The OAS Pension Recovery Tax: What To Do if the Claw back Ain’t For You
Introduction
If you really want to light a fire in belly of most middle class retirees, I strongly suggest turning the conversation to how their OAS pensions are reduced if their taxable incomes top about $71,600 as of the date of this post. More specifically, they will lose $.15 for every dollar in taxable income they receive above that point until, if they make enough, their entire OAS pension of $6,618.48 (what most long-time Canadians receive if they take their pension as soon as possible as of May, 2014) is a thing of the past. I plan to use this and a subsequent article or two to explain how the claw back works and some steps you can take to minimize the impact. Today’s offering will set the stage and explain why dividends may not be as good as advertised when the claw back comes calling.
Situations Where The Claw Back Most Often Occurs
Although many Canadian couples are able to income-split in retirement to keep the OAS claw back successfully kept at bay, things may change at the first death; RRIFs, pensions and investment portfolios previously taxed on separate two returns are now amassed on a single return. The result: a higher average tax rate since more money is being taxed in higher tax brackets and an unwelcome visit to the claw back zone. When the changes to how testamentary trusts are taxed kick in 2016, I expect to see more widows and widowers journeying into this scary land; these changes will likely result in more seniors declaring the income from an inherited portfolio on their own returns rather than a trust return, even if doing so hammers their OAS pensions.
I also want to pass along a quick warning to those of you not fully drawing on their RRIFs. Although I love deferring taxes as much as the next guy (and perhaps a little more), it’s important to realize that there is a day of reckoning that comes in the year you turn 72; you have to withdraw a minimum percentage of your portfolio that and each subsequent year, even if you don’t need the cash. Even worse, the minimum keeps increasing each year. Although I’m also an RRSP believer, I also believe that it may make sense to keep the size of your RRSP under control by making strategic early withdrawals in some cases. Sometimes, a little pain now really is better than a lot later. For early retirees, this could mean making more significant withdrawals prior to age 65 when your OAS pension kicks in.
Finally, I also want to put the impact of the claw back into perspective. Although no one likes to give up $6,600 in free money, it’s not like you were going to get to keep it all anyway. As the OAS is taxable, most people in the claw back zone would have paid back over 30% of it in taxes.
Secondly, some clients look at paying claw back as the cost of doing business; while they may not love it, they look at it as a price of their own financial success and as money they really don’t need anyway. Moreover, they might correctly see that in some cases combatting the claw back isn’t worth the effort. For example, although the rest of the article will focus on how dividends are often bad news for retirees trying to avoid the claw back, these same people might also be reluctant to modify their investments to produce other types of investment returns, especially if that means unnecessarily courting more investment risk or triggering a big capital gain in order to rebalance their porfolios.
All Types of Income Are Not Treated Equally
Many financial advisors utter the phrase “eligible Canadian dividends” as if it is holy writ. At times, I am one of them but mine is not a blind faith. Although eligible dividends can be manna from heaven for investors in the right tax bracket, they start to lose their lustre if you’re bumping up against the claw back threshold. This is because each dollar of dividends you receive actually shows up at $1.38 on your tax return. Although you later get a significant tax credit against this income, the added hit the “gross up” (i.e. taxing each $1.00 as $1.38) causes to your OAS pension might make other forms of income a more attractive proposal.
Even though interest still might not be way to go — while each $1.00 of interest is taxed as such for claw back purposes, this advantage over dividends is still outweighed by the lower taxes you’ll actually pay on the dividends themselves – capital gains are another story. Only $.50 of each $1.00 of capital gains you earn is included as income. Put another way, each $1.00 of capital gains earned only reduces your OAS pension by 7.5%, compared to 15% of each interest dollar and. . . gulp . . . 20.7% of each eligible dividend after factoring in the gross up.
What does that mean in the grand scheme of things? To get a clearer picture, I suggest adding the impact of the OAS claw back to the income taxes you pay on the different types of income in your tax bracket. In other words, treat the reduction to your OAS pension as another tax and add it to the tax bill on that type of income.
Converting theory to numbers, here is how to crunch the figures. Let’s assume that Colleen lives in British Columbia and earns $77, 000 per year, but has the choice of how to receive an additional $5,000 as interest, eligible dividends and capital gains.
In this situation, Colleen’s marginal tax rates on the different types of income ignoring claw back issues is as follows:
Interest Eligible Dividends Capital Gains
32.5% 10.32% 16.25%
On the other hand, Colleen will trigger claw back on this extra $5,000 of income, which needs to be calculated as well. Here are the basic claw back rates on each of these three types of income without factoring in the tax you’d have to pay on the clawed back money if you’d been able to keep it.
OAS Claw back Rate on Different Types of Income
Interest Eligible Dividends Capital Gains
15% 20.7% 7.5%
The next step is to adjust the figures just provided to account for the portion of the money that would have been clawed back that would have been paid in taxes away. To do this, I first investigate and discover that Colleen is in the 32.5% tax bracket when receiving this extra money. I multiply the $.15 per dollar claw back in pensions by (1-.325) in order show that she would have only been able to keep 67.5% (100% of the pension amount minus the 32.5% she would have lost in tax) of the clawed back pension if claw back hadn’t occurred. Here are the real effects of the claw back to the different types of income after accounting for the clawback.
Tax- Adjusted Claw back Rate on Different Types of Income
Interest Eligible Dividends Capital Gains
10.125% 13.9725% 5.0625%
The next step is to add the totals from the previous chart to the totals from the marginal rate chart on the different types of income to see the combined tax bill, including the OAS claw back, that Colleen would pay on the different types of income in her situation
Combined Income Tax and Claw back Tax for Colleen
Interest Eligible Dividends Capital Gains
42.3% 24.29% 21.31%
What if Colleen’s income was $105,000 before including the extra $5,000 of income? In that case, she would be taxed on the different types of income as follows
Marginal Rates for Colleen at $105,000 in Taxable Income
Interest Eligible Dividends Capital Gains
40.70% 20.35% 21.64%
OAS Claw back Rate on Different Types of Income
The OAS claw back rates remain the same before tax
Interest Eligible Dividends Capital Gains
15% 20.7% 7.5%
On the other hand, Colleen would have been able to keep less of her OAS pension anyway, since she’s in a higher tax bracket. Accordingly, the rates must be calculated as 1-.407 (i.e. she would have only kept 59.3% of the amount of her OAS pension clawed back anyway.
Tax-Adjusted Claw back Rate on Different Types of Income at $105,000 in Taxable Income
Interest Eligible Dividends Capital Gains
8.90% 12.28% 4.45%
Combined Income Tax and Claw back Tax for Colleen
Interest Eligible Dividends Capital Gains
49.6% 32.63% 26.09%
Interesting Implications
When I look at the various numbers above, I see the following:
- If Colleen was earning $105,000 before receiving her last $5,000, she is actually paying more tax per dollar than she would have paid if she was in the highest tax bracket, reserved for income earners making more than $150,000 in B.C. This is because Colleen would have already lost her OAS pension when her taxable income reached about $116,000. Accordingly, we wouldn’t need to calculate the impact of the claw back for that scenario, as it would no longer apply. As a result, if Colleen had a spouse already in B.C.’s highest tax bracket, he would actually pay less tax after including the claw back. This suggests that in some cases, it might actually make sense to income-split in order to attribute more income to the higher income spouse.
- Eligible dividends aren’t the ideal way of receiving investment earnings for seniors facing claw back. Even though they look at first blush to be a better deal than capital gains (10.32% tax rate on dividends vs. 16.25% taxes on capital gains using Colleen’s example at $77,000) the impact of the claw back makes capital gains a slightly better deal when the dust settles (21.31% vs. 24.29%). In a province like Ontario, where eligible dividends aren’t taxed as favourably as in B.C., the differences should be even more significant, though I will leave it to someone else to crunch the numbers. In fact, if you’re earning more than $88,000 in Ontario at the time I write this, you’re paying essentially the same tax rate on dividends as you’re paying on capital gains in the first place without factoring in the OAS clawback!
- Although I carefully selected Colleen’s income and the amount of extra money she could receive so she would be taxed in one tax bracket throughout, that’s probably not going to be the case for most of us. Since 1.38% of every dollar of dividend is taxed and only 50% of every capital gain, it is quite likely that many people would end up paying taxes in a higher tax bracket if they received dividends rather than capital gains, ignoring the claw back implications. In other words, using the first example, Colleen’s taxable income would have increased by $2,500 if she took her $5,000 as capital gains and $6,900 if she took it as eligible dividends. Using Colleen’s example, this would provide her with a total taxable income of $83,900 if she took the $5,000 as dividends and $79,500 as capital gains. If she had to pay tax on some of the $4,400 difference in taxable income between dividends and capital gains at a higher tax bracket than the rest, this would mean that the tax advantage of capital gains is even better in such situations.
- The potential benefit of investments that provide a tax-free return of capital or deferred capital gains might be even higher than you suspect. Although some investment options that allow you to do this, such as corporate class mutual funds, do carry management fees, it is important to understand the true savings they can provide when deciding whether they are the investment for you despite the management expense ratio blues. My goal today isn’t to answer this question but merely let you know of your options, especially if you already own mutual funds.
Conclusion
Although there are myriad worse problems in life than the OAS claw back (such as the plight of Canada’s NHL teams, for one), there is no point in paying extra taxes or unnecessarily giving up government benefits. My next article will provide some options and strategies for doing just that, again with the enormous caveat that sometimes the cure is worse than the disease. Until then, go, Habs, go!
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Colin S. Ritchie 