While most people are focusing on putting money in to RRSPs at this time of year, you also need to think about a good strategy for taking the money out in retirement if you don't want the taxman to have the last laugh.
Of course, figuring out a good withdrawal strategy can be vexing if you have large balances in both registered accounts (RRSPs and registered retirement income funds) and non-registered accounts. Which do you draw on first? The conventional advice has been to put off RRSP/RRIF withdrawals as long as possible. But experts who have looked closely at that question advocate balanced withdrawals instead.
"In the vast majority of cases it is beneficial to take the balanced approach in choosing which assets to create income," says Daryl Diamond, financial planner and adviser with Diamond Retirement Planning of Winnipeg and author of Your Retirement Income Blueprint.
"You can't just go by the old rule of thumb where you leave the RRSPs alone until the mandatory withdrawal age," says Ross McShane, director of financial planning at McLarty & Co. Wealth Management of Ottawa.
The rationale for "balanced is best" rides on the tax details. You probably appreciate that you shelter your money from taxes as long as you hold money in an RRSP or RRIF, but you pay tax at full rates when you take it out. In contrast, unsheltered non-registered money can for the most part be drawn tax free (except you pay taxes on capital gains when you sell a profitable investment).
Conventional advice rightly recognizes the tax sheltering advantages of keeping money in RRSPs and RRIFs for longer. But if you empty your non-registered accounts first and then take concentrated RRIF withdrawals later, that can produce spikes in taxable income. Because of the progressive tax system which taxes higher incomes at much higher rates, that can create a big tax hit down the road.
This eventual tax bite is typically triggered by rules that require you to convert RRSPs to RRIFs or annuities by the year you turn 71. You are then required to make stipulated withdrawals from your RRIF starting at a sizable 7.4 per cent of assets, which then increases with age.
For couples, the tax hit from these withdrawals is compounded if one spouse dies well before the other because their RRSPs/RRIFs are then combined for the benefit of the surviving spouse. Typically that doubles the survivor's required RRIF withdrawals, which often bumps the survivor into a higher tax bracket. So the "balanced is best" approach trades off the RRSP/RRIF advantages of tax sheltering for longer versus the advantages of avoiding tax spikes by smoothing out income.
While figuring out precisely the optimal balanced withdrawal strategy is no doubt too complicated for most retirees, you can still derive a lot of benefit from a few simple actions. For starters, says Mr. McShane, you can get a rough sense of the potential tax spike down the road by projecting out the value of your RRSPs and then applying mandated RRIF withdrawal rates to see what that will do to future income. Combine that with other estimated income and you'll get a rough sense of what tax bracket you might land in. From that you can assess potential tax spikes and the benefit of avoiding them.
You can also profit from a strategy which Mr. Diamond calls "topping up to bracket," which involves smoothing out income to stay just under the next highest tax bracket. To see how it works, consider the following example. Say you're a 66-year-old retiree who needs income of $26,000 a year. (That's a combined $52,000 a year for a senior couple with equal income needs.) You have $13,000 in taxable income coming from Old Age Security, Canada Pension Plan and non-registered investment income. You have sizable RRSPs and non-registered accounts and you're wondering which type of account to tap for the remaining $13,000.
As it happens, seniors can avoid paying any federal tax on income up to $19,892 using common tax credits, including the basic personal credit, the age credit for being 65-plus, and the maximum pension income credit that you get as a senior having at least $2,000 in income from a RRIF, registered annuity or employer pension. It makes sense to tap your RRSPs for at least $6,892 because you can get that money out of your RRSP without paying any federal tax. (However, you would pay a small amount of provincial income tax in most provinces.) You might then draw the remaining $6,108 from non-registered accounts. (That's if you think you won't be in too high a tax bracket later on when you need to make mandatory RRIF withdrawals.)
A key tax bump for affluent seniors to keep an eye on is the OAS clawback on taxable incomes greater than $70,954. Above that threshold, seniors give up 15 cents of OAS for every dollar of income until OAS is entirely eaten up. Smoothing out income to stay just under $71,000 will help you collect your full OAS entitlement every year. Another major tax bump occurs at $43,561, which is the start of the second federal tax bracket. Incomes above that threshold are taxed at a marginal tax rate that is seven percentage points higher than just below it. There is also a major step-up in provincial tax rates in many provinces in the $30,000 to $40,000 range.
All this shows that figuring a good way to take money out of RRSPs and RRIFs is just as important as putting it in. A balanced withdrawal approach will help ensure the taxman gets his due but no more.
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What about TFSAs?
Like RRSPs, TFSAs are a great way to shield investment income from tax. But unlike RRSPs, you're never forced to withdraw the money and you're not taxed on those withdrawals either. Because of all those advantages, it is generally a good idea to tap non-registered investments before TFSAs. In fact, it often makes sense to keep adding to TFSAs after retirement, even if you have to sell non-registered investments to do so. (However, an exception may arise if liquidating non-registered investments would cost you a big tax bite due to capital gains.)
David Aston, CFA, MA, is a freelance writer specializing in financial topics.