RRSPs are a fantastic vehicle for retirement savings and reducing your lifetime tax bill. I compare RRSPs to TFSA and Non-registered Accounts in this post. While RRSPs with re-investment of the tax refund are the best way to save for retirement broadly speaking, there are many caveats. Those caveats often make it easier, for newer investors in particular, to invest in a TFSA instead for simplicity's sake. TFSAs perform well from a tax-perspective, are very flexible accounts, and provide ease of tax management across all income levels.
However, the RRSP really shines if you earn an above average income and keep your spending levels low. Only RRSPs can provide really large tax arbitrage opportunities, especially if you can employ some tricks to keep your tax rate very low on RRSP withdrawals. You always want to contribute to RRSPs at high tax rates and withdraw at low tax rates.
While there are some withdrawal programs specific to RRSPs, such as the Lifelong Learning Plan for full-time adult education and the Home Buyers' Plan for new home buyers, this post will discuss tax issues on standard withdrawals. That said, if you are considering going back to university as an adult, or are buying a house, do not ignore the LLP and HBP because they do provide tax advantages in their own way.
1. Using the Basic Personal Deduction
All of the provinces and the federal government have a basic personal amount which you can deduct from your income. Essentially any amount of money you earn below this deduction amount is tax free.
The federal basic personal deduction is $11,809 (in 2018). The provinces range from a low of $8,160 in P.E.I. to a high of $18,915 in Alberta.
This means you can withdraw at least $8,160 from your RRSP and pay no taxes anywhere in Canada, provided you realize no other taxable income. That range for a couple by province is from $16,320 to $23,618.
Of course, this is a small withdrawal amount and your income will likely need to be increased with eligible dividends, TFSA withdrawals, spending cash savings, or selling investments which have no capital gains.
2. Split Your RRSP Income
If you want to increase your ability to withdraw money from your RRSP, get married and stay married. Splitting RRSP income with your spouse allows you to benefit from two sets of tax credits instead of one.
You can set up RRSP splitting in two ways. In the first method you contribute completely to your standard RRSP. Then, at age 65 or older, you can convert at least a portion of your RRSP to a RRIF. This way withdrawals can be eligible for the Pension Tax Credit. Income that is eligible for this credit can be split up to 50% with your spouse. Not only will you be able to take advantage of two basic personal deductions and other credits, you can further benefit from the Pension Tax Credit to increase your overall withdrawal amount at zero tax rates.
The second method requires more planning. Any contributor can set up both a personal RRSP account and a spousal RRSP account. Contributions to either RRSP are deducted from the contributors "RRSP room". However, the personal RRSP benefits the contributor while the spousal RRSP benefits the spouse of the contributor.
If I earn $100,000 per year and my RRSP contribution limit increases by $18,000 per year, I can contribute $9,000 to my personal RRSP account and $9,000 to my spousal RRSP account. My spousal RRSP contributions will in no way impact my spouse's personal "RRSP room". In retirement, the spousal RRSP withdrawals go completely to my spouse. Provided both accounts are invested the same way, the account values and withdrawals will be equally attributed to each partner in retirement.
3. Offsetting with Eligible Dividend Income
If you use your non-registered investment account to invest in Canadian-listed corporations which pay dividends, those dividends can be taxed at negative income tax rates in many provinces. The rate of negative tax depends on your income level and your province of residence.
B.C. is the best province for this strategy as it has the highest negative tax rates on income under the first federal tax bracket ($46,605 in 2018). Alberta, Ontario, and Saskatchewan also have negative taxes on eligible dividends, but at lower effective rates.
In this strategy, you can use dividend income to offset some of the income taxes owing on RRSP withdrawals. This strategy will often allow an individual to withdraw a few thousand dollars more from their RRSP tax-free above the basic personal amount for their province.
However, the amount of RRSP income you can realize this way is still quite limited. Also, you might need to top up any other spending needs with TFSA withdrawals, cash savings, or selling positions in your non-registered accounts that have no capital gains.
4. Offsetting with Interest & Carrying Costs
The best way to significantly reduce taxes on your RRSP withdrawals is to reduce your taxable income with eligible interest expenses. If you borrow money and use that money to purchase investments (not in registered accounts), you may completely deduct the interest expenses associated with that loan from your total income. That's right, if you earn $40,000 in fully taxable income and you have $40,000 in interest expenses, your net taxable income becomes zero!
There is a small caveat however. The investments purchased with the loan money must generate some form of income that's acceptable to the CRA. This includes dividends, interest, foreign dividends, business income, or rental income. The income amount is not required to exceed the interest cost. It's important to note that investments which exclusively distribute capital gains or Return of Capital do not meet the CRA's definition of income for this purpose.
There is really no limit to how much interest costs you can expense, but of course it's smart to try borrow at low rates, manage your debt as a percentage of equity, and to buy investments which are tax efficient. You always want to ensure your loan is used to buy investments which are profitable and fit your risk profile.
A HELOC loan on a paid off house is a great choice for a low interest investment loan. With a HELOC you can borrow up to 65% of the value of your house for Prime + 0.5% interest. Margin loans with Interactive Brokers, National Bank Direct, or RBC Direct (Royal Circle only) are also good options.
The most ideal investment from a tax perspective might be Canadian stocks which pay low yielding eligible dividend income. Some examples of companies which fit this profile are Alimentation Couche-Tard (trades as ATD-B.TO), CP Rail (trades as CP.TO), Brookfield Asset Management (trades as BAM-A.TO), Stantec (trades as STN.TO), Fairfax Financial (trades as FFH.TO), Imperial Oil (trades as IMO.TO), or Waste Connections (trades as WCN.TO) to name a few.
The key is to borrow at a reasonably low rate (under 4% at today's rate environment) and purchase stocks with a dividend yield under 2%. If you buy foreign assets, target a yield under 1% as foreign dividends at fully taxed.
For example, let's say you own a paid-off home worth $700,000 in B.C. You can borrow $455,000 with a HELOC at 3.95%, translating to an interest expense of $17,972 per year. If you invest that money in Canadian companies with an average yield of 1%, you could withdraw up to $30,000 from your RRSP completely tax free as a single taxpayer. The RRSP withdrawal amount would be even higher as a couple since you could split the interest expenses and dividend income.
5. Income Tax Targeting
I personally believe the best way to tax plan in retirement is by taking a complete, realistic portfolio approach. This means not focusing on any one account, one form of income, or complete minimization of taxes. Instead, target an acceptable tax rate based on your spending needs and formulate a plan around that.
For a moderate spending couple with investment assets an acceptable total retirement tax rate might be 10% if you are located in a lower tax province. RRSP contributions save you tax at your highest marginal tax rates--often well into the 30% range and sometimes even over 50%. At these refund rates, the tax benefit for using RRSPs would be substantial for most people, even when paying 10% tax on withdrawals.
We know that RRSPs (with tax refund re-investment) and TFSAs theoretically perform equally well from a pure income tax perspective when you contribute and withdraw money from the accounts at the same marginal tax rate. In a scenario of equal tax rates, the TFSA would win because of the flexibility the account offers and it doesn't expose you to clawbacks on benefits.
However, if you can gain a tax spread of 20%+ on your RRSP withdrawals relative to contributions, you are doing really well from a tax perspective. It's this spread that makes the RRSP an ultimate savings account for smart investors.
To execute a tax targeting plan, you would first start with the investment income types which are less easily controlled. This might include dividends, foreign dividends, and interest income. Then you would top off your taxable income with RRSP withdrawals or by realizing capital gains to increase your adjusted cost base. You would trigger just enough income to hit your target blended income tax rate.
It may be worthwhile to realize income at a low tax rate, even if you don't need the money for spending reasons. You can always re-invest the unused income in your TFSA accounts or your non-registered accounts. This can help reduce tax rates in the future and allow for more flexibility in spending. Remember, if you are able to shrink your taxable income down to very low levels when you are 65 or older, you can get some great social benefits.
On the other hand, if you have a year in which you are planning to spend a significant amount of money relative to your usual spending, you may also use tax targeting for that. You could withdraw the money from your TFSA or by realizing capital gains to pay for renovations, vacations, or other similar one-time expenses. Since TFSA withdrawals can be re-contributed in future tax years, the penalty for a short-term withdrawal is not that significant.
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