travel Europe. He then came back and instead of working decided to go back to school and get another degree. He starts working at the age of 35 and starts putting away $1000 per year for the next 30 years. Over that 30 years, he invests a total of $30,000 which is three times more than his sister Elizabeth.

At age 65, Elizabeth and Larry compare portfolios and Larry is shocked to see that he only has $122,346 compared to Elizabeth’s portfolio of $157,435. Even though he invested 3 times the money, he has less because compounding plays a big role if you can start investing sooner than later.

Compound interest is an old concept but is very powerful and such an important one to know.