When managing future taxes due on retirement savings accounts, is it best to empty RRSPs today or is there a way that doesn't break the bank as much?
Desmond and Jung-soon, ages 66 and 68, are looking for help in planning their retirement spending and managing the amount of income tax they pay. Their current financial advisor is retiring – an increasingly common situation among Canada’s greying advisor population – and as a result, they’ve decided to seek advice from a new source, advice-only planner Brett Martinson in the Niagara Region of Ontario.
The couple’s goal is to make use of their savings during their lifetimes while minimizing their lifetime tax bill. Desmond was diagnosed with Parkinson’s disease about three years ago and thinks he won’t live to an advanced old age, but Jung-soon expects to live to age 90 or beyond.
The couple has sufficient income from their work pensions, the Canada Pension Plan and Old Age Security benefits to meet their day-to-day spending needs, including discretionary items such as annual travel (in pre-COVID times). In addition to maxed-out Tax-Free Savings Accounts (TFSAs), they also have a combined $250,000 in non-registered accounts and $300,000 in Registered Retirement Savings Plans (RRSPs). None of these funds are needed to meet their current spending requirements, so they haven’t been withdrawing from any of these accounts.
Jung-soon is very concerned about how much tax their estates might face on their retirement savings. When she was their executor, Jung-soon saw her parents’ RRSP accounts taxed highly on their final tax returns. Now, she wants to make sure the Canada Revenue Agency isn’t the inadvertent beneficiary of the savings she and her husband have built over time. “Sometimes, I feel like just withdrawing all of our RRSPs today and paying the tax – just to be done with it,” she tells Brett. But is that the right plan to reduce their lifetime tax bill, or are there better options?
Four Options to Consider
Martinson explains to the couple that compared to drawing down their TFSA and non-registered accounts, withdrawals from their RRSP accounts will attract the highest tax bill during their retirement, as each dollar of income from the RRSPs is fully taxed. Their non-registered accounts, in comparison, will generally produce tax-advantaged capital gains, and withdrawals from their TFSAs won’t generate any tax bills at all. Accordingly, the couple and their planner agree to focus on developing a plan to reduce their expected tax bills from their RRSPs and, after they hit age 71, from their Registered Retirement Income Fund (RRIF) accounts.
After reviewing their situation, the planner outlines four potential paths for the couple to consider:
- Option 1: Withdraw all RRSP income now, and pay tax on the full amounts in the year of withdrawal
- Option 2: Forgo RRSP income until age 71, then take the required minimum withdrawals once the RRSPs have been converted to RRIFs
- Option 3: Slowly withdraw income from RRSP accounts, starting now, as a tax planning method to reduce their lifetime income bill
- Option 4: Purchase a life insurance policy to cover the projected tax bill on the RRSPs, assuming the lifetime premiums are lower than the expected tax cost
Martinson estimates Option 1 would give the couple a tax bill of approximately $120,000 in the year of withdrawal, which immediately rules out this option for the couple. They are also not interested in purchasing a life insurance policy to cover the anticipated final tax bill. This leaves the approach of withdrawing funds from the RRSPs slowly, over time, to manage the tax payable. Although the couple could wait to start withdrawing until they’re required to after age 71, Martinson recommends they explore Option 3, and start withdrawing now.
The Big Picture
Martinson outlines the projected tax consequences of Option 3:
- Over their lifetimes, their “base” incomes – from work pensions, CPP, and OAS – will never decrease, and thus they can expect to remain in the same tax bracket and pay tax at the same marginal rate (barring a change to tax rates – which the planner noted have been recently increasing, not decreasing).
- Both Desmond and Jung-soon have an individual pre-tax income of about $55,000, which means they each face a combined (federal and Ontario) marginal tax rate of 29.65 percent, applied on income between $49,021 and $79,500 in Ontario.
- As a result, they can withdraw up to $24,500 annually from their RRSP accounts at the same marginal tax rate as they are already paying (as an additional $24,500 of taxable income will bring them to the “top” of their existing tax bracket). The annual withdrawals will be adjusted for inflation to match any inflation adjustments to the tax brackets
- With $79,500 of taxable income each year, they will also avoid any OAS recovery (“clawback”) tax.
Putting the Plan into Action
Here’s how the strategy would be implemented: each October or November, the planner would meet with the couple to review their expected tax bill for the year in light of any larger-than-expected interest, capital gains, or dividends in the year. Then, based on that review, an amount would be drawn from each RRSP to bring Desmond and Jung-soon up to the bottom of the next tax bill of additional yearly household income taxed at their marginal rate of 29.65 percent.
This strategy is expected to manage and lower the couple’s lifetime tax bill as follows:
- The couple would reduce their RRSP balances to zero in about eight to 10 years, moving the $300,000 in their highly-taxed RRSPs to lower or non-taxable accounts (non-registered accounts and/or TFSAs).
- By implementing this strategy, the amounts in their RRSPs that will need to be converted to RRIFs by the end of the year in which they turn 71 will be reduced, thus lowering, in turn, the amount of required minimum withdrawals from RRIFs.
- Finally, starting withdrawals now, when both members of the couple are alive, is another tax management strategy. If either member of the couple were to pass away, the tax on their remaining investments would fall entirely on the surviving member, reducing the amount that could be withdrawn before hitting the next tax bracket – at a time when that spouse is also dealing with lower household income due to reduced government and work pensions.
The Bottom Line
Desmond and Jung-soon settle on the plan to gradually empty the RRSPs instead of withdrawing them all at once or, conversely, leaving them untouched until mandatory RRIF withdrawals start.
Martinson estimates this strategy will result in tax bills of about $40,000 to $50,000 each over the next eight years, or up to $100,000 for the household. He thinks this is about $20,000 to $40,000 less than the tax cost of withdrawing the full amount from the RRSPs in 2021. By moving forward with this strategy, the couple has satisfied Jung-soon’s concern about high taxes on their future estate – and the planner has given the couple hands-on tools to optimize their tax outcomes.
