Leave to Grow or Withdraw Some Dough: Factors to Consider When Pondering Early RRSP Withdrawals – Part 2
In my first article in this series, I hopefully persuaded at least some of you that sometimes, getting your money out of your RRSP or RRIF before absolutely necessary can be a better than average financial decision. I showed you a specific calculation where calling for your cash early and investing it tax efficiently outside of your RRSP resulted in a significantly larger cheque for your heirs at death, as well as increased financial flexibility for you along the way. On the other hand, I hedged my bets and suggested that whether or not you should do the same as our fictitious hero depended a lot depended on the specifics of your own financial situation, vaguely promising to provide more details later.
In today’s offering, I will do just that in excruciating detail. There really are a surprisingly large number of factors to consider when deciding what to do with your RRSP and it is generally impossible to combine them all into a single neat algorithm or formula of universal application. Read on and see for yourself. But when you are done reading both this article and the final installment in this series, I am still hopeful that you have enough general principals and factors to consider so you can make an educated decision on what is right for you. Time to begin. For ease of reference, I will resort to bullet points.
- Do you have a really, really large RRSP that you doubt you’ll fully spend during your lifetime? If so, this will mean that a lot of it will ultimately be taxed at the highest marginal tax rate, which can mean losing over 50% of the remaining balance at that time to our provincial and federal governments, depending on your province of residence. As an aside, I see the Federal Liberal Government’s decision to create a new tax the other year that ultimately increased the top tax rate by 4% in order to purportedly “tax the rich” as a hidden estate tax that will affect the majority of Canadians. This is because most of us will be taxed at this top rate at our death or the deaths of our spouses when, or those of us destined to inherit will have inheritances reduced as a result of these rates when our parents or other relatives pass on. The higher the highest tax rate grows, the more incentive there is to reduce the amount of RRSPs and RRIFs that might be taxed at this rate on your death, particularly if in a significantly lower tax bracket right now.
- Will You Be Able to Tax-Efficiently Deploy the Money You Withdraw? Although you’ll have fewer dollars to work with than if you leave your RRSP well enough alone, you can potentially make up all or some of difference if the money you withdraw grows more tax-efficiently than inside your RRSP or RRIF. In the example in my last article, our hero was in a low enough tax bracket that non-registered dividends were almost free money for him, which offset the fact that he is earning fewer dividends per year in the non-registered portfolio he created with the after-tax value of his early RRSP withdrawals than inside his RRSP. Although the portfolio from his RRSP withdrawal cash will appear to grow slower than if left in his RRSP, the real question is how much is each worth after taxes rather than before his day of reckoning. As the example showed, a small but efficient non-registered portfolio may actually provide more value in the long run.
Eligible dividends from Canadian companies can be extremely tax efficient for Canadians in the first few tax brackets. Other tax efficient ways of using your RRSP withdrawals are:
- funding your TFSAs or potentially those of other family members;
- investing in products that pay return of capital or that focus on capital appreciation rather than on paying income;
- buying life insurance or other insurances, such as LongTerm Care Insurance;
- paying down debt;
- gifting to children in lower tax brackets to invest or to buy that first home;
- putting it in a trust for the benefit of future family members so gains and growth can be taxed in some of their hands
Adding a wrinkle to the debt repayment strategy, if you do have debt but still like the thought of investing, consider using the RRSP money to pay off non-deductible debt but then borrow the money back for investment purposes. The debt is now an investment loan and the interest is tax-deductible if you invest in an open account (i.e. not in your TFSA). Thus, if you invest to earn Canadian dividends and are in a relatively low tax bracket, the low tax rate (or potential tax refund) they generate, coupled with extra taxes you save by writing off your borrowing costs against other income may be a game changer.
Also, if you have a lot of unused capital losses on the books, you may ultimately be able to apply them against some of the future gains in your non-registered portfolio along the way, which you might not otherwise be able to use until death. This ultimately means that you could get a lot of capital gains for free along the way.
- What are the Relative Rates of Return if You Leave the Money in Your RRSP Compared to What You Do When You Withdraw It?Until now, I’ve mostly assumed that you’d use the money you take from your RRSP to buy back the same investment in your non-registered portfolio or TFSA. That is not always the case. Perhaps you use it to pay off high interest loans for you a family member. In that case, you may be getting a better return on the money than if left alone in your RRSP, even when ignoring the future tax bill on your RRSP growth. Likewise, you might hope to get a better return from buying a rental property or, indirectly, by helping a child buy their first home, then by keeping it inside your RRSP.
- How Tax-Efficiently Can You Withdraw Your RRSP Money Now? As I’ve written about in previous articles, if you can get your RRSP money out for free at any point in time, such as if you’re not earning any money, then it’s probably a good idea, especially if you have TFSA room. The less tax you pay on withdrawal, the less hard your non-registered portfolio needs to work to replace the lost profits you would have earned on the tax you’re paying ahead of schedule, particularly if you plan on deploying the money you withdraw tax- efficiently. Thus, it often makes sense to systematically withdraw RRSP money over a number of years at lower rates rather than melting it down all at once and paying more total taxes even if means having to wait a little longer.
If you are over 65, you can also have up to 50% of your withdrawals taxed in your spouse’s hands at their rate if you put some of your RRSP into a RRIF and make the withdrawal from the RRIF rather than your RRSP.Thus, you can potentially access more money at a lower combined rate if the tax load is shared by two.
Finally, there are other more advanced techniques for getting money out on the cheap, such as buying flow through shares in order to create a tax-deduction or taking out an investment loan. That last idea involves borrowing money to buy tax-efficient investments that produce income. Since you are able to write off the interest on that loan and the tax deduction is higher than the bill from the investment income, you can thus pull out money from your RRSP equal to the extra write-off you get on your interest net of any taxes you pay on the income you generate from the borrowed money. In other words, the tax bill from withdrawing the money from your RRSP is offset by the tax deduction you get on your investment loan. This is obviously not a strategy for many of us and, if you are looking at this, I strongly suggest investing the borrowed money conservatively and to even consider looking at segregated funds that protect you against losses on your death, although the fees for these products are not insignificant.
- What Tax Rate Do You Expect to Pay on the RRSP Money Later if You Leave It Alone for Now? Obviously, the higher the rate you expect to pay later, the greater the incentive for pulling it out now. As I said earlier, if any remains at your death, many of us will have to pay tax on it at the highest rate at that time (which could actually be higher than it is right now, unless you believe taxes will go down rather than up in the future, which currently seems synonymous with a belief in a jolly fellow named St. Nick and that there is a fairy that pays money for teeth). For the money, you plan on accessing during your lifetime, here are some of the things to consider when anticipating the future tax costs if you leave your RRSP money alone for as long as possible.
To begin, you will eventually need to start withdrawing the money at age 72 and must withdraw a minimum amount each year from either than age or from the year after you first convert your RRSP to a RRIF.Although you can control how much money you withdraw from your RRSP and RRIF prior to age 72 by only RRIFing a portion of your RRSP equal to what you want to withdraw each year, you are at the mercy of the government rules after that point. In a nutshell, once you RRIF, you must withdraw a set percentage of your RRIF value each year based on what your RRIF is worth each January 1st. This rate increases each year depending on your age or, if you set this up when you open your RRIF, your spouse’s age. Obviously, it is usually a really good idea to pick the younger spouse’s age, as this means having to withdraw less money each year, particularly since this doesn’t prevent you from withdrawing more than the minimum if necessary.
For someone who is 72 before January 1, this means having to withdraw 5.4% of what was previously your RRSP that year. This percentage increases yearly. Here is a link to a table from one of my favourite websites that tells you the required withdrawal rates for different ages: http://www.taxtips.ca/rrsp/rrif-minimum-withdrawal-factors.htm. The upshot of this is that, whether you like it or not, you’re forced to pull out $54,000 per million in RRIF dollars and climbing per year from that point. Returning to last article’s example, if our hero left his RRSPs alone and they were worth about $2,000,000 by that point, he’d be forced to withdraw about $108,000 per year and be taxed on it accordingly after also including any income he earns from other sources like pensions, rental properties, non-registered investments, and private companies. Although he wouldn’t be at the highest tax rate, he would be paying a lot more tax per dollar than if he had withdrawn some of it in his 60’s.
Our friend would also lose all of his OAS pension to the OAS clawback, which I see as a hidden tax. Although he would have paid tax on his pension anyway, I would estimate that each dollar of OAS pension lost is like increasing his tax rate by, conservatively, 8%. Reaching higher tax brackets also turns eligible dividends from a best friend to something of a frenemy. Although they are still more tax efficient than interest, capital gains are now preferable in many ways. Instead of paying perhaps 8% on average in tax on dividends, he will now be paying 25% tax for dividends taxed in that tax bracket, although this can climb to as high as almost 40% in Ontario if his income topped about $220,000! Also, our tax system shows each dividend dollar as $1.38 of income for tax purposes, which pushes payers into higher tax rates sooner, which can also make it easier to trigger a clawback of OAS pension or increase its impact.
One strategy I encourage exploring if you are hale and hearty is deferring when you start your OAS and CPP pensions until as late as age 70 in order to reduce your income until that time and potentially withdraw more of your RRSP income on the cheap before then. Not only do get paid by the government to defer these pensions (i.e. they will pay you a higher pension per year when you do start getting pension cheques); taxpayers in potentially higher tax brackets have a better chance of keeping more of their OAS pensions when they do finally arrive, as their total income has to be significantly higher at that point before all of their OAS Pension is gone to the clawback but not forgotten.
If our fictional hero was married, he would be able to hopefully allocate some of his RRIF income to his spouse and reduce the tax hit, although that depends on how much money she is earning on her own and her age. If she was younger and they set up his RRIF based on her age, then they wouldn’t have to withdraw as much money per year. Also, she won’t have to withdraw any of her own RRSP money until she turns 72, which makes it easier to keep her in a lower tax bracket until then. Unfortunately, they could both be in the same boat when she also comes of age and their family tax bill will increase accordingly.
Although the RRIF withdrawal rate increases each year, it’s important to remember that the value of the RRIF will probably start to shrink over time unless our imaginary friend corners the market and consistently earns more he has to withdraw each year. Thus, it is quite possible that his total RRIF withdrawals will shrink at some point and potentially drop him into a lower tax bracket, although if he’s merely reinvesting the money has withdrawn along the way, his tax bill on his non-registered portfolio might offset some of these potential savings once his RRIF withdrawals start to decrease.
Finally, what if our protagonist’s wife also had a substantial RRIF, work pension or income from other sources? Many Canadian couples do a great job of protecting their OAS pensions and reducing their combined tax bill by arranging their affairs so both of them are in a similar tax bracket during retirements. When one of them passes, however, the survivor is often pushed into a higher tax bracket and potentially the OAS clawback zone. For example, if both spouses were earning $65,000 or $130,000 before taxes, combined, both spouses would get their full OAS pensions and would be a tax bracket of around 30% in most province. After the first spouse’s death, the survivor will lose her spouse’s OAS pension and at least part of his CPP pension (and perhaps all or some of any work pensions).Thus, although there will be less money coming in when they were both alive, she will now lose all of her OAS pension and will have some of the combined RRIF money taxed at over 43% in Ontario and about 41% in B.C. Accordingly, the benefits of her spouse cashing in some of his RRSP early and reducing the amount to be withdrawn at higher rates during his spouse’s widowhood can have a big impact down the road even if not particularly helpful early on.
- Flexibility. As outlined earlier in a different context, there is a lot more you can do with non-registered money than with money inside your RRSP, such as gifting to children to help them buy homes, paying down your own debt, buying rental properties and putting it into a trust, where income and gains can be paid and reported on other family members’ tax returns if done correctly. Just as importantly, it is far easier to access and triggers far less tax than if you need to pull money out of your RRSP or RRIF for an emergency during a time you are already in a high tax bracket. For example, someone looking to pay for a private retirement facility can easily have expenses exceeding $7,000 per month. If this has to be funded by increasing RRIF withdrawals by enough to both eliminate the shortfall and cover the taxes owing on the extra withdrawals, this could be a rather expensive decision. It could also be the difference between keeping most or all of an OAS pension or making a one-way trip to clawback city.
Despite the preceding pages, there are still many more factors to take into account when deciding what to do with your RRSPs and RRIFs. In my next article, I promise to finish up this grocery list of relevant considerations so you can get on to the important business of better evaluating your own situation.