"Will I have enough?" is a question Canadians often ask as they get closer to retirement. Those who have saved diligently and invested wisely may feel confident about their post-work finances – until they file their first income tax return as retirees and realize they could lose a significant chunk of their nest egg to the taxman.
This is why preretirement tax planning is important, says Anthony Fielding, a chartered accountant with Bluenose Accounting in Halifax.
"It does no good to design a retirement plan that might generate a higher rate of return but where higher tax rates eat away any advantage," he says.
Some Canadians may not see the need for an effective tax strategy because they expect their incomes to drop once they retire, shifting them to a lower tax bracket. But many retirees actually end up drawing more income than they had intended to during the first few years of retirement, says Michael Taglieri, a financial adviser with Assante Capital Management Ltd. in Mississauga, Ont.
"In their initial years of retirement, they're trying to occupy their days by frequently going out for lunch or shopping, or visiting relatives – activities that all cost money," he says.
Regardless of how much income they expect to draw in retirement, Canadians need to understand how income from each source is taxed. The goal is the most tax-efficient mix of income from registered and non-registered investments, says Mr. Taglieri.
For example, if you are withdrawing RRSP money through a RRIF (registered retirement income fund), every dollar you pull out is considered taxable income, he says. "So if you're getting $50,000 a year from your pension and pulling out $50,000 from your RRIF, that means you're making $100,000 in taxable income."
By comparison, non-registered investments such as stocks pay out capital gains, of which only half is taxed as income, notes Mr. Taglieri. If they can afford it, retirees should consider taking only the minimum required withdrawal from their RRIF and instead draw money first from non-registered investments.
Mr. Fielding advises Canadians to look at non-taxable forms of retirement income, starting with a home that can be sold tax-free.
Tax-free savings accounts (TFSAs) have "huge potential," he says. "Not only is the income tax-free, the actual withdrawals are also tax-free."
When it comes to non-registered investments, Mr. Fielding says it's a good idea to consider stocks that generate eligible dividends as well as capital appreciation. Both types of income incur the lowest taxes, says Mr. Fielding.
Paul Shelestowsky, senior wealth adviser at Meridian Credit Union in Niagara-on-the-Lake, Ont., agrees that it makes sense to draw income primarily from non-registered money. But for retirees with no spouse or dependent children to name as beneficiaries of their RRSP, this strategy could leave a big chunk of money taxable to their estate when they die.
"My question to the client is, 'Are you okay with that?' and some will say they worked hard for the money and they want most of it to go to their estate beneficiaries and not to CRA (Canada Revenue Agency)," says Mr. Shelestowsky.
Instead of withdrawing only the required minimum, Mr. Shelestowsky suggests taking out an extra $10,000 a year in RRIF money and putting it straight into a TFSA.
"This may generate an extra $3,000 in tax, so that over a 10-year period you would have moved $100,000 from your RRIF and paid an additional $30,000 in taxes," he says. "But consider that the marginal tax rate on $100,000 is 43 per cent, which means you would be paying $43,000 in tax. So you're saving yourself $13,000."
Wayne Cahill of Cahill Professional Accountants in Vancouver says retiring couples may also be able to whittle down their tax bill by splitting income from a pension, RRIF or life annuity. This basically means that, come tax time, up to half of one spouse's income gets attributed to the other spouse when they file their tax return.
It's also a good idea for couples to try to even out their investments before they retire, says Mr. Cahill. If one spouse has more money saved than the other, the couple should funnel all future savings into the lower-value account. "Ultimately you want to make it so each spouse is taxed within the same income bracket."