Sunday, March 12, 2017

Retirement and Income Tax: Moving Beyond the RRSP

As retirement savings plans go, the difference between the TFSA versus the RRSP epitomizes the concept of "pay me now or pay me later".  Sooner or later, the taxman gets you.  The RRSP  allows you to postpone paying income tax on any contributions made during your working years when your income is presumably higher.  But once you retire, it is time to pay the piper.  At that point, funds withdrawn from the plan are taxed at 100%.   By contrast, you do not get a tax deduction for contributing to the TFSA, but any funds withdrawn from it, including growth in value or income earned via dividends or interest payments, are tax free.

The short term allure of paying less income tax or even getting a refund as a result of making a RRSP contribution masks the long term implications to your tax burden in the retirement years. This made sense when life expectancy post-retirement used to average around 10+ years compared to 40+ years of working.  These days with people striving to retire earlier and commonly living to age 90 or more, it is quite possible and even likely for some people to have as many if not more retirement years compared to working years.  For example, my husband and I retired at 48 after working for 26 years.  We only need to reach age 74 before our retirement years start to outnumber our employment years. With so many potential retirement years ahead of us, it made sense to have a plan that balanced out the tax burden both before and after retirement.  Given this new normal, I believe that it is unwise to have all your retirement savings come solely from an RRSP, pushing off so much of the tax burden to the future.  We chose instead to spread out the allocation of our retirement savings to include the TFSA and even a non-registered account which receives extremely favourable tax treatment for Canadian eligible dividends by means of a generous dividend tax credit.

Let's look at an example of how $50,000 of retirement income is taxed when it comes out of the various types of accounts.  Not all of these cases are realistic options, but they highlight the differences between the tax owed from RRIF income vs. TFSA income vs income from a non-registered account that holds only Canadian eligible dividend paying stock.  I pumped each of these income scenarios into a 2016 tax calculator to determine the estimated tax owed.  Note the significant difference in tax burden for the income from the RRSP/RRIF  (taxed at 100%) as opposed to shifting some of that income to a TFSA (0% on withdrawal) and/or a non-registered account holding dividend-paying stock (reduced average tax rate due to dividend tax credit).  Imagine having to pay this tax differential throughout your retirement years.

The current conventional wisdom dictates that low income earners should choose the TFSA while mid income earners should pick the RRSP as their first savings vehicle of choice, and high income earners that make enough money should max out on both.  While this definitely makes sense if you are only looking at minimizing tax during the working years, there is more to the story when you look beyond that into the retirement years.  I believe that the RRSP is over-used as a retirement savings platform and that a more balanced strategy would be more beneficial in the long term. In 2013, I wrote an article detailing my strategy for contributing to an RRSP vs a TFSA.  I suggested that RRSP contributions should only be made to the point where you no longer have to pay more income tax beyond the amount held at source by your employer.  After that, all extra funds should be allocated to the TFSA or non-registered account in an effort to reduce your tax burden after retirement.

Implementing this plan of diversifying our retirement savings platforms during our working years gave us a good jump that we try to continue even after retirement.  We continue to strive for the goal of moving income sources from registered to non-registered accounts.  A tax strategy detailed in my book Retired at 48, One Couple's Journey to a Pensionless Retirement describes the advantages of collapsing our RRSP into a RRIF immediately after retirement and actively trying to reduce the size of the RRIF each year, or at least prevent it from growing too much.  So far we have tried to accomplish this by withdrawing the dividends generated from the stocks within the RRIF, saving us from drawing down the equivalent amount of this money in our non-registered account and stopping the RRIF from growing by the value of these dividends. But since we did not touch the capital within the RRIF, the value of our RRIF has continued to grow, as the bull run of the TSX over the last 8 years have caused stock prices to continue to rise.  This means we continually need to withdraw more income from our RRIF each year.  And despite that income being generated as Canadian eligible dividends, it is still taxed at 100% when it comes out of the RRIF, since the dividend tax credit does not apply.

Next year we will try a new tactic aimed at slowly reducing the actual value of our RRIF by shifting the capital to our non-registered account.  Rather than making our annual legislated minimum RRIF withdrawal in cash (i.e from paid dividends), we will transfer the equivalent value of stock shares "in kind".  The tax on the withdrawal should be the same since we are taxed at 100% of the value regardless of whether we take it in cash or in stock.  The shares that we transfer will start generating dividends in our non-registered account, while our RRIF will decrease both in value and in the amount of new dividends it is capable of producing.  There is no capital gain tax in the transfer, which will be made at the end-of-day fair-market value p ice of the stock on the day of the transaction.  The new adjusted cost base of the shares in the non-registered account will equal the price that it was transferred at.  This strategy works for us as long as we generate sufficient income from our non-registered account and don't need to spend the income from the RRIF.  If this turns out not to be the case, we can achieve the same result of reducing our RRIF capital and dividends by selling stock each year and withdrawing the cash.

In selecting which stock shares to transfer, we decided that we would not pick any of the income trusts that we have in our RRIF.  The reason that we put the income trusts in the registered account in the first place was so that we would not have to keep track of complicated adjusted cost base issues rising from return of capital, which would be the case if these companies were held in our non-registered account.  Next we determined that it would be more advantageous to transfer shares that have grown in value since we purchased them, as opposed to those that have decreased.  Since the new adjusted cost base of the shares will be based on the deemed fair market share price used for the transaction, transfering stock that has increased in value means that if we decide to sell this stock in our non-registered account later on, we would owe less capital gain or would generate a larger capital loss.

We will contact our discount broker to find out what steps we need to take and how much advanced notice we need to give in order to change the instructions for calculating our 2018 RRIF withdrawal.  Presumably we will need to provide exact details in writing as to which and how many shares we want transferred in-kind in order to come close to the minimum withdrawal amount and then make up the rest in cash.  There should still be no extra withholding tax if we only take out the minimum. Hopefully if we follow this new strategy for some number of years, we will accomplish our goal of slowly moving capital and the source of future income from our RRIF to our non-registered account.  Doing so will help keep our tax burden from steadily and dramatically rising as we are forced to withdraw a larger and larger percentage from our RRIF with each passing year, taxed at 100%.

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