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Planning Ahead to Avoid a Large Tax Liability

Mann Team - Jun 04, 2019

We are taught at an early age that in order to enjoy a comfortable retirement we need to save as much as possible, and the earlier we start the better. Until the introduction of the TFSA in 2009, RRSP had been the exclusive tax-sheltered account used for retirement savings. For many, the drive has been to keep plowing money into the RRSP until the magical number was reached for financial freedom. Despite this, finally saving enough to reach the mythical life threshold of retirement hardly means that the financial headaches are over, even if a sizable amount of money has been socked away.


One major challenge in the retirement years is how much capital to pull out. The biggest concern for many is running out of money by drawing down the registered account too quickly. Taking out too little can also be a costly mistake, especially if you have a considerable sum in an RRSP. The period between the saving and spending years should be looked at as the Retirement Risk Zone Years. This important period includes the last ten years of earning an income and the first ten years of drawing down a retirement income. The choices you make during this time can be critical and often irrevocable.


Anyone putting money into an RRSP should understand that it is merely a mechanism to defer income by contributing in high earning years and pulling out at low income years, regardless of age. CRA prescribes that by the end of the year in which one turns 71, Canadians must convert their RRSPs into annuities or RRIFs, which come with mandatory and taxable minimum withdrawals every year thereafter. This doesn’t necessarily mean that one must wait until then to start drawing funds out of the RRSP.


Baby boomers, the wealthiest generation in history, are now largely entering retirement, and many of them have registered retirement accounts worth $1 million. The challenge ahead is drawing out capital from these large accounts in a tax efficient manner. Just as you plan how much to put away each year for savings and tax deferral, one must have a plan to pull this money out once in their lower income years.


For some with a large RRSP the instinct is to take out as little as possible so that the capital grows tax-free as long as possible. This belief of not touching the RRSP until it has been converted to a RRIF at age 71 and making only minimum withdrawals at age 72 and beyond is not necessarily wise for everyone. There may be a case for pulling money from RRSPs if you occupy lower tax brackets in your late 50s or 60.


The strategy isn’t necessarily to deregister more funds in order to spend more, but rather to manage the income level for tax purposes and to transfer additional funds into a tax-free savings account (TFSA) or a non-registered investment account if there is no more TFSA room available. Savings inside of a TFSA would flow to your beneficiary tax free. Only capital gains and/or income from dividends or interest from the time of death would be subject to taxation. From an estate perspective the TFSA account is a much more efficient account of delivering maximum capital to your loved ones.


Couples should develop a withdrawal strategy together. The right strategy depends on a variety of factors, including other sources of retirement income, government benefits, when retirement starts and the couple’s age. It’s helpful to work backwards from the last surviving spouses age of life expectancy in order to make sure the pace of the withdrawals guarantees there’s enough money to cover expenses for the entire period while minimizing the overall tax. A large RRSP is a nice problem but the real crunch arrives when the first partner passes away. Once the RRSP or RRIF assets pass to the survivor spouse, the combined nest egg could subject the remaining partner to high tax levels and OAS claw backs as RRIF funds are withdrawn.


The most common way to reduce the income level from a RRIF/LIF is by income splitting with a spouse. At age 65, RRIF (60 for LIF) income qualifies for income splitting, which can significantly lower a couple’s overall tax burden. But if you’re retiring early and living off your working spouse’s income, the years up to age 65 may be an opportunity to draw down on your RRSP at a low tax rate. The first $12,069 in income, would come tax-free, while annual withdrawals up to around $40,000 would have an average tax rate of only 14%.


Government benefits should be part of the consideration as they will increase taxation. Both CPP and OAS pension payments are considered taxable income, which could bump you into a higher tax bracket. Canada Pension Plan (CPP) and Old Age Security (OAS) benefits can be postponed, in order to strategically draw out more RRSP/RRIF capital at a lower tax rate. One should properly plan for the optimal age and income to start taking these benefits. If your overall income for the year reaches above $77,580 for 2019, OAS claw back results in a reduction of the benefit by 15% for every $1 above. At an income level of $144,843 the OAS benefit is fully clawed back and reduced to zero.


Figuring out the optimal withdrawal strategy can be rather complex, but one rule of thumb to consider is withdrawing as much as you can from an RRSP or RRIF without hitting the next tax bracket. If you were to receive the maximum CPP ($1,134.17/month) and OAS ($570.52/month) benefits of just over $20,000 annually, another $20,000 approximately could be taken as income by making an RRSP, RIF, LIRA, or LIF withdrawal and be taxed at the lowest tax bracket.


For many this is often overlooked and pulling funds out of an RRSP and LIRA isn’t done until forced to. Even once converted to RIF or LIF some are just taking the minimum requirement for withdrawal, when an excess RIF or LIF payment would make sense because of a low-income level even with the RIF or LIF minimum payment.


Whether its legacy planning or income planning investors are leaving thousands of dollars up for grabs and the CRA has been the beneficiary. Significant tax savings can be achieved by knowing one’s tax brackets and strategically drawing down the registered account based on income level. A large registered investment account can become a significant tax liability in later years of life, as death would trigger a collapse of the register accounts, if there is no spouse to spouse transfer. It is best to get in front of this early and avoid excessive taxation by poor planning.


Designating a spouse as beneficiary to your registered accounts will allow everything to transfer tax free. This avoids taxation temporarily, but the eventuality is that after the death of the last surviving spouse the total value of the registered accounts are added to the annual income for the year. It is conceivable that for many that the CRA would take half of the value of the accounts prior to passing along to one’s family. Carefully planning on how to manage income and drawdowns can avoid this final tax reckoning.


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