Reduce Taxes on RRSP Withdrawals in Retirement

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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TFSA or RRSP or Non-registered Investment Account

In Canada investors and savers have three primary accounts in which they can place money for retirement. All these accounts will allow you to invest in a wide range of financial securities. The most common securities include bonds, publicly traded stocks, mutual funds, ETFs, and publicly traded REITs both domestic and foreign listed.

The biggest difference between these accounts is how they impact your personal tax situation. Taxes, unfortunately, can become very complex even at the individual level. This unnecessary complexity is why all these special tax treatment accounts, like the RRSP and TFSA, have been created.

Read this post to get an understanding of investing and investment taxation across different accounts.

The complexity of these special accounts have given a distinct advantage to people who hire professionals to assist them with their finances (generally the wealthy crowd), or Canadians who have taken the time to understand the implications of each account on their wider tax and benefit situation.

Lets discuss the differences between these accounts and which accounts you should choose for your situation.

TFSA

Tax Free Savings Accounts are available to every Canadian over 18 years old. The annual contribution is capped at $5,500 (in 2018), but the contribution room amount is cumulative if you don't put money in your TFSA. You contribute to a TFSA with after-tax money, but you don't pay any taxes on withdrawals. Any investment returns made within the account, including dividends and realized capital gains, are not taxed.

Under the current system, you don't even need to report withdrawals from your TFSA account on your income tax forms. This means, if all your income is from a TFSA, you could appear to have ZERO income and maximize your benefits in retirement--including benefits designed for very low income seniors such as the Guaranteed Income Supplement (GIS).

RRSP/RRIF

Registered Retirement Savings Plan is a tax-deferral account available to every Canadian who files taxes. The annual contribution limit is equal to 18% of your earned income up to a maximum contribution increase of $26,230 (in 2018); unused RRSP room is cumulative and can be carried forward. You get a tax refund for RRSP contributions at your highest marginal tax rate, but you must pay full income taxes on withdrawals from RRSP accounts. Realized income kept within the RRSP account are not subject to tax until withdrawals are made.

Once RRSPs are converted to a RRIF (Registered Retirement Income Fund), any withdrawals you make are eligible for the Pension Income tax benefits and can be split with your spouse. RRSPs must be converted to a RRIF when you turn 71. RRIFs have mandatory withdrawals which are based on your age and the value of the account. The minimum withdrawal rate increases as you get older. You may not make any contributions to a RRIF account.

You can make withdrawals from a RRSP account when you are working, but the withdrawals will be added to your other income and be taxed at full tax rates. However, you can "borrow" money tax-free from your RRSP using the Lifelong Learning Plan (LLP) or Home Buyers Plan (HBP). You are required to "pay back" your RRSP when using these special plans. If you don't make those payments, the minimum required repayment for that year is added to your income and taxed as if it were a RRSP withdrawal.

Non-registered Investment Accounts

These are standard investment accounts which receive no special tax sheltering or deferral treatment. There are no limits on how much money you can contribute to a non-registered investment account, which makes them the default choice once contributions to registered accounts have been maxed.

Taxes on certain types of investment income--Canadian dividends and capital gains--are lower than taxes on employment income. You must pay taxes on any gains you realized during each tax year which reduces your net investment returns. Due to the lower realized investment returns after taxes, registered accounts (RRSP/TFSA) are often preferable to non-registered accounts. You can make your non-registered accounts more tax efficient by investing in products that do not generate income and where capital gains can be deferred for long periods of time. Swap-based index ETFs are a good example of this.

Low Income Comparison ($40,000)

Source: TheRichMoose.com

When you are in a lower income situation, you will find minimal differences between the accounts. From a pure income tax view, the RRSP with reinvestment of the tax refund is the best choice, just slightly beating out the TFSA. That's because you would slightly benefit from the difference between the highest tax rate on contributions and a lower blended tax rate on withdrawals. This small difference is mostly due to the basic personal deduction. Non-registered accounts do quite well for low income individuals because the tax rates on realized gains within the account along the way do not significantly impact returns and can actually reduce your overall tax bill in certain situations.

Middle Income Comparison ($70,000)

Source: TheRichMoose.com

If you are in a middle income situation, you will find the RRSP account with reinvestment of the tax refund to begin pulling away from the other options. The spread between tax refunds on the RRSP contribution and taxes owing on the RRSP withdrawals to increase. Even with relatively careful investing, the actual return on investments after taxes in the non-registered account will begin to suffer more.

High Income Comparison ($120,000)

Source: TheRichMoose.com

If you are a higher income individual, RRSP accounts should be your first priority. The spread in tax refunds on RRSP contributions and taxes owing on RRSP withdrawals continues to grow. Also, you must be very careful how you manage any investments in your non-registered investment accounts because the taxes on realized income there get quite punitive! Again, the TFSA is always a reasonable option that performs well.

It's Not This Simple

If you take a quick look at these charts, you might assume it is always best to invest in your RRSP first--as long as you reinvest your tax refund. While the RRSP is certainly a decent choice regardless of your income, the way our system of tax credits and other social benefits are designed makes it much more complex.

The real answer of the best account for you depends not just on your gross income, but also on your spending and total savings rates. For example, a reasonable person earning $120,000 should be saving much more than $5,500. You should save at least 10% of your gross income if you start young, expect a reasonable retirement, and will have a paid-off house by the time you retire in addition to your investments.

An individual saving $12,000 per year returning 6% over a forty-year period will see their account grow to nearly $2 million. You can't invest $12,000 per year in a TFSA, so you will be forced to save in your RRSP from that perspective. However, if your RRSP is worth $2 million at retirement, your tax rate on $80,000 of RRSP withdrawals will be quite high (22.09%). You will also get benefit clawbacks at this level of income.

RRSP accounts are also less flexible than TFSA or non-registered accounts. When you turn 71, your RRSP must be converted to a RRIF and you must make mandatory withdrawals from the account at a rate that climbs higher every year--even if you don't need the money. Since RRSP withdrawals are taxed similar to employment income, they are more difficult to access during your working years as well.

When RRSPs Should Be Prioritized

Although there are numerous complexities involved and it's never very straightforward, you should consider making the RRSP your first priority if you:

  • Are more educated in financial planning and are serious about reducing income taxes
  • Will always invest the tax refund back into your RRSP
  • Have a moderate to very-high income when you are working (over $50,000)
  • Don't spend a lot of money relative to your income
  • Plan to retire early so you can reduce your RRSP before it must become a RRIF
  • Have a very small amount of money to contribute and want to maximize your total investment value
  • Make sure your RRSP account doesn't get too big so you can keep your withdrawals to a minimum
  • Invest in a more active style, often realizing gains
  • Will not make any withdrawals for any reason while you are working
  • Might use advanced strategies to reduce taxes on withdrawals (borrow to invest strategies)
  • Will go back to pursue full-time education as an adult
  • Are buying a house in the future after not owning a home for four years
  • Plan to take a sabbatical or otherwise reduce your income substantially before retirement
  • Have an uneven income with very high years and low years (self-employed in resource sector)

When TFSAs Should Be Prioritized

TFSA accounts are newer, but they offer many advantages that RRSPs don't. You should consider making the TFSA the first account to invest in if you:

  • Value maximum flexibility in investments, contributions, and withdrawals
  • Want a tax efficient option that performs well in all income and spending situations
  • Believe you might make withdrawals while you are working for any reason
  • Are likely to spend as much, or more money in retirement than when you are working
  • Think your retirement will include large, but in-frequent expenses (travel, new vehicles, etc.)
  • Anticipate moving from a low tax province while working to a high tax province in retirement
  • Are already contributing to a pension plan that will pay a large benefit in retirement
  • Would like to maximize government benefits as a senior (OAS, GIS, Pharmacare, etc.)
  • Invest in a more active style, often realizing gains

When Non-registered Accounts Should Be Prioritized

In general, non-registered accounts are the account of last resort. This means you have contributed everything you can to RRSP and TFSA accounts. However, there are some exceptions and you should invest in a non-registered account first if you:

  • Have a rapidly rising income and will transfer to a RRSP later to maximize your tax refund
  • Invest in a Canadian dividend strategy, have a low income, and live in a low-tax province
  • Are low income and borrow money from a high income spouse (spousal loan)
  • Borrowed to invest in a tax-efficient way and use the interest expense to offset other income
  • Borrowed to invest so that you can maximize your net worth
  • Want to access a wider range of investments without restrictions
  • Are a very active investor who might be considered a "trading business" by the CRA

Mixing Account Contributions

Particularly for higher income individuals with high savings rates, the best strategy is likely to spread contributions across several accounts. Start with aggressive contributions to your RRSP to get large tax refund. Then you will use the refund money and any other savings to maximize your TFSA account contributions. Finally, whatever is left will go into a non-registered investment account. This is the strategy I employ.

I am targeting a sizeable, but not enormous RRSP account. A target valuation of somewhere around $1 million is probably as high as I want to go. This means I will either stop contributing to my RRSP, or significantly reduce contributions to my RRSP as I reach this value. If I can keep RRSP withdrawals under $40,000 a year per person and top up the rest of my income with TFSA withdrawals or dividends from my non-registered account I will be happy. I will also use interest costs to reduce my taxable income from RRSP withdrawals.

Summary

In Canada the typical saver and investor can save for the future in three different account types: the TFSA, RRSP, and Non-registered investment account. The TFSA and RRSP exist to provide savers with distinct tax advantages. TFSA are "tax-free" after your contribution; RRSPs are actually a tax-deferral mechanism, but you save on taxes by getting tax refunds at a high marginal tax rate but pay taxes on withdrawals at a lower blended tax rate after tax credits and deductions.

While TFSA contributions are not tax-deductible, you can invest in your account without being taxed on investment income and you can withdraw money from your TFSA without paying tax on your withdrawal or even claiming it on your income tax return.

You deduct RRSP contributions from your income, so you get a tax refund which should always be invested. You don't pay taxes on any investment income within your RRSP account until you make a withdrawal. RRSP withdrawals are taxed like regular income and you must report withdrawals on your income tax return. When you are retired, you would normally convert your RRSP to a RRIF so withdrawals can be treated as Pension Income for tax purposes. RRSP accounts are more intricate, not very flexible, but offer several embedded programs for earlier withdrawals. RRSPs are the ultimate account for tax arbitrage if you have a good understanding of the tax system.

Non-registered accounts are normally used after you have already contributed the maximum amounts to your RRSP and TFSA. Investment income from this account is taxed, but at preferential rates for Canadian dividends and capital gains on profitable trades. Non-registered accounts might be used first by individuals who are highly active traders, borrow money to invest, or are waiting until they are higher income before moving their investments to a RRSP. High income individuals should avoid realizing investment income in non-registered accounts.

Generally speaking, the RRSP can be the best account for investing even if you are lower income due to tax arbitrage. However, they are somewhat restrictive and require a reasonably good understanding of income taxes and Canada's social benefit system to get the maximum benefit. The average person is probably best off investing in a TFSA because the flexibility is unparalleled and it performs well in nearly all scenarios.

Side Note: I'm on vacation, so my posts next week will be put up a few days late.

Comments & Questions

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