Investing

Chequing Or Checking? How Canadian And U.S. Personal Finances Differ

photo: borderfilms (Doug)

Canada and the United States may be right next to each other and share a language, but when it comes to investing and personal finances in general — and the tax implications in particular — there are a lot of disparities between the two countries.

Whether you live in Canada, are considering doing so or are simply curious, here are the top five differences in how Canadians and Americans handle their finances.

You Think Your Taxes Are High?

Because of the health care system and other social programs, it’s generally expected that taxes are higher in Canada than in other countries, but by how much? Based on 2005 data for a household earning the country’s average wage, a single person with no children was paying 31.6% of their income to taxes in Canada, while the same person in the U.S. was paying 29.1%. While that’s rather close, the gap widens quite a bit for a married couple with two children, paying 21.5% in income taxes in Canada but only 11.9% in the United States.

What Happens in Vegas…

While Canadians have higher personal income tax rates, it doesn’t mean we pay that rate on all money we bring in. If Americans win a big prize, from a lottery or gambling, they have to pay taxes on those winnings as a form of income. (Indeed, not all that happens in Vegas stays there.)

In Canada, on the other hand, we don’t get taxed on our winnings. I’m not saying that gambling is a great financial decision, but if I were to win $1 million, I don’t have to give the government any of it!

Home, Sweet Home

In the US, the interest portion of your mortgage payment is tax deductible, but in Canada it isn’t. While you certainly need a home to live in, and most people are not able to buy a house without taking on some debt, it does make a mortgage slightly less of a “good debt” than it is in the United States.

The Canada Revenue Agency does, however, allow a deduction for the interest on an investment loan. This has lead to a concept called the Smith Manoeuvre which, at it’s simplest, converts your mortgage into a deductible investment loan. This is done by using a readvanceable home equity line of credit to invest in dividend paying stocks, then taking the dividends to accelerate the mortgage payments and borrowing the newly available room in you HELOC to invest in more stocks. This cycle can pay down the mortgage faster and get you investing sooner, but does eventually leave you with a large investment loan. Once the mortgage is paid off, you could decide to sell the majority of your investments to pay off the investment loan, but if you’re comfortable with that debt, you could keep things as they are, since the dividends would likely be paying more than the cost of the interest, after tax savings.

Who said home ownership had to be simple?

The Retirement Alphabet Soup

Canada’s Registered Retirement Savings Plan, or RRSP, is similar to the 401k in the United States. Both plans grow tax free, but you are taxed at your marginal tax rate when you make a withdrawal during retirement. While 401ks are employer-sponsored, RRSPs are mainly set up by the individual. (Somewhat like Individual Retirement Accounts, or IRAs, in the U.S.) Because of this, 401ks may make it simpler for someone to get started investing. However, there are more choices available to Canadians and since most will invest with after-tax money (some may have the option to contribute through work), it will create a tax refund at the end of the year.

The 401k and RRSP both have annual contribution limits; the 401k allows $16,500 in 2010 while the RRSP gives you contribution room of 18% of your income with a maximum of $22,000. Another bonus of the RRSP is that the unused contribution room is carried forward each year. Because of this, it may actually make sense to not invest in an RRSP in lower income years and let the contribution room build up to have more available to reduce the tax burden of higher income years.

Another advantage of the RRSP: yhe 401k has a 10% penalty for early withdrawal, while the RRSP does not. (On the flip side, the penalty encourages Americans to keep their money in the 401k for their retirement.) Canadians, on the other hand, can employ some nifty tax strategies, such as contributing during high income/high tax rate years and then withdrawing some of the money at a lower tax rate when leaving work to go back to school or to care for children.

Saving for College

Both Registered Education Savings Plans, or RESPs, in Canada and 529 Plans in the U.S. allow you to save for post-secondary education while sheltering the money from taxes. Both also come with penalties if you don’t use the money for that purpose.

While some states in the U.S. have grants or offer state tax deductions for your 529 contributions, the RESP has the Canadian Education Savings Grant (CESG), which matches 20% of your contribution up to $500 each year. So if you contribute $2,000 a year, the Canadian government will add an additional $400.

Withdrawals from 529 Plans are not taxable if used for qualified education expenses, but RESP withdrawals are taxable for the beneficiary. But this isn’t a problem for most Canadians, since the beneficiary is likely making very little money and will have a low marginal tax rate, maybe even 0%.

Tom Drake is the head writer for Canadian Finance Blog, writing about universal topics such as saving, frugality and earning extra income, as well as Canadian specific topics like RRSPs and TFSAs. Tom’s other site is Money Index, which aggregates all the best sites into one easy to use source for everything finance.