By Fred Petrie
During peak earning years, the common tax strategy of working Canadians is to defer taxes (through Registered Retirement Savings Plans) in order to put more income into savings, which also get tax free growth. Part of this tax deferment strategy is to shelter income subject to the highest marginal tax rate, with the expectation that we will be taxed at a lower marginal rate in retirement when our incomes are less.
We tend to continue this deferment strategy in retirement, using non-registered savings to supplement pensions and “deferring” RRSP withdrawals that would be taxed. Often this is continued to our 71st birthday when we are required to terminate our RRSP, with the option of converting it into a registered retirement income fund, with mandatory annual withdrawals. Even then we usually limit withdrawals to the minimum, to pay the least possible tax.
Revenue Canada is going to tax you eventually. All registered money and capital gains on assets like the family cottage become income on your expiry date (except for transfers between spouses). One reason for Revenue Canada’s patience is that all income realized at the end will put much of your estate into the highest marginal tax category (currently 46.4 per cent in Manitoba.)
So the first step in tax planning in your retirement is to plan how to withdraw your registered money, even if it is taxable. You will need to consult your accountant to calculate how much you can take out each year while still minimizing the overall tax you end up paying. One key after age 65 is to keep your taxable income below the level where OAS is clawed back. The clawback together with the higher marginal rate invoked by the RRIF withdrawal may result in an effective marginal tax rate greater than 50 per cent! Currently, the clawback begins when net income is just over $67,000 a year.
With pension splitting, you should be able to divide your family income pretty evenly. Your gross family income would be in the order of $150,000 before the clawback kicks in. Say your taxable income is $50,000 each, that would allow you to withdraw some $15,000 each or $30,000 total without triggering an OAS claw back and still keep to a marginal tax rate of about 35 per cent (instead of 45 per cent if the funds remain registered till death).
So a husband and wife should be ahead of the tax man if each makes a $15,000 withdrawal on Jan.1. After the 20 per cent withholding tax on that, you net $12,000. (With the 35 per cent marginal tax rate, you will each have to pay another $2,250 by April 30 of next year.)
So what should you do with your $12,000? (assuming you are still living comfortably on the $50,000 net you had before). I often recommend investing in a segregated fund. A seg fund is an insurance product that can serve as a tax shelter because of the unique treatment of insurance in the tax law. On the same principle as a lottery ticket that is purchased with after-tax income, insurance benefits flow directly to the beneficiary, escaping the delays (and fees) of probate, and are even protected from creditors.
Suppose a husband and wife each withdraw $10,000 a year from an RRSP or RIFF worth $100,000. After six years, the couple would have $100,000 of non-registered after-tax money, versus the $54,000 after-tax value of the $100,000 RRSP when they started.
After 12 years when the RRSP funds are fully withdrawn, the non-taxable investment will be worth $140,000, a nice gain on what was only worth $54,000 after tax. If circumstances are appropriate for using leverage to start the seg fund at $100,000, the value after 12 years would be $240,000, which could provide a supplemental tax-free income of $1,500 a month, without ever using up the capital.
A future article will explore how an individual can convert an RRSP to income for life without using up the principal, or paying tax .
Fred Petrie, at Navigator Services, prepares financial plans. He can be reached at 298-2900 or email@example.com.