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Expert Opinion: Retirement preparation
What to do after you've turned 55
JAMES YIH
The baby boomer bulge is just starting to hit what might be called early retirement. The oldest boomers are turning 60, and right behind them is one of the biggest demographic waves ever in history.
As boomers hit the pre-retirement years, they should be looking at RRSPs differently than other demographic groups.
What factors should RRSP investors take into account from age 55 to retirement and beyond?
Should I still buy RRSPs after age 55?
In general, the answer is yes. Many boomers are hitting their peak discretionary-income years. This means their income is higher than it has ever been and their expenses are lower because of freedom from mortgages and dependent children. Boomers are typically behind on retirement savings, however, because they have just gone through this expensive phase. Today they are trying to get as much into their RRSPs as possible.
Of course, there are exceptions to every rule, and not all baby boomers should necessarily buy RRSPs.
For example, Danny, who is age 50, works for the government and has 26 years of pensionable service. Danny is planning to retire in four years with a maximum pension that will keep him in a fairly high tax bracket. Although Danny will get a tax deduction when buying RRSPs, he will also find himself in a future predicament of taking them out and having to pay tax at a fairly high rate because of his pension income.
Add the fact that his pension will cover his lifestyle needs and you have a clear argument why this boomer should not buy RRSPs.
Should boomers be more conservative with their investments?
As part of the aging process, our bodies naturally slow down. Along with the physiological changes comes the natural tendency to behave more conservatively.
It is only natural to want to be more conservative as you age and your investment portfolio grows. In fact there is an old rule that suggests your age should also be the percentage of your portfolio that should be held in such conservative investments as guaranteed investment certificates (GICs) or other fixed income investments.
Consider Rebecca, who is 55 years old. According to the rule, Rebecca should have 55 per cent of her money invested in GICs. The problem for Rebecca, like many other boomers, is she can't afford to earn low interest rates of 3 to 4 per cent. She either needs to sock away a lot more money or she needs to invest her money in such a way that she can earn 8 or 9 per cent. Earning higher returns means more risk, and that goes against her natural tendency. This will likely be the biggest dilemma that baby boomers will face in pre- and postretirement.
When is the best time to convert my RRSP into income?
The answer is: when you need the income. Typically, this occurs when you retire and have no other sources of income. Taking income from the RRSP while you are still working can be very costly and will negate the benefits you derived from putting money into the RRSP in the first place. You have to pay tax on the money you take out, so it's best to do so when you are in a lower tax bracket. Also for tax reasons, you are usually better off taking money out over time rather than all at once.
That being said, you could convert RRSPs to income as early as age 18, but you should wait until later in your life.
How long can I defer income?
Some experts say you should defer your RRSP income for as long as possible. Most people defer the conversion of their RRSP into income based on the desire for tax deferral. But this does not apply in all circumstances.
In any case, government rules stipulate that you must wind up your RRSP by the end of the year in which you turn 69. You must convert it into an income vehicle during the year you turn 69, but you do not have to start that income in the year you turn 69 - it must start in the following year. If you turn 69 this year and you have not converted your RRSP into an income vehicle, you need to see your financial adviser before Dec. 31.!
What are my income options?
When you retire and start drawing money from the RRSP, you will have four income options:
- Cash in the RRSP. While this may be an option, it is not usually a good one. Cashing in the RRSP means that the full value of your RRSP is added to your income and taxed accordingly. Unless you have a very small RRSP, this can mean a significant part of your wealth will go to the government.
- Registered Retirement Income Fund (RRIF). In essence, if the RRSP is a bucket of money, the RRIF is the same bucket of money with a hole in it. Any money that comes out of that hole is taxed. It's estimated that more than three-quarters of all Canadians select RRIFs as their retirement income option.
The current flexibility of RRIFs has made them extremely attractive. You can select the investments, income frequency and amount of income. You can also make changes to all of these aspects in the future.!
- Life annuity. Like a pension plan, it provides you with a fixed stream of income that is guaranteed for the rest of your life. Regardless of markets, interest rates, inflation or the economy, your income remains stable and fixed for your lifetime. In the conversion to a life annuity, you simply give your money to a life insurance company. In turn, it pays you a guaranteed fixed income for the rest of your life. Once you die, the income stops.
Generally, the annuity will give you a higher income than a RRIF because the income is a combination of interest and repayment of capital.
While the annuity will appeal to conservative investors who like low maintenance and guaranteed investment, one of the key downsides to an annuity is that current interest rates are low. Not only are incomes tied to interest rates but buying an annuity with your RRSPs today means locking into current rates for the rest of your life. Once an annuity is set up, it is set up for life with no option for future changes.!
- Fixed term annuity. Unlike the life annuity, the fixed term annuity does not pay you an income for a lifetime. Instead, you choose a fixed term, such as 5, 10, 20 years or more. The only stipulation is the term cannot extend past age 90.
How do you know which option is best for you?
Remember, this is not an all or nothing situation - picking one of the options doesn't mean you can't choose other options. Sometimes a combination may be ideal.
If you are comparing RRIFS and annuities, here are some points to consider:!
- Flexibility: If you are looking to set up the income the way you want, and you need the option of making changes in the future, the RRIF wins hands down.
- Control: Some people want control, while others want to set something up and let it run on autopilot. Annuities have the distinct advantage of being easy to set up and understand. RRIFs require more decisions and more management.
- Estate preservation: Generally, the best way to provide an estate benefit is through the RRIF. You can provide an estate with life annuities if it is set up with proper guarantee periods, but these options can reduce your level of income.
- Spousal protection: Providing survivorship options for your spouse can be done with both RRIFs and annuities. However, in the case of annuities, you must make sure they are set up properly.
Jim Yih is an Edmonton-based financial adviser and author of Mutual Fundamentals
Seven Strategies to Guarantee Your Investments.
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