Retirement savings plans (RSP) can be a powerful tool to defer taxes until into retirement.
Nowadays, we have seen many investors delay drawing from their RSPs as late as possible because they do not need the income and do not want to pay any additional taxes. As a quick recap, you must convert your RSP to a form of retirement income, including a retirement income fund (RIF), in the year you turn 71. If you convert your RSP to a RIF, your first payment needs to be taken by the end of the following year.
At a glance, deferring taxes seems ideal; however, there may be some situations in which it makes sense to draw upon these funds sooner:
1. No other pension income: At age 65, a $2,000 pension credit becomes available, which means the first $2,000 of RIF income may be tax-free. For those who do not have a workplace pension, it could make sense to draw at least $2,000 a year from your RIF in order to maximize this credit beginning in the year you turn 65. Essentially, you could receive $2,000 tax-free per year.
Beware that drawing out from RSPs is not considered eligible pension income under the Income Tax Act. Canada Pension Plan (CPP) and Old Age Security (OAS) incomes are not eligible for this pension credit, either.
2. OAS clawback avoidance: Some investors have done a great job amassing a large RSP and, should they continue to leave these balances to grow on a tax-deferred basis, they could have a substantial increase in taxable income upon converting to RIF. This could result in having some or all of their OAS being clawed back. OAS Clawback in 2020 applies once net income (line 236 on your tax return) exceeds $79,054 and this amount is adjusted each year with inflation. The repayment is 15 per cent of excess income and fully eliminated once an individual's net income reaches $128,137.
For example: Jane is 60, has been very diligent in her retirement savings and has amassed $500,000 in her RSP. If she waits until age 71 and assuming a five per cent rate of return, her RSP will grow to $670,038 without making any further contributions. Upon converting to RIF at 71, Jane is required to take a minimum payment of 5.28 per cent the following year, spiking her income by an additional $35,378.
3. Income splitting: Retired couples 65 and older can benefit from pension splitting, which is arguably one of the best tax-saving strategies available for retirees. This also presents an opportunity to draw from your RIFs early, while maximizing income splitting with your spouse to remain in a lower tax bracket. As a planning point: At age 60, couples can assign or split CPP income. Under age 65, company pensions are eligible for pension spit, whereas at ages 65 and over, RIF and Life Income Fund (LIF) income is eligible for pension split.
While we hope for a long and healthy retirement, sometimes life takes an unexpected turn for the worse. Should you or your spouse pass away prematurely, you lose the ability to income split and the surviving spouse is often left in a higher tax bracket and with fewer tax savings options.
Sample strategy: Bob and Cathy each make $30,000 in retirement income after pension splitting. In B.C., currently taxable income between $12,298 and $41,725 is taxed at a marginal tax rate of 20.07 per cent. This means they can each draw out an additional $11,725 of income and remain in the same low marginal tax rate.
4. Estate planning: As they slowly melt down their RIFs, Bob and Cathy can place funds in tax-free savings accounts (TFSAs) to grow tax free for as long as they like. They can also elect beneficiaries on their TFSAs for estate planning and to avoid probate.
Remember Jane in the first example, drawing her RIF minimum starting at 71? At age 90, she will still have more than $370,000 in her RIF account, which could present a massive tax bill for her estate — upwards of 47 per cent in B.C. and much higher than Bob and Cathy drawing their funds out at the 20 per cent tax bracket.
Prior to considering any of these strategies, you should talk to a wealth advisor or tax specialist to ensure they fit for your personal circumstance.
Until next time, Invest Well. Live Well.
(Written by Keith Davis.)
This document was prepared by Eric Davis, vice-president, portfolio manager and investment advisor, and Keith Davis, investment advisor, for informational purposes only and is subject to change. The contents of this document are not endorsed by TD Wealth Private Investment Advice, a division of TD Waterhouse Canada Inc.-Member of the Canadian Investor Protection Fund. All insurance products and services are offered by life licensed advisors of TD Waterhouse Insurance Services Inc., a member of TD Bank Group. For more information, call 250-314-5124 or email Keith.firstname.lastname@example.org.