senior couple money tree / Julkirio

Many people quickly identify the RRSP as a key component of successful retirement planning. But they often overlook the TFSA, unaware of the complementary role this instrument can play in planning for and enjoying retirement.

Your clients should know that earned income is required to create RRSP contribution room. For 2021, the maximum contribution is 18% of pre-tax earned income up to $27,830.

“For retirement planning, there’s a huge advantage where [clients] can save in a tax-free vehicle without having earned income,” said Tina Di Vito, partner with the family office services division of MNP LLP in Toronto.

For example, drawing dividends might be advantageous for certain business owners because the tax rate on dividends is lower than that for salary income. But dividends are not considered earned income for RRSP purposes. However, the business owner may be able to contribute up to their TFSA limit in order to save in a tax-free environment, with no earned income needed, Di Vito said.

TFSAs also can be useful when a client receives a windfall, such as an inheritance. The extra cash flow from that windfall can be contributed to their TFSA up to their limit, regardless of whether they have earned income, Di Vito said.

The role of an RRSP and a TFSA in a retirement planning portfolio can differ, depending on a client’s circumstances. Clients who typically maximize their RRSP annual contribution limit are good candidates for contributing to a TFSA if they still have surplus cash to invest, said Graeme Egan, president of CastleBay Wealth Management Inc. in Vancouver.

In situations in which a client is limited in their RRSP contribution room because they are a member of an employer’s pension plan, the TFSA would be the next logical choice, Egan added.

Lower-income clients who anticipate relying on old age security (OAS) or the guaranteed income supplement (GIS) during their retirement may be better off investing in a TFSA, Di Vito said.

In contrast, withdrawals from an RRSP, a RRIF or an annuity purchased with registered funds are included in taxable income. The OAS and GIS are income-tested, which means a client’s entitlement to those programs will be reduced or eliminated in any year in which their income is above the annual threshold.

For example, GIS is designed for Canadians with very low income, with any dollar of income above the annual minimum reducing GIS by 50¢. Therefore, a RRIF withdrawal that is $5,000 above the minimum would require a repayment of $2,500 of GIS, Di Vito explained.

Withdrawals from a TFSA are not included in income and therefore do not impact the OAS or GIS amounts, or income taxes.

Investment choices within a TFSA depend on each client’s specific goals, timeline and risk tolerance. Nonetheless, “you’d like to grow that as much as possible and make use of the fact that investments are going to grow tax-free and come out tax-free,” said Doug Carroll, tax and estate specialist with Aviso Wealth Inc. in Toronto. “So, you would probably lean a little bit more toward equities in there than you would in your RRSP because [theoretically] higher equities returns would eventually be taxable when withdrawn from the RRSP or converted RRIF.”

When drawing down a RRIF and a TFSA upon retirement, the goal in general is to keep income consistent from year to year and to avoid fluctuations among tax brackets.

In many cases, Egan said, it may make sense for a client to draw down their TFSA ahead of converting their RRSP to either a RRIF or an annuity, a conversion that must be done by age 71. (See story, Timing is everything.)

For example, Egan said, assume a client retires close to age 65 and has no pension plan. They can make TFSA withdrawals to pay for annual living expenses and to top up their potential CPP and OAS entitlements. That allows the client to leave their RRSP funds untouched so the funds compound tax-sheltered until age 70 or 71. TFSA withdrawals will be non-taxable and will not affect the client’s OAS entitlement or eligibility for other federal income-tested benefits and credits.

Then, after the RRSP has been converted into a RRIF and if the client is married, there may be income-splitting benefits with their spouse from splitting the RRIF income annually for tax purposes, effectively lowering the combined tax rate for the couple going forward.

“TFSAs can be used strategically to enhance after-tax income before RRIFs kick in,” said Egan.

Carroll agreed. When considering the TFSA and the RRSP in conjunction with CPP and OAS payments, “use the [TFSA] as your ballast,” he said. “Use your TFSA instead of an RRSP to make withdrawals [and] keep from going up into higher marginal tax rates, and then you can reduce your expected longer-
term taxes.”

Registered accounts will still be the primary retirement planning savings tool for most people. But as that investment vehicle grows in value, clients must keep in mind the taxes that will apply on the eventual withdrawals, Carroll added.

As clients get closer to retirement, allocating an increasing portion of savings to their TFSA to provide themselves with greater flexibility in managing taxable income in their retirement years can be a prudent strategy, he stressed.

Withdrawal rules rule

A key benefit for clients who have a TFSA at retirement is that there is no mandated withdrawal at any age. There are, however, specific rules for RRSPs, which, if converted to a RRIF on or before the year the client turns 71, mandates minimum withdrawals beginning in the taxation year following the conversion.

For example, consider a client born in 1950, who will turn 71 in 2021 and convert an RRSP worth $1 million to a RRIF on or before the Dec. 31, 2021, deadline. Beginning in 2022, that client will be required to withdraw at least 5.28% of the value of the RRIF, or $52,800, and declare that amount as income.

That minimum withdrawal percentage will increase each year until age 95, when 20% of the remaining balance must be removed over each of the following five years, terminating the RRIF at age 100, should the client live that long.

A TFSA has no minimum or scheduled withdrawal obligations — ever. In addition, any voluntary withdrawals that take place will be added to contribution room the following year.

Moreover, noted Graeme Egan, president of CastleBay Wealth Management Inc. in Vancouver, clients can continue to make TFSA contributions at any time, whereas RRSP investors can no longer make contributions after the RRSP is converted to a RRIF.