Maximizing Your RRSP

RRSP’s are the central planning tool for many Canadians’ retirement objectives.  Say what you like, but the tax advantages of the deductible contribution are a powerful incentive to add to this tax-deferred investment vehicle.

It is important to note that the RRSP is just that – a tax deferral.  Most Canadians understand that their wealth accumulates tax free in an RRSP (more specifically, free from accrual taxation), however what most investors do not properly recognize is the effect of unwinding their RRSP.  If you are not careful, the tax that you are saving currently will be recouped by the government again later on.

So the bad news is that the RRSP is not a perfect vehicle.  The good news is that it does the trick up front, affording you tax incentive for savings, and defers tax on growth.  However, there are a variety of strategies that can help you maximize the after-tax value of your RRSP, both to you while you are living, and to your estate if/when you pass the assets to beneficiaries.

The Facts about RRSP’s

There are two main attributes of the RRSP/RRIF that we are looking to deal with in this article.  The first is the tax liability generated when the RRSP is converted into a RRIF and income is taken on an annual basis, and the second is the tax liability that exists when the RRSP/RRIF is passed along through the estate.

• First – income that you receive from your RRSP is taxed just as though it were interest or employment income, meaning at your top marginal rate for the given tax year.  Most individuals recognize this in their planning.  The rules for RRIF payments is that there is a minimum amount that must be taken out each year, based on your age, or the age of your spouse (whichever is more beneficial).  This means that you can be forced to take out more than you need.
• Second – in the year of death of the second spouse, the entire balance of your RRSP is included in order to calculate income tax payable on the RRSP/RRIF.  This income would come in excess of any other investment, dividend, and/or capital gain income declared on the final return.  This means that, if your RRSP was the only income you took in your final year (in Ontario), a $1,000,000 RRSP would have a tax liability of roughly $448,000, leaving your estate with only $552,000.

The tax treatment of the RRSP/RRIF at death is what we are most concerned about in this article – effectively, how do we reduce a tax liability that will erode almost one half of the savings you have worked so hard to accumulate?

Three simple approaches

Broadly defined, there are three different categories you can take to managing the ongoing and terminal tax liability in your RRSP.

• Effectively manage your tax brackets while you take income from your RRSP.  Tax bracket management for estate planning takes a little bit of discipline.  Essentially what you are trying to do is remove income from your RRSP/RRIF at a tax bracket lower than what it would be at death.
• Reconsider your asset allocation to reduce double taxation of Capital Gains in the RRSP structure.  Look at the tax treatment of the assets you have, and allocate the least tax efficient assets into your RRSP/RRIF.  Income producing assets are going to be taxed at the highest rate, so leave them in the RRSP/RRIF.  However, dividends and capital gains are tax-advantaged vehicles; leave them in your non-registered portfolio.
• Use complimentary assets and strategies in combination with your RRSP to maximize the value that the RRSP delivers to you while you are living, and to your estate.  The first and simplest would be to incorporate a permanent insurance strategy into your planning, starting early if possible.  Simply put, life insurance will be able to fund the tax liability that exists within your RRSP/RRIF.  Furthermore, most permanent life insurance contracts allow you to accumulate assets within the contract on a tax deferred basis (returned tax-free if the proceeds pass on at death).

When considering a plan to minimize taxes, please remember that any tax driven strategy should be considered carefully by an independent tax professional.  The information presented above depends on certain assumptions which may or may not be relevant to all of our readers.

The long and the short of it is that the RRSP/RRIF is a great planning tool with powerful front end benefits that the average consumer enjoys – a tax deduction for savings.  But be careful: without proper planning, those savings will be eliminated by the government in retirement, or, at the latest, at death.  If your intent is to maximize your after-tax income during retirement, or to maximize the value of your estate to your heirs, careful attention should be paid to your RRSP/RRIF and how it is interacting with your tax rates and other assets and cash flows you have at your disposal.