Tax Credit for Student Loans

In the process of helping some students in my family with their finances, I came across the fact that certain types of student loans benefit from a tax break on the loan interest.

The benefit is in the form of a tax credit, meaning that it is a straight reduction of tax. Other key features and conditions (see CRA's page on tax matters for students) include:

• the credit is non-refundable, meaning that if the student has no tax to pay before applying the credit, the credit is not refunded and the credit goes to waste; in other words, apply for the credit only when there is tax to pay.
• the credit does not have to be used in the same year as the interest on the loan was paid, it can be carried forward and used up to five years later
• the credit is not transferable to another person, like a parent or spouse, only the student him or herself can use it, even if someone else actually paid the interest
  
• the credit is calculated at the lowest Federal tax rate (currently 15%) plus the lowest Provincial tax rate (e.g. Ontario is 6.05% so $100 interest would get the student $21.05 in tax credit/reduction); Québec as usual does its own thing and gives 20% flat credit; the credit does not change or increase if the student is in a higher tax bracket and since it is a tax credit not a deduction that reduces taxable income it cannot help to bring someone down into a lower tax bracket; in other words, there is no advantage in waiting - as soon as the student starts earning enough income to have tax to pay, he/she should claim the credit.
• the credit only applies to loans issued under the Canada Student Loans Act, the Canada Student Financial Assistance Act, or similar provincial or territorial government laws for post-secondary education (to check if a loan qualifies, ask the national student loans service center or see the list of provincial student loan contacts here on Canlearn.ca); loans from banks or private lenders don't qualify, nor does a qualifying loan if it has been combined with or refinanced as a private loan
• the claim is made on line 319 of Schedule 1 Federal Tax of the T1 and on the corresponding line in the provincial tax form - e.g. line 5852 on ON428 Ontario Tax
  

Manulife One: a Mortgage-Banking Combi Product to Like

So often one comes across financial products that sound good in principle but are not good value for money. It looks to me that Manulife's ONE Account is a winner that every aspiring homeowner should have a good look at. Back in 2007, Million Dollar Journey did a review of Manulife One and generally seemed to like it, though not as much as me.

How It Works: The account combines a mortgage with a normal chequing and savings bank account. Every day, Manulife sums the positive amount on deposit on the bank side with the negative amount in the mortgage to arrive at a net amount borrowed, and then calculates interest at the mortgage rate on the net amount. There is no interest paid on the savings while the mortgage is not yet paid off and the daily balance is negative. Meanwhile the bank account can be used like any normal chequing account to pay bills, write cheques, withdraw cash at ATMs, the whole bit. If you ever suddenly need to spend extra, and go overdrawn, that is possible too, up to 90% of the appraised value of your home according to Manulife.

As an aside it is surprising that these types of accounts are not more prevalent in Canada. In the UK they have been around for many years and are commonly known as offset mortgages or current account mortgages (because the savings offsets part of the debt).

The Key - Staying Positive: The account works best when there is a positive bank balance however small and variable, because this accelerates paying off the mortgage. It does so not just by a bit but by a surprisingly enormous amount, in many cases years off the time it takes to pay off the mortgage. Manulife has a calculator on its site in which you can plug in your own numbers to see by how many years and how much interest is saved. If you have your pay deposited into the account and then use it till the next pay for normal household spending, then there could/should be a net balance throughout, which reduces the net debt and the interest charged.

Earning a Higher Rate with Savings: One of the neatest aspects is how a positive bank balance works in your favour. Instead of having your money sitting earning around 0.5%, the going rate these days on many chequing accounts, and which is taxable (perhaps taking another third off that, making it more or less zero), it saves interest at the much higher mortgage rate, currently around 4.75% for variable mortgages, which is after-tax dollars by the way. That's the equivalent of earning 4.75% on your bank balance. Getting no interest paid to you on the bank balance even saves the hassle of reporting the puny interest to the CRA of your annual tax return.

Multiple Applications: Manulife suggests several other uses of the account

• debt consolidation and reduction of net interest costs by moving higher rate credit card debt, car loans, personal loans into borrowing against the secured debt of the mortgage, which is the cheapest rate available
• access to home equity or reverse mortgage replacement for retired people
• emergency savings fund instead of keeping this in a savings account, term deposit or GIC, which will earn less than the interest saved on the mortgage
  

Life on Autopilot: The great feature of the account is the combination by Manulife makes it all happen automatically. So many good plans for paying down a mortgage early never happen through neglect or being too busy with life.

Value for Money: All these benefits would be lost if the pricing was bad, the mortgage rate too high, the options too restrictive or the account fees uncompetitive. Happily, Manulife's pricing seems to be very comparable and competitive all round.
Mortgage rate - the open variable rate at prime 4.75% matches the big lenders and the 1 year seems to be the lowest around (see table from Cannex that I downloaded today)

Banking fees - the $14/month fee looks roughly comparable to big bank chequing options e.g. Bank of Montreal's Performance Plan charges $13.95 per month unless one keeps a minimum $2500 balance, which earns a princely 0.5% per year; Scotiabank's PowerChequing is better at $3.95 month unless a $2000 minimum balance is maintained, which earns exactly 0%. Nevertheless, even at $10 / month extra, the thousands saved in mortgage interest more than makes up for it.

Downside - Debt Temptation: The only downside I can see is that anyone with a tendency to get too easily tempted to use the borrowing margin and increase debt instead of paying down the mortgage will find this account too convenient and easy to abuse.

Other than that, I say kudos to Manulife for a smart, flexible and good value product that enables Canadians to pay down their mortgage much faster and with money that they are actually using for their everyday expenditures.

Investing an Inheritance: How to do a "File and Forget for Forty Years"

Most of us save for retirement in tax-deferred accounts like RRSPs and LIRAs. But what happens when you suddenly receive a large lump sum and you do not have RRSP contribution room, in other words you must invest in a taxable account?

Here's a situation I've come across recently that got me thinking and researching. (Initially, I thought it was simple but it has taken me some time to figure it out to get the practical details right.)

Situation:

• $50,000 inheritance, specified in the will to be "for retirement"; a very wise thing the person who died has done, creating a very strong moral, if not legal impediment to spending the money since half the battle of saving is actually doing it; I would note in passing that the person receiving the inheritance does not have to include the amount in income and pay tax since that would already have been done in the process of settling the estate; I would also note that it is not a testamentary trust, which could absolutely ensure that the money not be touched till retirement.
  
• 40 years till retirement; the person is in his twenties so the planning horizon is at least that long; due to the above-noted restriction on the lump sum, it is highly likely that the actual time horizon will correspond to the planned horizon - in other words, people frequently suddenly decide that their "retirement nest egg" needs to be cracked open for an omelette craving today, thus blowing the value of a long term approach to smittereens.
  
• No RRSP room: the inheritance must go into a taxable account, which means that income taxes for various types of investment returns (interest, dividends and capital gains) can play a crucial role in net returns, especially over the long term; though the person could or should intend to move the investments progressively into an RRSP as his career advanced and contribution room became available, in this case, his apparent career orientation into government or educational jobs suggests that one of those golden defined benefit plans will use up most or all of tax-deferred pension room, so it is better to plan as if it will not happen
• Maximize net after-tax wealth: obviously ... but he is not interested in high-risk investments that may suffer absolute final losses, as opposed to waiting through market ups and downs, and subject to the following constraint,
  
• Zero maintenance and attention portfolio: the person would ideally like to have to do nothing at all for forty years! No buying and selling, no rebalancing, nothing, if at all possible; unfortunately, it is still required to file a tax return every year, so tax reporting simplicity is a consideration. As a consequence, things should be as simple as possible - few holdings at one broker.

General Principles: these should always apply to investing

• low costs - paying higher fees for others to manage your investments is a sure way to end up with less; 0.1% less per year can add up to many thousands difference after 40 years - 4.1% return compounded will see $50k reach $240k while 4.2% yields $249k; high MERs = low net returns; this eliminates from consideration all equity mutual funds except index trackers
  
• diversification - the "not all eggs in one basket" and "some go up while others go down" factors entail being invested in many assets with as low as possible correlation with each other; this ensures that there is a net gain, not a loss, over the long term
• tax-effectiveness - deferring and reducing taxes means a greater net in the future; tax rates in Canada are lowest on dividends, higher on capital gains and highest on interest as this previous post on tax rates shows. There is a significant advantage to dividends for all taxable income up to the mid-$70k range, which is where our person is most likely to end up based on his career path. However, the portfolio diversification principle must be respected - meaning that it is not acceptable to ignore the fixed income component of a well-structured portfolio merely to avoid taxes. Fortunately, there is a way - substitute preferred shares returning dividends for bonds returning interest income.
  

The Proposed Solution: this is necessarily a combined solution of portfolio and broker/financial service provider due to the practical constraints outlined below; theory may tell us to do things a certain way but it is not quite possible in practice.

There are three good alternative solutions, the best ranked first.

1. Portfolio of Four ETFs at Questrade

Portfolio Composition:

• 35% / $17,500 XIC - iShares Canadian Composite Capped Index Fund, MER 0.25% (the alternative is XIU, the TSX 60 fund, which has a lower MER of 0.17% and distributes much less income as interest, but it only includes the 60 largest companies as opposed to the 270+ companies in the Canadian market, which means less diversification as the 60 only account for three-quarters of total market value of the TSX and presents less opportunity to benefit from small company growth, from income funds and from real estate); negatives of XIC are the MER and the fact that some of the annual distributions are higher-taxed interest; XIC exemplifies the simplicity and advantage of a fund that enables one to own a piece of a large number of assets/companies through one purchase; in the proposed portfolio XIC is the Canadian equity asset class
• 15% / $7,500 VTI - Vanguard Total Stock Market ETF, MER 0.07%; this is a broad market index, representing some 95% of the total US market according to Vanguard; it is exposed to USD vs CAD currency swings, which can be good or bad, depending on the direction; to some degree, there is also a diversification advantage (see discussion in a Burgundy Asset Management paper and research by Mark Kritzman - when the Canadian market falls, often the Canadian dollar follows, meaning that a VTI owner will end up with more Canadian dollars (as long as the US market doesn't fall by the same percentage); alternatives might be IYY and IWV, two index ETFs that track the broad US market but they have higher MER of 0.20%
  
• 20% / $10,000 VEU - Vanguard FTSE All-World ex-US ETF, MER 0.25%; provides very broad exposure to some 1300 companies in 47 countries around the world outside the USA
• 30% / $15,000 CPD - Claymore S&P TSX CDN Preferred Shares ETF, MER 0.45%; this is the fixed income portion of the portfolio, in which preferred shares are substituted for the bond funds typically held in registered tax-deferred portfolios; preferrred shares produce dividends so the person in a middle tax bracket will lose only about 8% to tax vs 30% - preferred shares pay less than bonds (James Hymas says about 0.89% for corporate bonds) in an article Corporate Bonds - or Preferred Shares? in the May 2006 Canadian MoneySaver) but compound the tax difference over 40 years and the difference is enormous e.g. 6% gross on $15,000 bonds would net reinvested and compounded after annual tax at above example rates $77,767 in bonds and 5.1% on dividends would net $93,892; note that bond funds always include lower yielding government bonds so this comparison understates the after tax advantage of preferred share dividends; the alternatives to CPD are three closed end funds DPS.UN - Diversified Preferred Shares Trust, PFR.UN - Advantaged Preferred Share Trust and PFD.PR.A - Charterhouse Preferred Share Index Corporation according to Portfolio Construction in the July/August 2007 Canadian MoneySaver issue but a cursory look suggests they suffer from making large distributions of return of capital, which is just giving his own money back to an investor, as well as trading often at well-below NAV.

Why the portfolio allocation proportions and holdings?

This is perhaps the most uncertain area. While the whole world is represented, Canada has a much larger proportion of total equity - equal to the sum of the USA and the rest-of-the-world - than in my own portfolio. The logic is simply that the person is likely to live and retire in Canada and use Canadian dollars. The foreign holdings introduce a significant enough exposure to diversification benefits from the equities themselves and from currency swings, but not too much. I've wrestled with this in the past e.g. this post on IFA Canada's model portfolio and this post on my own portfolio but cannot find the "perfect answer".

What does the above portfolio achieve?

• diversification through diffuse ownership of a large number of companies
• diversification through investment in most areas of the world
• diversification through equity and fixed income asset classes that move in different ways at different times (but which all move upwards over the long term)
• higher net returns through low fees of the ETFs
• higher net returns through use of a discount broker, which will charge nothing for account administration or management and only charges for trading
  
• higher net returns through lower taxes
• zero maintenance through index tracking - the fund managers regularly restructure the holdings to reflect market evolution requiring nothing of the investor
  
• zero market knowledge and investigation required - you get the market average automatically year after year, sometimes that is down but mostly it is up and certainly over the long term it is up
• zero maintenance through automatic dividend/distribution reinvestment by Questrade
  
• minimal administration through the small number of funds requires less work to do annual tax returns for distributions and down the road when they are eventually sold
  

What does it not achieve and what are the risks?

• rebalancing to keep the portfolio proportions the same will not happen without selling and buying by the investor; rebalancing every four years or so, or when one holding gets more than 5% (e.g. XIC goes up to 41% or down to 29%)out of whack, is the optimal strategy (see this post for discussion); over many years, the equity investment growth should far outstrip the fixed income CPD, which will increase the overall riskiness of the portfolio; normally, that's a cause for concern and the reason for rebalancing; in this case it is quite possibly a good thing, a worthwhile natural evolution. Why? As this person gets older and if, as expected, he begins to build up a defined benefit pension plan paying a fixed inflation-adjusted income at retirement, that in effect has increased the fixed income portion of his total personal wealth.
  
• shifting the portfolio into an RRSP for tax deferment and tax-protected growth as and when that becomes possible can only happen with monitoring and action by the investor; contributing the funds in-kind is possible but that will trigger a deemed disposition and the necessity to calculate and declare capital gains along the way, more work for the investor; the first thing that should go into the RRSP is fixed income, but the CPD should then be sold and replaced by a purchase of a bond fund like XBB the iShares Canadian Bond Index Fund since bonds will produce a higher gross and net (once protected from taxes) yield
• keeping a record of the Adjusted Cost Base of ETFs is a manual procedure as I explained in this post and it is a pain in the you-know-where; it doesn't really need to be done till the ETF is sold and the gain is to be reported on a tax return so maybe it can be put off and done in one massive catch-up session after 40 years but I'd want to not be further than five years behind simply because corporate fortunes rise and fall, companies come and go and records disappear or become hard to find (I had a lot of trouble some years back trying to figure out mutual fund ACBs to do final returns going back a mere 20 years)
• potential instability of the solution is an inescapable risk, especially over forty years, since the practical evolves greatly e.g. forty years ago, index funds did not exist and there was no capital gains tax in Canada; change will happen, it's just not possible today to know where, when and to what degree; one thing to remember is that big does not equal absolutely safe, stable or permanent - the current financial turmoil is affecting most the world's biggest banks, some will fall and over the long term, most will fall (just check the stock listings of the TSX, oops it used to be the TSE, 40 years ago and see how many names you recognize); Questrade is a relatively new, smaller player and going with them entails a degree of risk that it will be necessary to shift the portfolio to another institution if they run into business problems ... or maybe their superior product will see them grow into the dominant broker of tomorrow; is CIBC a good place to be, they seem to keep stumbling? Regardless, it will always be necessary for the investor to keep a general eye on developments for this maximum passivity portfolio.
  

Broker: All ETFs produce cash distributions, either monthly, quarterly, semi-annually or yearly, and there is no option, like there is with mutual funds, to have the ETF manager reinvest the cash automatically. So the investor can do it at his own time and expense or a broker can offer the service. But the objective is to have everything run on autopilot. The choice of Questrade boils down to one thing - Questrade is the ONLY Canadian discount broker I found that could reinvest the cash distributions for all the above ETFs so that the cash would not sit around in the account earning little or nothing. CPD was a particular no-can-do for everyone but Questrade and we see above above, it is a key element of the plan.

2. Portfolio of DFA Mutual Funds described on IFA Canada from Advisor De Thomas Financial.

This approach consists of handing over the $50k to De Thomas Financial for them to invest in the DFA mutual funds described in detail on the IFA Canada website. They follow passive indexing principles to the nth degree, they say convincingly enough (i.e. they back up their assertions with believable data) even more than the various index ETFs. The breakdown of asset classes is more numerous, enabling reductions in volatility and higher returns. Though De Thomas charges a 1% annual fee on top of the 0.25-0.70% embedded in DFA funds, their approach makes up for that 1.25 to 1.7% vs 0.07 to 0.45% ETF fee spread by lower tracking costs, by stock lending revenue and by tax deductibility of the fees (on taxable accounts only). Michael Hill of IFA Canada & De Thomas explained all this in my Q&A blog post of Oct.23. The end result is that the investor should attain a higher net return. The fact that the holdings are mutual funds eliminates the special ACB record-keeping hassle of ETFs, as well as the reinvestment of distributions problem. The rebalancing issue goes away too since De Thomas does it. Finally, part of the De Thomas service is general financial advice (I notice that Mr. Hill is a Certified Financial Planner, one of the better designations) and that may come in handy.

My biggest concern is that all of the portfolios have only bond funds and none with preferred shares and so taxes will be considerably higher. Another is that the "Easy Chair" portfolio for accounts smaller than $100,000 (the minimum required to do the full asset allocation using all the funds) has some limitations but those are not described.

3. Portfolio of TD Canada Trust e-Series Mutual Funds

This portfolio mimics the ETFs in the first portfolio with the difference that they are mutual funds available only through having an account at TD Canada Trust. The funds are:

• TDB900 - TD Canadian Index Fund, MER 0.31%, tracks the TSX Composite Index (it doesn't appear to be a capped fund like XIC, which limits any stock to no more than 10% of the fund; this shoudn't cause any difference or problem as long as there is no tech bubble II where Nortel gets up to 30% of the total value of the TSX!)
• TDB902 - TD US Index Fund, MER 0.33%, tracks the S&P 500, which is only three quarters or so of the total US market and really only tracks large companies, a disadvantage since small company stock returns historically have outperformed large company returns
• TDB911 - TD International Index Fund, MER 0.48%, tracks the Morgan Stanley Capital International Europe, Australasia and Far East Index("MSCI EAFE Index"), which is probably quite a bit less diversified ( we cannot tell because TD's fund information on the above website is too incomplete) than VEU
• TDB909 - TD Canadian Bond Index, MER 0.48%, tracks the Scotia Capital Universe Bond Index ("Universe Bond Index"); because it's a bond fund in a taxable account this is much less desirable than CPD
  

The TD funds do offer the advantages of mutual funds over ETFs already noted above but the higher MERs and a bit less ideal diversification characteristics promise lower long run returns. The biggest negative is the absence of a preferred shares fund. Of course, it would be possible to take the $15,000 for fixed income, go to Questrade and have an account only for that holding there. But why start to complicate life with accounts here and there if there is a better overall solution with Questrade?

The Lowdown on the Most Popular UK Financial Comparison Websites

Just came across a fabulous report - Compare and Contrast: How the UK Comparison Website Market is Serving Financial Consumers - released by the Resolution Foundation on October 11, 2007.

The report assesses the eight most popular financial comparison websites serving the UK market along with that of the regulatory agency itself, Financial Services Authority:

• www.moneysupermarket.com
• www.fool.co.uk
• www.uswitch.com
• www.moneynet.co.uk
• www.moneyexpert.com
• www.moneyextra.com
• www.moneyfacts.co.uk
• www.kelkoo.co.uk
• www.fsa.gov.uk/tables
• 
  
• www.themoneypages.com - not on the report list but another one I think is worth a look
  

The areas assessed include: mortgages, credit cards, loans, savings and car insurance. From reading the report it seems that mortgages and car insurance are especially tricky areas to get accurate and complete quotes online as many questions need to be asked to get it right and the various websites vary in how well they do it.

Though it specifically states that the aim of the study is not to determine which is the best, the detailed and impartial comparisons give a consumer a pretty good idea of which one is good or not so good in which area. I really like that the comparison dimensions used in the study are all of critical importance to a consumer: accuracy, completeness and impartiality of the information provided, explanation of technical terms, relevance of fact finding to provide an accurate quote, consumer ease and flexibility in searching and sorting results of the website and facility to contact the providers directly. Interesting factoid: not all providers participate in the comparison websites - Royal Bank of Scotland does not, per the report.

The report does conclude, however, ''there was no “all round best performer”''. It does say the websites perform a very valuable service (i.e. they are not slimy, evil things to be avoided), a re-assuring statement since so many people use them and since the number and complexity of financial choices keeps rising. In fact, some of the sites were found to provide better information on secured loans than the providers themselves! The main criticism is that some of the websites don't properly disclose when their editor's choice or best buys are actually the result of commercial sponsor ties and not the objective best value product.

Here's my summary (caveat emptor, it may not be 100% the way you would read it or the way the authors would say it) of the results:
1) Accuracy of product info - the best: moneysupermarket and MoneyExpert; FSA and uSwitch the worst
2) Accuracy of product quotes - the best: MoneyExpert and Moneyextra; Kelkoo is awful
3) Completeness of info - varies between products more than sites; info on mortgages ''generally poor''; Kelkoo weak across the board
4) Relevance of fact finding - generally poor across all sites for mortgages, credit cards and savings; Motley Fool, MoneyExpert and Kelkoo miss key info in every product
5) Terms explained - moneysupermarket best due to forums where people can ask experts; Motley Fool, uSwitch and FSA explain all terms while Kelkoo explained none and has no product guides
6) Consumer experience - MoneyExpert the best by a lot; Kelkoo is c-r-a-p
7) Flexibility - Moneynet the best, Motley Fool not far behind; MoneyExpert the pits, while moneysupermarket is not much better
8) Market coverage - no one wins but Kelkoo loses with ''low coverage''
9) Impartiality - Motley Fool and uSwitch exemplary by being ''frank and open''; moneysupermarket, Moneynet, MoneyExpert and Kelkoo are completely unforthcoming about their editor's choices as being based on commercial relationships
10) Ability to act on info - Motley Fool, MoneyExpert and FSA are the leaders; the others all only give contact info for affiliated providers (is it so hard to look them up yourself if you have their name?)
About my only overall conclusion is to not bother with Kelkoo; it scores lowest on too many dimensions and is really good in none.

Now that you be aware, you can also beware.

Well done to the Resolution Foundation, an organisation devoted to improving the financial capabilities of the low and medium income person.

Update October 29 - we used moneysupermarket today to get car insurance quotes and found one that has saved us several hundred pounds for the coming year. It was very slick, we were even able to complete the deal directly with the provider by phone after generating the quote online using a quote. There were no less than 26 different quotes and there would have been more except a bunch of providers don't want to insure recently arrived Canadians. Very impressive, took about 30 minutes from start to finish.

Tax-Free Saving for Children in the UK

What is the best way to save for the future for a child in the UK? Recently, that question was put to me by a family member who had seen a TV program in which Martin Lewis of the MoneySavingExpert has said something to the effect that an ordinary child savings account at a bank or building society could give a higher tax-free return / rate of interest than specialized products such as Child Trust Funds. I decided to take a very broad approach to comparing the options, including using a parent's ISA or other investments like National Savings and Investments various tax-free bonds. It turns out that there are a number of excellent alternatives all offering tax-free saving but which differ considerably according to flexibility, control of the funds, types of risk, likely after-inflation returns, ease of investing or topping up and amount of effort to manage.

Child Trust Fund
Every child born in the UK after September 1, 2002 gets a CTF, courtesy of the government which provides a £250 voucher (plus £250 extra for low-income families) that parents can use to open a CTF account. If you don't bother opening one yourself, after a year the government will open one for your child with the voucher and pick a provider at random, so you'd be just as well do it and choose yourself. The government adds another £250 (plus £250 again if eligible) when the child reaches age 7. You have a choice of one of three types of CTF available - 1) a savings account with a bank or building society, 2) a stakeholder equity account and 3) a self-select equity account. You can change from one type of CTF to another later on without penalty.

The CTF ''wrapper'' imposes certain common rules that should be considered when deciding how much of the savings for the child should be deposited in it. The first is that the funds are locked in till the child is 18 and cannot be withdrawn, not by parent nor child. The second is that the funds belong to the child, not the parent (or the government). At 18, the child can do absolutely whatever he/she wishes with the money. If you have doubts about whether the child will spend the money wisely at 18 and blow it all on frivolities, then you may want another type of vehicle. On the other hand, isn't part of your job as a parent to teach your kids how to handle money properly? They can't be children forever.

One additional good thing about the CTF is that the child can choose at age 18, when the account must be closed and the funds paid out, to transfer the whole amount into an ISA, which allows it to continue to grow tax-free. Given that the balance in the CTF may have grown far above the annual contribution allowed of £7000 for an ISA, that provides a way to avoid feeling that the money must be spent immediately. Perhaps the 18-year old will want to save further for a house purchase.

In other words, the CTF is meant to be a long-term savings vehicle. If you think you might need the funds before then, you should use another tax-free savings method. To my mind, the CTF should not be invested in a savings account, whose chief merit is to be safe from loss / decline in value in the short term, but whose long-term return is minimal after inflation. Instead the CTF should be in equities of some sort, either the Stakeholder account or the Self-Select. As I described in a previous post on Stakeholder CTFs, all such CTFs are invested in some form of UK Index Tracker Fund. F&C's is the best of the lot since it has slightly lower fees (1.22% per annum vs the usual 1.5%, which is the legal cap on this type of CTF). You don't have to watch the stock market and worry what to do since you are just getting the UK market average, a very good thing for busy parents who don't have the time or inclination to be an investment expert. In fact, it's best to ''file and forget'', ignore the market ups and downs, just let it grow on average over a long period as equities show their long-term superiority over savings. The Stakeholder CTF is the ideal way to have a no maintenance investment in equities for amounts up to perhaps £2000. Above that, a Self-Select Share Dealing CTF offers the opportunity for lower overhead costs and better diversification. My preferred choice there is Self-Trade due to its zero annual account admin fee, though The Share Centre is a close second because of its low trading fees. Why diversification? The UK is not the only market in the world and good investment practice is to include holdings from around the world and in other types of assets such as real estate. The Self-Select CTF accounts offer the ability to invest in any type of equity, or bonds available on the UK market, though I am partial to ETFs ( and not OEICs or other types of actively managed funds). There is apparently now even a shari'a compliant CTF for Muslim parents. I would put all the CTF money into equities and not any into bonds or cash-type fixed income since the other types of tax-free vehicles below can meet those needs and provide total portfolio balance of equities and fixed income. The chart below shows the detail of the terms and conditions.



Individual Savings Account (ISA)
An ISA is another tax-free account wrapper that enables various types of savings and investments free of income or capital gains tax. It is really a product for adults - you must be at least 16 to have one in your own name - but parents can use their own annual allowance of up to £7000 to save for the future needs of their children or themselves. The funds within the account are under the complete control of the parent/adult and can be withdrawn at any time. The money of and for the child is mixed in with the adults' own money.

Normally, this shouldn't be a problem, unless the parents themselves are spendthrifts and cannot save or unless a situation like a marital break-up complicates matters. Grandparents, other relatives or friends who may wish to contribute may feel more comfortable giving money to a child when it is clearly in his/her name. Better, I believe, to establish a formal and psychological barrier between what belongs to the child and what is the parents', i.e. not use ISAs at all for children. Anything invested for the children reduces the amount that parents can save tax-free for themselves. In any case, the £250 government voucher cannot be put into an ISA, only into a CTF.

ISAs from different institutions offer the same range of investment alternatives as CTFs - everything from bank and building society savings accounts, to investment funds, to self-select investment accounts. An additional player is National Savings and Investments, which offers two types of mini cash ISAs (whose annual contribution limit is £3000). The one in the table below on the best ISAs, shows the higher-yielding alternative, the Direct ISA, which can only be managed by phone or on-line. The other one, the Cash Mini ISA, currently pays about a percent less at 5.35% but it can accept additional contributions of as little as £10 at a time (vs £100 or £250 for the Direct ISA), better for those of more modest ability to save.



Child Bonus Bonds and Index-Linked Savings Certificates
These two investments are available only from National Savings and Investments, a government agency that started out as the Post Office bank (which explains why Post Offices in the UK display racks of NS and I brochures). Both types of investment are automatically tax-free. Both belong legally to the child and in-trust forms are available for non-parents to buy the bonds for children under 7. It is interesting that the Index-Linked certificates can be controlled by a child 7 or over ... hmmm, imagine a 7 year-old with £15,000 under his/her own control.

Both are better considered for medium-term three to five year investments. Though the funds are not locked-in and can be withdrawn on demand, interest is not earned at all or is considerably reduced if the funds are withdrawn early. A week ago, it might have been said that the direct backing of the government provided extra protection from loss than other bank accounts, but now that the Northern Rock debacle seems to confirm that no bank depositors will be allowed to lose their money, that seems to be a moot point.

The interest rate offered is almost identical - 5.1% vs 5.15% - but the index-linked certificates offer a guarantee that they will beat UK inflation by 1.35%, not a lot, but that eliminates the major risk of fixed rate investments, that inflation will reduce their value in real terms. I think I'd rather have the Index-linked Certificates. The table below gives the details of these two savings alternatives.


Child Savings Account at Bank or Building Society
Yet another alternative is to open an account in the name of the child at a bank or building society. Very many, if not all, such institutions offer them. The advantage is that most often a higher rate is offered. In the quick search for the best rate from the MoneySavingExpert's website, the Chelsea BS had the highest the day I did it, but it can and does change almost constantly and that's the problem. Unless you are prepared to be checking the website and changing banks frequently, a hassle in itself, you wouldn't be getting the absolute best rate for long. On top of that, at some point down the road, the bank/BS might just drop the rate without notice, a point that MoneySavingExpert warns about. There's also a limit of £100 interest per year that the child can earn from a parent's gift (the idea being to quash parents hiding their own savings in children's accounts), which equates to about £1600 max in the account. In order to avoid tax being deducted automatically (at a tax rate of 20%) from the interest earned on the account, you must fill in form R85 (said to be normally available at the bank branch) and send it on to HMRC, which is a bit of extra work, though only needs to be done once. Despite the complications, such an account may still be a valuable tool for a child to learn how to save and spend money under his or her own control. The table below gives details of a Child Savings Account.


Bare Trust
Not to leave out any, another option is the bare trust which is, in the definition of HMRC:
''A bare trust, also known as a 'simple trust', is one in which each beneficiary has an immediate and absolute right to both capital and income. The beneficiaries of a bare trust have the right to take actual possession of trust property.

The property is held in the name of a trustee. But that trustee has no discretion over what income to pay the beneficiary. In effect, the trustee is a nominee in whose name the property is held. The trustee has no active duties to perform.''

The child is the beneficiary and gets taxed at his or her rate on dividends and capital gains, which is usually lower than the parents'. The £100 limit on interest income from funds donated by each parent applies to a bare trust as well so the maximum benefit accrues when non-parents donate funds for the trust. Bare trusts are used to reduce inheritance taxes and are most appropriate when many thousands of pounds sterling are involved given that professional legal and accounting advice to set things up correctly is highly recommended e.g. see this UK DirectGov website on trusts.

Since the alternatives are not mutually exclusive, I tend to feel that the best course of action is to spread things around and utilize several simultaneously.

Other Websites with Useful Info
BBC.co.uk - see Savings and Investments in Your Money section
SavingforChildren.co.uk
Child Trust Fund Official website

Canada's High-Taxes vs the UK

When I decided to come over to Scotland, I investigated the tax consequences, expecting to find myself paying more tax over here in the UK. I was surprised to find the opposite, in fact, quite the opposite. For my fellow Canadians out there, here's the shocking news - the excess rate of taxation is considerable and across the board in all types of income and investment taxes.

Refer to the chart for all the numbers. I've used Ontario as my benchmark province.
The UK advantages start with the personal exemption of about $11,500 vs only $8839 in Canada. Take your marginal tax rate and compute the savings on the difference.

On income and interest, treated as the same in Canada but taxed at a slightly lower rate on interest in the UK, the Canadian rate is higher in every single tax bracket and the difference is the worst for middle income earners. For example, in the blue highlighted line for taxable income in the $60k range the Canadian marginal rate is 33% vs 22% in the UK. Ka-ching, another difference that could reach into the four figures.

On dividends, the UK has a zero effective rate due to an offsetting dividend tax credit until a person has more than about $76,000 taxable income.

On capital gains, the rate is actually higher in the UK throughout the tax brackets but everyone is given an annual exemption of about $20,150 in net gains. That should suffice to ensure a tax-free existence for most investors of modest means.

Not shown in the chart are the comparable retirement savings vehicles, the RRSP in Canada and the Individual Savings Account (ISA) in the UK. An ISA offers the same tax-free accumulation/compounding as the RRSP. An ISA does not allow a tax deduction as does the RRSP. Instead, any withdrawals are tax-free as opposed to the RRSP where withdrawals are taxed at the rate for marginal income. The RRSP advantage of saving taxes by withdrawing after retirement when one's tax rate would be less is not there for the ISA ... but the UK tax rates are lower in the first place and more uniform up to high levels. In addition, the ISA doesn't create artificial incentives to keep interest bearing securities inside the RRSP and dividend or growth investments outside. For anyone who has struggled with portfolio balancing across both RRSP /LIRAs and regular accounts while minimizing taxes, this ISA feature would be a big boon. Perhaps the biggest plus of the ISA is that the £7,000 annual allocation that is not reduced by contributions to a regular pension plan and thus allows a much high tax-free savings rate if desired.


Though such differences are and were not the motivation for my move to the UK, nor would I advocate moving to another country just to save taxes, it does lead one to ask those people who make our taxes why they are so high.

Taxes on Interest vs Dividends vs Capital Gains

A friend asked about how dividend taxation works and the difference in tax rates between the different types of investment revenue - interest vs dividends vs capital gains. He tried unsuccessfully to figure out the answer browsing through the Canada Revenue Agency's comprehensive but daunting website. Since he, being a smart guy, did not succeed, I figure this is worth a post for someone else's benefit.

I must acknowledge the excellent free Taxtips website, already linked under the Resources sidebar of this blog, for providing the calculators and information that produced the following results, though of course, if I've made any errors of interpretation that's not their fault.

The tax calculation of Canadian dividends goes through a grossing up process of the actual dividends we receive by cheque. Currently, this means adding 45% on top of the actual dividend, and the new higher amount is included in our taxable income. Yikes, you may say, that will raise my taxes! But through a clever tax credit calculation on the amount, the CRA gives it back and we all end up better off. Better even than interest or capital gains. (I'm referring to the most common type of dividends, those paid by companies listed on stock exchanges such as the TSX. See this Taxtips page for the nitty gritty of what is in this category termed "eligible" dividends.)

Use the Taxtips calculator to do your own numbers for your own province. I used Ontario for me and my friend. For almost every tax bracket, dividends have the lowest marginal tax rate, better even than capital gains, which may surprise some. The dividends tax advantage against capital gains diminishes progressively as you go up in tax bracket, being about 1% in the $72k-118k brackets for 2006. In the very top bracket, over $118k, the tax rate is higher on dividends. However, both dividends and capital gains have a significantly lesser tax rate - half or less - than interest or ordinary income (like salary) at all taxable income levels. (See this Taxtips chart, which shows both 2006 and 2007 brackets and marginal rates for Ontario.) That's why we are constantly told to put our bonds, GICs, CSBs and the like into our tax-sheltered RRSP.

Hmm, those banks stocks and utilities look better and better.