Loonies And Savings Plans

Back in August, I wrote my Loonies And Lexicons post, which attempted to draw parallels between Canadian and American personal finance terminology. I wanted to follow up with an exploration of the different savings plans available in Canada and the US. Specifically, I'll be focusing on the education and retirement savings plans that offer a tax advantage.

Education

In Canada, parents can save for their children's education using an RESP, whereas the American equivalent is the 529 plan (named after section 529 of the Internal Revenue Code). The basic idea of the accounts is the same, but the details are different:

RESP

• Contributions are made with after-tax dollars


• Interest and other investment income in the account are taxed upon withdrawal, at the recipient's tax rate. Since the recipient is a student, their tax rate will typically be in the lowest bracket (if not zero), due to their low income and education tax credits. This means that the growth of the account is very tax-efficient


• There is a lifetime contribution limit of $50,000; any contributions over this limit will be subject to taxation


• Through the CESG, the government will match 20% of the first $2,000 in annual contributions to the account. Note that the CESG match is taxed as interest when it is withdrawn by the recipient

529 Plan

• Contributions are made with after-tax dollars


• Interest and other investment income in the account are not subject to federal tax upon withdrawal


• Two types of plans are available:
  
  • Prepaid Plan - Tuition "credits" are purchased, at today's rates, to be used in the future. Think of this as a defined-benefit plan, with performance based on tuition inflation
  
  
  • Savings Plan - Contributions to the plan are invested, and their future value is based on investment growth. Think of this as a defined-contribution plan


• Specific plan details vary from state to state, but investors can choose to join an out-of-state plan. Several states, however, offer state tax advantages, as well as matching grants, for investors who participate in their own state plan

Note that the tax treatment of 529 withdrawals can be much more favorable than that of RESP withdrawals. Canadian Capitalist, Quest For Four Pillars and Million Dollar Journey have written extensively on how to navigate RESPs.

Retirement

In Canada, the only tax-advantaged retirement plan is the RRSP, while the US offers a variety of IRA options.

RRSP

• Contributions are made with pre-tax dollars, and withdrawals at retirement are fully taxed as income


• Employers will often offer employee savings plans, with contribution matching via a DPSP, which are treated as RRSP contributions when withdrawn at retirement. DPSP contributions are typically subject to a vesting period


• Annual contribution limit is 18% of previous year's earnings, up to a maximum ($19,000 for 2007)


• If an individual participates in an employer's pension or DPSP, then they receive a pension adjustment which reduces their contribution limit for the next year

IRA

• Two flavours of IRA are available:
  
  • Traditional IRA - Contributions are made with pre-tax dollars, and withdrawals at retirement are fully taxed as income
  
  
  • Roth IRA - Contributions are made with after-tax dollars, and withdrawals at retirement are not taxed


• Annual contribution limit for 2007 is $4,000 if under 50, and $5,000 if 50 or older. If an individual holds both a traditional and Roth IRA, then the limit applies to the combined total of contributions to both plans


• Employers often offer a 401(k) plan, which is also available in both traditional and Roth varieties. 401(k) plans often include an employer match on employee contributions. As with the 529 education savings plan above, the 401(k) is named for a section of the Internal Revenue Code. 401(k) contribution limits for 2007 are $15,500 if under 50, and $20,500 if 50 or older


• Certain kinds of employers may not be eligible to provide a 401(k) plan, but may be able to offer a 403(b) or 457 plan as alternatives

Canadians do not have an option equivalent to the Roth IRA; income from investments made with after-tax dollars is subject to applicable taxes (whether interest, dividend, or capital gain). Note that the 2007 contribution limits for Canadians and Americans under 50 are roughly equivalent ($19,000 and $19,500, respectively).