WITH ALL THE BENEFITS OF USING RRSPs to save for retirement, sometimes the care needed to orchestrate RRSP withdrawals in a tax-efficient way – while ensuring that clients have sufficient cash flow for unexpected expenditures – is forgotten.
Indeed, the key to a financially comfortable retirement is not just saving enough assets to generate sufficient income, but also having flexible sources of cash flow, says Michelle Connolly, vice president, retirement and estate planning, with CI Investments Inc. in Toronto.
What clients should avoid is paying for major expenses that may not be anticipated – such as emergency home repairs – with amounts from the their RRSPs or registered retirement income funds (RRIFs), which could generate large tax bills in the year of the withdrawal.
The difference between income and cash flow is that taxes are payable on income, whereas cash flow is money on which taxes have been paid already.
Withdrawals from RRSPs/RRIFs are considered to be income, on which taxes must be paid. The same is true for old-age security (OAS), the guaranteed income supplement (GIS), the Canada Pension Plan (CPP) and other pension income.
On the other hand, withdrawals from tax-free savings accounts (TFSAs) and funds in non-registered accounts are not taxable and, thus, are considered to be cash flow. TFSAs are a particularly good source of cash flow because taxation is not triggered even if securities held in the TFSA have to be sold. Similar sales of assets from a non-registered account could trigger taxable capital gains.
That is why David Ablett, director of tax and estate planning with Investors Group Inc. in Winnipeg, strongly recommends that clients make maximum contributions to their TFSAs – including making withdrawals from RRSP or RRIF assets if no other funding is available. This strategy should, of course, be done in a tax-efficient way. That is, withdrawals must be orchestrated at a pace that does not push clients into higher tax brackets or trigger clawbacks of the OAS or the “over 65” age tax deduction.
Ablett provides an example: a 65-year-old man collects $6,000 a year in CPP income, holds $40,000 in RRSP assets and has $40,500 of unused TFSA room; he qualifies for the full GIS of $5,556 a year, but will lose much of that when he turns his RRSP into a RRIF and starts withdrawing from it. Ablett’s advice is that the man withdraw all his RRSP assets in increments spread over two years. This will result in total taxes of $6,000 and no GIS for those years. But when the withdrawals are complete, the man will be back to owing no taxes and receiving the full GIS. He then can make use of the remaining RRSP proceeds of $34,000 in his TFSA whenever he wishes, without triggering taxes.
Ablett’s example is for an extreme situation, but the principle applies – minimum RRIF annual withdrawals may push clients into a higher tax bracket or trigger clawbacks. You must make projections continuously regarding potential tax liability. If there is a real possibility of being pushed into a higher tax bracket or triggering clawbacks of public pensions, a series of early withdrawals should be considered – particularly if those withdrawals can be accomplished in lower-income years.
For example, clients in this situation can defer the start of their OAS and CPP benefits to age 70. In the years before turning 70, these clients would make suitably large withdrawals from their RRSP or RRIF and transfer those assets to non-registered accounts, assuming the clients have maximized their TFSA.
Ceasing RRSP contributions, and also not using up any unused RRSP room, also may make sense for clients in such a situation. These strategies are most effective when retirement-income tax planning starts five or even 10 years before retirement.
Another factor to be considered is that if a client has most of his or her assets in an RRSP or RRIF, those assets could be heavily taxed upon the death of the accountholder or, in the case of spouses, when both have died. All of the assets will be considered income on the final tax return for the estate and could be taxed at the highest rate: 40.5%-55%, depending upon which province or territory the clients lived in.
This is yet another reason to unlock as much of clients’ RRSP or RRIF assets as possible in a tax-efficient way.
Once upon a time, the argument was that clients were better off leaving their assets in RRSPs or RRIFs because those assets would grow tax-free. But that scenario applied before TFSAs were introduced in 2008, and before corporate-class and T-series mutual funds became widespread. All these products allow for tax-sheltered growth of assets outside of RRSPs and RRIFs.
Mutual fund trusts have to distribute all of their net income each year, and it is taxed in the hands of the unitholder according to the income type: interest, dividends or capital gains. Corporate-class funds, which are structured as mutual fund corporations, do not have to distribute all of their income. Any distributions are in the form of either eligible dividends or capital-gains dividends, both of which are taxed at preferential tax rates in the hands of unitholders.
As well, most corporate-class mutual fund structures offer a variety of funds within the corporation, each of which has a different investment mandate. This allows the unitholders to switch among the various funds on a tax-free basis, thereby allowing the unitholders to shift their asset mix as markets or their needs and goals change.
T-series funds are a further refinement on corporate-class funds, allowing unitholders to create cash flow in retirement. Those withdrawals are classified as a return of capital (i.e., cash flow, not income), which is not taxable.
© 2015 Investment Executive. All rights reserved.