Portfolio Strategy presents a case study on how seniors can put a higher contribution limit for tax-free savings accounts to work.
The federal government says seniors will be prime beneficiaries of a move announced in this week's budget to boost the annual TFSA ceiling to $10,000 from $5,500. One way to get your fair share if you're just entering retirement is to start withdrawing money from your registered retirement plans and moving it into a TFSA.
This isn't an automatic strategy for all. "I don't want to give the idea that registered money is bad and you need to collapse it as soon as possible," says Daryl Diamond, president of Winnipeg-based Diamond Retirement Planning and author of Your Retirement Income Blueprint.
But, for two reasons, this strategy is worth a look. In addition to estate planning benefits, there's the potential for lowering your income-tax bill over the long term. You set all this in motion by pulling money out of your registered retirement savings plan or registered retirement income funds, paying the taxes and then parking it in TFSAs. With the new TFSA limit, there's a lot more parking space available. Mr. Diamond's comment on the change: "Are we enthused about it? Damned right we are."
Conventional thinking on registered retirement savings is to defer withdrawals as long as possible to conserve money. The government acknowledged this mindset in the budget by reducing the mandatory minimum withdrawals on RRIFs from age 71 onward.
But there are times when it makes sense to start pulling money out of your registered retirement savings well before you reach 71. Mr. Diamond said the profile of an ideal candidate would be someone who has a sizable RRIF and wants to plan ahead to minimize the tax bill on those mandatory withdrawals. A drawdown of retirement savings would also be of interest to people concerned about their total retirement income being high enough that some or all Old Age Security benefits are clawed back.
Here's a case study created by Mr. Diamond to explain his thinking. It starts with a retired couple, both age 65, who want a combined after-tax income of $6,000 monthly (see the chart for how this works on an individual basis). In Ontario, it would take taxable income of $41,000 to produce $3,000 monthly per person after tax.
Both spouses have full Canada Pension Plan and Old Age Security benefits, which add up to $19,572 this year. They also have pension income of $28,000, which works out to $14,000 each after pension income splitting. To reach their goal of $6,000 a month after tax, Mr. Diamond figures this couple would have to take $7,500 each per year from the $400,000 in retirement savings they each have (we'll assume their retirement savings are in a mix of RRSPs and RRIFs).
Mr. Diamond's suggested strategy: Take out $22,000 each year from these registered accounts, which is substantially more than is needed to meet this couple's income needs. At a 31-per-cent tax rate, this additional $14,500 withdrawal would produce about $10,000 after tax. With the newly increased annual contribution limit, TFSAs are the natural home for this money.
Mr. Diamond says the extra income would erode this couple's benefit from the age amount, a tax credit available to people who are 65 and older. It would also result in more income taxes paid than if they stuck to the $41,000 income they needed to meet their spending requirements.
But that's only for the first several years of retirement. After that, the drawdown strategy results in a lower taxable income. Simply put, there's a smaller pool of RRIF money on which to apply the mandatory minimum withdrawal.
As for those early years of retirement when the drawdown strategy results in a higher tax bill, there are a couple of mitigating factors. Mr. Diamond said the couple's marginal tax rate would still be 31 per cent, presumably lower than when they were contributing years ago to their retirement savings. That means the amount of tax they're paying on withdrawals is less than the tax deduction they received when contributing years ago to their retirement savings. Also, the couple's incomes would remain below the $72,809 threshold where Old Age Security benefits start getting clawed back.
To recap – the couple in Mr. Diamond's case study start at age 65 and each are withdrawing $22,000 of registered money from a combination of RRIFs and RRSPs annually. They must convert any remaining RRSP portion of their retirement savings to a RRIF in the year they turn 71. Thanks to his accelerated drawdown strategy, this will be a smooth transition. He has them both starting at 65 with a withdrawal rate of 5.5 per cent ($22,000 divided into $400,000). That's right in line with new 5.28-per-cent minimum withdrawal rate for people age 71, down from 7.38 per cent. Mr. Diamond said he would have suggested still higher withdrawals of money before age 71 if the RRIF withdrawal schedule had remained where it was before, while being careful not to move them into a higher tax bracket.
The estate-planning benefits of converting registered retirement money to TFSAs would come into play if one member of our couple died and passed on RRIF assets to his or her spouse. There would be a considerable tax hit if the surviving spouse had to make annual withdrawals from both RRIFs, and the total level of income could trigger some degree of OAS clawback. This risk is limited to some degree if both spouses start drawing down their RRIFs early in retirement to build TFSAs.
Mr. Diamond believes that the higher TFSA limit means people will accumulate significant balances in these accounts that won't just be preserved and conserved for the future. In fact, his firm has already begun suggesting to clients that they tap their TFSAs for additional income that is tax-free and won't affect eligibility for OAS. "We've said things to clients, like why don't we create cash flow for you in the summer – $750 per month to pay for your golf, tax-free?"
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The benefits of unravelling your RRIF
The increase in the maximum annual tax-free savings account contribution to $10,000 calls for a look at whether it makes sense to withdraw money from your registered retirement savings and move it to a TFSA.
Daryl Diamond of Winnipeg-based Diamond Retirement Planning has created a case study for a couple with identical savings and retirement benefits that shows how accelerating withdrawals from retirement savings at age 65 can work to their benefit.
Here, we look at how this strategy would work for one spouse in this couple. This person has full Old Age Security and Canada Pension Plan benefits, some additional pension benefits and $400,000 in retirement savings in a blend of a registered retirement savings plan and registered retirement income fund. This individual needs to withdraw about $7,500 a year from these registered savings to meet income needs, but chooses to increase that amount to $22,000 and put the after-tax difference of $10,000 in a TFSA.
Accelerated RRIF withdrawals offer two benefits in this case - lower taxable income starting at age 72 and a growing tax-free TFSA balance that can be used for spending or saved for future use.
**Minimum RRIF withdrawals for ages 71 and up were changed in the federal budget and shown in bold; minimums for earlier years were not changed;
***Again, assuming a 5.5% investment return;
Assumes 2 per cent inflation rate annually;
RRIF withdrawal and TFSA contribution at beginning of year;
RRSPs must be converted to RRIFs in the year in which you turn 71
Source: Daryl Diamond, Diamond Retirement Planning