The OAS Pension Recovery Tax What To Do if the Clawback Ain’t For You (Part 2)

Introduction

Now that you know how the OAS pension clawback is applied and its actual effects on your bottom line in after-tax dollars, I want to pass along ways you can organize your affairs so that you can get (and keep!) as much of your Old Age Security Pension that is humanly possible. Since a lot (but not all) of these techniques focus on keeping your taxable income down, you might also save some income tax dollars, too, if you’re not careful.

Before diving in, I realized that there was one additional situation where I see seniors taking an unwanted sojourn into the clawback zone that merits comment: the curse of the saver. If you are one of those thrifty and savvy investors who actually grow their incomes during retirement, you could unwittingly end up in the clawback zone at some point. Even if you don’t become a regular inhabitant, you still may be an occasional visitor during years you report significant capital gains. Accordingly, this article is written for those of you as well in the hopes of keeping your visits to this unpopular destination as infrequent as possible.

In no particular order, here are some of the various strategies, manoeuvres, and creative solutions that can maximize your OAS pension, although a lot turns on the specifics of your own circumstances:

A. Delaying Your OAS Pension

Last year, seniors were given the choice for the first time to defer the start date for up to five years. To sweeten the pot, the federal government agreed to top up your pension benefits by .6% per month for every month after age 65 that you waited until starting your pension until age 70. In other words, if you are willing to wait an extra 5 years to start collecting pension cheques, each payment you eventually do receive will be 36% higher than the ones you would have received at 65.

Why would you do this, you ask? First, if you have good genes in your family and don’t believe yourself to be particularly accident-prone, you might ultimately get more money over the long term if you’re willing to hold off starting your pension for a few extra years. This might sound even more appealing if you expect to be in a lower tax bracket when you start collecting your pension, since you would have lost more of your pension to taxes at that point anyway.

Secondly, assuming you believe that the OAS pension is here to stay without significant changes and aren’t worried about clawback, you might like the idea of having a larger guaranteed payment each month later in your retirement even if it means giving up some smaller cheques early on. This idea might be particularly attractive to people who are very conservative investors (i.e. GIC lovers) who are willing to court the risk of dying young and losing out on extra pension payments in exchange for knowing that they will have a larger guaranteed payment for life. If your GICs are only paying out a few percent a year in taxable income, maybe you’re more excited about ‘buying’ more inflation-indexed pension dollars each month by deferring your OAS pension past its normal start date and drawing down your GICs in exchange for bigger cheques later.

Third, and most important for our purposes, deferring your pension might be a great way of avoiding the clawback. This can work in a few ways. For example, if you just love, love, love your job and don’t want to retire at 65, your continued salary might be enough to clawback a good chunk of your OAS pension, especially if you decided to already start your CPP pension or are receiving a work pension. In cases like this, you’re not really giving up all that much. In fact, if you’re making more than about $115,700 without your OAS pension, you were going to lose your entire pension anyway if you started collecting at 65.

On a similar note, perhaps you are still in the work force but are able to keep a portion of your OAS pension. If this is you and you’re only keeping a small chunk of your pension, the benefits of deferring until you are out of the clawback zone may still be a lot higher than the .6% a month you get for each month of deferral. This is because:
a) You’re giving up some pension dollars now that would have been clawed back anyway; and
b) You are going to pay less tax per dollar on your pension when the first cheque finally hits your bank account since you’ll probably be in a lower tax bracket.

Alternatively, you might have already retired by 65 but are already brushing up around the $115,700 upper limit for the clawback. If you defer your pension until age 70, you’re trading in a pension that isn’t paying you anything now for one that might at least pay you something later. The extra 36% you’d get at age 70 wouldn’t be clawed back until your taxable income exceeded about $131,600. In other words, you may be able to keep all or some of the deferral bonus even if you are trading away the right to a pension at 65 that would have never paid you a dime in the first place. By my calculations, the deferral would add about $2,400 to the normal pension. While this isn’t a lot of extra money and will be heavily taxed anyway if that’s the only portion of your pension you get to keep, why leave extra money on the table?

B. Taking your CPP early

Although I don’t think it is a no-brainer (see my previous articles on the subject), most planners seem to recommend taking your CPP at age 60. If that makes sense for you, this can help you reduce clawback. Since you’ll be getting less CPP per year at age 65 onward than if you’d waited, that also means getting to keep more of your OAS pension.

C. Income Splitting

If only one spouse is above the OAS clawback zone, there are numerous techniques for transferring taxable income from that spouse to the others’ tax return in the hopes of reducing their combined tax bill and maximizing their combined OAS windfall. As well, perhaps you have children or grandchildren in lower tax brackets. Here are a few ideas for taking advantage of these opportunities:

• Income-Splitting CPP pensions, work pensions and RRIFS with your spouse subject to the different rules that apply for each;

• Spousal Loans. If a non-registered investment portfolio is the problem, the high income spouse could loan the other spouse money at the prescribed government rate (currently 1%, which can be locked in for life). The other spouse would then be able to claim the income from the investments on his or her own return, deducting the 1% interest expense. The lender spouse must declare the 1% interest for tax purposes and the interest must be paid by January 30 of the subsequent year. In the end, this can result in a lower combined tax bill for the couple and higher combined OAS pensions;

• Declaring dividends from private companies strategically. If you own a business and your spouse or a family trust naming your spouse owns a different type of share than you own, you should be able to create a dividend mix between the different type of shares to generate the best tax results possible. You might also do the same thing with adult children as well if they are in a lower tax bracket. Even if they are not, the clawback savings may still make this a good idea. Another option, especially if you’re earning income that is taxed at the small business rate, is simply parking the extra money inside the company or a holding company and investing there. You may have more money left to grow and, as an added bonus, get to keep more of your OAS pension, too.

Strategic Investments

• You may invest in flow through shares or limited partnerships that may give you tax deductions along the way to reduce your taxable income and increase your OAS pensions. If you want to investigate this option further, I suggest doing it with eyes wide open, as these investments are often risky. Although the tax benefits are wonderful, they shouldn’t trump making good investments decisions.

• Although I don’t recommend this for most retirees, you could borrow money for investment purposes and write off the interest. The assets you buy must have the potential of eventually paying income (not merely capital gains), although this rule is rather liberally applied. Since the interest expenses will be less than your income (excluding the hoped-for capital gains payoff at a later date), you’re hopefully going to get to keep a bit more of your OAS pension. As noted in my previous income, if you invest in something paying dividends, be sure to take into account that fact that every dollar of dividends from an eligible Canadian company will show up as $1.38 on your tax return when calculating your OAS clawback. You also need to take into account the potential tax hit if you sell your investment at a later date and what that might do to your pension!

• Investing in Corporate Class Mutual Funds. There is a type of mutual fund that is designed for tax efficiency. While mutual funds aren’t everyone’s cup of tea, (particularly in light of the fees) perhaps the tax savings these offer may change some minds. They strive to pay out tax-free return of capital payments first if that’s what you want and to convert the income to deferred capital gains that are only taxed when you decide to pull the trigger. If you need money before you want to sell, you can get paid some of your original money back as a tax-free return of capital up to set limits. As an added benefit, you may also rebalance your portfolio within the same family of corporate class funds without triggering a gain. Finally for those rare investors who have unused capital losses on the books, converting different types of income into capital gains allows them to use up these losses, which further keeps tax bills down.

Unfortunately, the government has imposed rules that will make it difficult for most corporate class funds to convert interest from bonds into capital gains. On the other hand, I met with Jeff Smilgis, Financial Advisor, with Raymond James in Coquitlam, B.C., who sells NexGen mutual funds. Although Jeff also sells individual securities like stocks and bonds (and some other specialized products), he uses NexGen inside non-registered portfolios for clients in higher tax brackets or if facing the OAS clawback.

As NexGen uses a different method to convert interest into capital gains than other corporate class funds, they will not caught by the new rules. Even better, their structure allows you to dictate each year the exact type and amount of income you receive from your difference funds in any or all of: eligible dividends, deferred capital gains, realized capital gains and tax-free return of capital each year. The theory is that the tax savings through realizing income as tax efficiently as possible and converting what you don’t need into deferred capital gains pays for the extra costs or perhaps lower returns that some investors associate with mutual funds. As many investors have strongly held views regarding funds vs. individual securities, I will leave it to make up your own mind.

Gifting During Life

• Although I caution clients to be careful about gifting during their lives for many reasons, the tax side of things is often very attractive. For example, a parent battling the clawback might gift their child enough money to buy a home. Instead of earning future income that might reduce their OAS pension, the money is going to work to build tax-free capital gains in their kids’ hands. Rather than calling it a gift, I prefer to set it up as a loan that can be forgiven in the parent’s Will, complete with a promissory note so that the parent has some protection if the kid has creditor or matrimonial issues or if you ever need the money back again.

• Gifting to fund a child’s TFSA. If junior already has a home or mom and dad prefer smaller gifts, they might fund the kids’ TFSAs each year. The money grows tax-free in the kids’ hands and, assuming the investments listen to reason and perform well, will provide more money to the kids than if mom and dad had held onto it for life. Unlike RRSPs, TFSAs can be used for collateral, so mom and dad might want to take back a promissory note from the kids that is forgiven at death just like the home loan option.

• Funding RESPs. I love the 20% + grant money, the tax-deferred growth and the fact that the income will be taxed in the student’s hands when the money is finally put to use. You may wish to gift the money to your kids to fund the RESP which simplifies your Will planning. Again, you may be able to set this up as a loan.

Life Insurance

• If you’re still insurable, putting your money into life insurance converts taxable money into money that grows tax-free and will pay out a tax-free death benefit down the road. Some policies allow you to invest inside the policy and have tax-efficient leveraging strategies that allow you to access both your capital and the gains tax-free during your life. In many cases, this can also mean a bigger estate for your heirs that they can receive without having to wait for probate. As I’ve discussed these options in excruciating details in previous articles, I will say no more for now.

• Insuring kids and grandkids. Although this may sound ghoulish to some, taking out policies on the next generation provides many potential benefits, from ensuring protection for future generations to providing them with extra money for school or a first home. If the policy is set up correctly, the cash value in it won’t be taxed on your death. Moreover, it is possible to set up policies on grandkids so that you can pass the policies to their parents rather than the young’uns directly on your deaths, with the understanding that your kids could transfer them tax-free to their own kids at a later date. In any event, once the kids or grandkids do take over the policy, any taxable withdrawals will be taxed in their hands, not yours. Moreover, for larger policies, these future generations may be able to take advantage of some of leveraged life insurance opportunities I’ve discussed in the past.
Capital Gains and RRSP Planning

• You may wish to sell that rental property or your stock with the big unrealized gain prior to age 65 so that it won’t trigger clawback.

• If you sell past age 65, you may sell a bit in different tax years to spread out the gain and hopefully minimize the tax hit. If you are willing to delay receiving payment for a few years, it is also possible to spread the capital gain out through something called a “capital gains reserve” that achieves the same result. These reserves can spread the gains out over 5 years in most cases, although sometimes arranging payment over two separate tax years (i.e. getting one payment in December and one 30 days later in a new tax year) can be enough to solve the problem.

• If you’re the one being clawed back and still have RRSP room, consider continuing RRSP contributions, especially via a spousal RRSP if your spouse is in a lower tax bracket. Of course, you’d have to also look at the size of your RRSPs as well to make sure that this this will not only delay but worsen the pain when your spouse needs to convert to a RRIF.

• Look at making strategic RRSP withdrawals prior to age 65, even if you don’t need the money. Although I love deferring taxes when possible, doing so might not make sense if it means paying tax at a higher rate later while also incurring clawback. In B.C., strategic withdrawals can often mean taking out as much money as possible at the 20% rate, noting that things go up hill steeply from there. Sometimes this type of planning might also be combined with delaying CPP or OAS pensions as well.

Conclusion

As you can see, there are many potential ways of saving all or some of your OAS pension. Some are no-brainers and others will take a bit of work to analyze and set up if and when you do decide to take the plunge. Ultimately, the question I suggest that you ask yourself — particularly before you look at taking out investment loans, investing in flow through shares or gifting to the kids — is whether the cure is worse than the disease. Although I would love it if each and every one of my readers could keep their full pensions, sometimes it just isn’t worth the risk. Even if it means that your blood boils just a little bit every April when you calculate all the OAS you didn’t receive, maybe that’s better than stewing daily on investment losses resulting from a leveraging strategy or a poorly performing flow through share! On the other hand, if some of the other tactics can put pension in your pockets without materially increasing your risk, no one would be happier to hear about it than me.