While it's tempting to "bask" in the low tax rates that may prevail between the years of full employment and full-stop retirement, in the long run you may be better off paying a little more tax now in order to avoid a lot more tax later. The latter can happen once you're required to annuitize or convert your RRSP to a RRIF.
Because of Canada's graduated tax system, tax rates escalate the more you earn. This has left many would-be retirees with the impression their retirement income will be lower and they'll be paying taxes at a lower rate. That in turn has led to the strategy of deferring receipt of registered retirement savings plan (RRSP) or registered retirement income fund (RRIF) income as long as possible.
However, more than a quarter of retirees are in a tax bracket that's either the same or even higher than in their working years, says a BMO Wealth Institute report published in 2013.
The solution may be to accelerate the drawdown of RRSPs in the decade prior to the RRIF years, or even to set up a RRIF years before it's required (by the end of the calendar year when you turn 71), especially if you have fallen into a lower tax bracket during the transition between full employment and traditional retirement.
Counterintuitive though it may appear, there is a strategy for people who are temporarily in lower tax brackets, says Robert Armstrong, Bank of Montreal's vice-president of managed solutions. He calls the strategy "Topping up to Bracket," which involves ensuring you receive a yearly income in the range of $12,000 (zero tax) and $42,000 (the lowest tax bracket).
Matthew Ardrey, a wealth adviser and vice-president of Toronto-based Tridelta Financial, says "there is certainly a benefit to ensuring your income remains below $42,000 if you can."
If you're temporarily in a lower bracket – perhaps you're between full-time jobs – you should move heaven and earth to maximize the precious non-taxed dollars you take into your hands every year, and after that, at least the very low-taxed dollars.
For everybody, including high earners, the first $11,635 of income is tax-free: This is the federal "basic personal amount" (BPA) in 2017. So the first $11,635 is a no-brainer, but next best are the lower-taxed dollars, which is where Mr. Armstrong cites the key number of $42,000. Between the BPA and $42,000 the federal tax rate is 15 per cent. Add in provincial tax and the result in Ontario is that in 2017, the first $42,201 of income has a top marginal tax rate of 20.05 per cent. After $45,916 of income, the combined federal/provincial tax rate becomes 29.65 per cent, and gets higher still for larger incomes.
For couples, if one spouse is fully employed and paying a top marginal tax rate (in Ontario) of 53.53 per cent (taxable income of $220,001 or more) while the other spouse has minimal income, I'd argue this: Every non-taxed or low-taxed dollar that the latter brings into the family unit is more valuable than each (roughly) 50-cent dollar the higher-income spouse generates in any extra income.
For pensioners 65 or older, the tax-free zone can exceed $20,000: That's the BPA, plus federal $7,225 age amount (in 2017) plus (if applicable) the $2,000 pension credit. (The age credit can be clawed back at high enough levels of income.)
Topping up to bracket in low-earning years is a use-it-or-lose-it proposition. If you let a year go by and bring in none of that tax-free income at all, you don't get to carry forward the opportunity to another year.
What if you have no earned income? Then it may make sense to withdraw some RRSP funds, as you probably were in a higher tax bracket when you made the original contributions. Raiding your TFSA makes little sense here because they're tax-free dollars anyway, so there's no urgency to de-register TFSA money while you're in a low tax bracket; besides, you want to maximize precious TFSA room after the age of 71, when those forced RRIF withdrawals put you in a higher tax bracket again.
Once you're 65, there's a case for limiting annual intake to $74,788, beyond which Old Age Security benefits are subject to clawback. OAS is completely clawed back at $121,071.
This is why Mr. Ardrey proposes "melting down" RRSPs before OAS or CPP kick in. Assuming they are in a lower tax bracket, "when many people think of an RRSP drawdown they only think of doing it up until the basic personal amount." But for someone with a large RRSP, this could be a detrimental decision.
Warren MacKenzie, head of Financial Planning at Toronto-based Optimize Wealth Management, says if you expect future income, and thus tax, to be higher, as well as clawed-back OAS "then it makes sense to withdraw some money from a registered account if it can be taken into income at a lower tax rate." However, if income is projected to be lower in old age, it may not make sense to pay tax sooner than necessary, he adds.
For most couples, the biggest tax hit comes after the second partner dies, RRIFs are collapsed and capital gains realized. Since the RRIF of the partner who dies first passes tax-free to the survivor, he or she is often pushed into a higher tax bracket
Mr. MacKenzie says spousal loans may help one partner stay in lower tax brackets longer: "Overall, the lowest amount of income tax will be paid when each spouse has the same level of income."