When it comes to retirement costs, most people think about food, shelter, travel and entertainment. Yet, there’s a more common expense that requires some very detailed planning: taxes.
”When it comes to taxes, we need to recognize it is often life’s single greatest expense,” says Doug Nelson, president and senior financial planner at Nelson Financial Planning Corp. in Winnipeg and author of Master Your Retirement.
Advisors are called upon increasingly to help investors navigate the tricky world of taxes and to help them build a sustainable, tax-efficient income stream in retirement.
“Tax-efficient income planning is really where many advisors are most focused today,” says Frank Di Pietro, assistant vice-president, tax and estate planning, at Mackenzie Investments.
A recent Canadian Imperial Bank of Commerce report shows about three-quarters of Canadians worry about having enough money in retirement, yet most don’t understand how retirement income is taxed.
Mr. Di Pietro says a top concern among clients is avoiding so-called “tax traps” that can lead to paying more taxes than necessary, reducing the likelihood of successfully achieving retirement goals.
How advisors can help
Advisors can help clients pay less in taxes by assessing their overall portfolio and suggesting different strategies, such as the size and timing of withdrawals in retirement and taking advantage of income-splitting opportunities that may be available.
The planning starts when investors are in their working years and evolves as they enter their golden years.
For instance, the advice might be for someone to maximize their use of the registered retirement savings plan (RRSP), which enables investors to defer paying taxes when their income is higher in their working years and letting the money grow, then withdrawing it at a lower tax bracket, which is often the case in retirement.
Having too much invested in an RRSP can also be an issue, especially if a retiree has a large expense and no other savings vehicles to cover the cost. Withdrawing too much from an RRSP in a single year can result in a larger tax hit, and a potential claw back of Old Age Security (OAS) benefits when income reaches a threshold ($79,054 for the 2020 taxation year)
Ideally, advisors help retirees plan by forecasting how RRSP and subsequent registered retirement income fund (RRIF) withdrawals fit with other fully taxable income sources such as the Canada Pension Plan (CPP), OAS, more lightly taxed sources such as stock dividends, as well as non-taxable income sources like the tax-free savings account (TFSA).
“We like to encourage clients to think about their TFSA as a health care spending reserve account in retirement,” Mr. Nelson says, adding it can be used for rising expenses for enhanced home care and medications.
Increasingly, the TFSA is becoming a central planning tool to serve many different retirement needs, including a tax-free asset for the estate, says Marty Clement, a partner and business advisor with the tax services team at MNP in Kelowna, B.C.
Clients with large RRSPs may also want to consider withdrawing more than they might need in certain years, and then contributing those excess funds to a TFSA, even if it means paying a bit more taxes.
The challenge, however, is that clients “tend to want to pay the least amount of tax,” he says, and can be reluctant to make these higher withdrawals.
Advisors can navigate this with a detailed tax plan, illustrating how paying more taxes on registered withdrawals today helps avoid larger tax bills later in retirement, Mr. Clement says. It’s also a concern when RRSPs are converted to RRIFs, which have growing mandatory withdrawal rates as people age.
Options for couples
Tax planning for couples can also be complex. It’s rare that couples have equal incomes in retirement, and pay similar amounts of taxes, so the onus is on advisors to come up with strategies to help balance out uneven income streams, Mr. Di Pietro says.
“[The goal] is to push income into the hands of the spouse that will be taxed at a lower rate to maximize after-tax cash flow in retirement and helping make their money last as long as possible,” he says.
Canadian tax rules provide several opportunities for married or common-law couples to split income from sources such as workplace pensions, CPP and RRIFs, which help to reduce the overall family tax bill.
With pension income splitting, higher-income-earning spouses can transfer up to 50 per cent of their eligible company pension income to their lower-income-earning spouses. (In Quebec, this only applies for provincial tax purposes if the taxpayer is 65 or older.) Spouses can also split income from their RRIFs with their partners, but they need to be 65 or older.
Spousal RRSPs are also an option for couples with varying incomes to save for retirement and split income to reduce taxes but should be setting up well ahead of retirement.
Another option is a spousal loan, in which the person with sizable non-registered investments lends capital to the other spouse at a prescribed rate set by the Canada Revenue Agency, currently 1 per cent.
Mr. Clement adds that the spouse receiving the loan would then invest the money and pay tax on income generated from those assets at a lower rate than the spouse with more assets.
“This is a strategy that definitely gets traction in a low-interest-rate environment,” Mr. Clement says.
Fear and cost of the unknown
Even the best-laid plans can be derailed by unknowns about clients’ entire financial picture, Mr. Clement says.
“I always remind clients when they’re working with advisors to give a full view of all their assets.”
An example is a discount brokerage account that a client may not disclose unless advisors ask explicitly.
Real property, inheritances and even small business assets are other often overlooked sources that can affect tax-efficient plans devised by advisors negatively because they would be unaware of these assets’ existence, he says.
“The more the advisor is aware of these, the less likely the client is going to hit a tax trap,” Mr. Clement says.
Much like clients themselves, advisors are best served by planning and asking the right questions to ensure nothing is missed, Mr. Di Pietro says.
“Certainly, advisors we’re working with are having these more precise conversations five to seven years prior to retirement.”
Part of that job involves helping clients understand taxation and, in turn, how their decisions regarding their assets can affect sustainable, after-tax income streams during retirement, Mr. Nelson says.
Although most advisors recognize tax traps and know how to avoid them, their clients may not, he adds.
“Having even a basic knowledge ... helps most people avoid most tax-related traps at any stage in life.”