Tag Archives: RRSP

Retirement Income Options – So Many Ways

As each year passes, the Canadian population becomes older on average.  The well documented effect of the boomer generation means that there are more and more Canadians approaching the age of 71, which is the year in which a taxpayer is forced to convert their RRSP’s into some form of retirement plan.

Let’s take a look at the variety of accumulation accounts at the average Canadian’s disposal, and then explore the different methods that can be used to access the funds in retirement.

We’ll start with accumulation, because the options you have at your disposal when you convert your accumulation plan to a income plan depends on what kind of accumulation asset you have.  There are two basic types of tax-deferred plan that you can have as you save for retirement, a personal plan, or an employer sponsored plan, or pension.

Personal Accounts

Registered Retirement Savings Plan (RRSP):  This plan allows for contributions of 18% of income up to an annual maximum.  A taxpayer must convert an RRSP into a retirement vehicle by December 31st in the year in which they turn 71.

Tax-Free Savings Account (TFSA):  The federal budget that was read in February introduced a which is designed to augment the tax deferred savings available to Canadian taxpayers.  Each taxpayer can contribute $5,000 per year into this, and there are no stipulations on withdrawal.

Locked-in Retirement Account (LIRA): This investment account is created when an employee leaves a company sponsored pension plan “rolls over” a certain portion of their pension into the LIRA.  Like the RRSP, the investor can control the investment decisions, but there are strict guidelines as to how the funds must be withdrawn.

Employer Sponsored Accounts

Many companies will have a pension plan for their employees, but these can take a variety of forms.

Defined Contribution Pension: This plan simply states up front what amount the company and the employee are each going to contribute to the plan.  Once the contribution is made, the funds are invested, and the employee has a variable pension depending on the investment performance of the pension fund.

Defined Benefit Pension: This plan uses a formula to determine what benefits are due to the employee upon retirement, based on years of service, income levels, etc.  The employee or the employer, or both, can contribute to the plan.  The corporation is liable to ensure that the plan is funded to meet the amounts that their employees are entitled to.

Group RSP: this is not really a group plan in the same manner that the pensions plans mentioned above are.  The group RSP functions just like a personal RRSP, except that the employer usually bears some of the costs of investing in the plan (i.e. account fees, lower fund management costs), and may match contributions as an employee benefit.

Commuted Pensions

Often, employees are given the option to “commute” their pension when they retire.  This means that they will be given a sum of money in lieu of an income stream from the pension fund.  This is most often made available to people given early retirement, and the funds are usually transferred a combination of a LIRA (tax free) and sometimes an open investment account (taxable).

A commuted pension can be a highly attractive option for a departing employee, specifically if they are planning to work again after they have left their current employer.  However, too often investors are encouraged to commute their pension in search of high returns.  However, when an investor commutes their pension, they often forgo other benefits that provide significant value.

For instance, an employee may have lifetime medical/dental benefits associated with their pension plan.  If the employee commutes their pension, they usually lose the right to have such types of benefits.  This leaves the investor open to significant long term risks of covering the cost of long-term care.

One final thought: the pension fund sees each pensioner as a liability.  When it commutes a pension, it pays an amount out to the employee to relieve themselves of that long-term risk.  When commuting a pension, be careful about taking that risk off the pension fund’s hands.  In this process, greed is not good.  A careful look at your risk management and tax planning options should be considered in this decision, not just the potential for big investment returns. 

Retirement Options

So what is an investor to do once they have reached the age of 71, and is faced with the choice between income options?  Well, it depends on the account you have used to accumulate your retirement income.

Registered Retirement Income Fund (RRIF): this account is created when an RRSP is rolled over into a newly formed RRIF.  The RRIF has an annual minimum withdrawal amount that is prescribed based on either the owner’s age, or the age of the owner’s spouse.  Since the minimum withdrawals rise as the age increases, it is usually beneficial to calculate the RRIF payments from age of the younger spouse.  The investment options are similar to an RRSP, and there is no maximum withdrawal amount that can be made in any given year.

Segregated Funds with Income Guarantees: these types of “variable annuities” have been available for many years in the US, but have really gained ground in recent years.  These are segregated funds that offer guaranteed income streams (usually 5% simple interest), with an account value that rises and falls with the investments selected.  This allows the investor to receive a guaranteed life income (usually available once investor reaches 65), while also participating in the upside of the market.  On the upside, there is potential for capital appreciation, and on the downside, the market value of the investment could deteriorate to nothing, leaving the investor with little value beyond the annuity-like contractual guarantee.  However, this is a powerful option for investors who wish to expose themselves to upside, without risk of losing an income stream.  

Life Annuity: Converting to a Life Annuity will guarantee income for life, which provides security to the individual who is receiving the funds.  However, this means that the (potential) estate value of the funds invested into the Life Annuity will be lost, should the investor die prematurely.  The annuity option can also be selected to guarantee income to age 90 (of either spouses’ age), so that if both spouses die prior to the 90th birthday chosen, there will be some estate value.

Lifetime Income Fund (LIF):If an investor elects to have a LIF, withdrawal minimums are the same as for RRIFs. LIF’s however, have a maximum withdrawal amount whereas RRIFs do not.  In some provinces, LIFs must be converted to a Life Annuity when the owner turns 80.  This means giving up investment control at age 80, which may or may not be a good thing.  Investors should be careful to manage volatility as age 80 approaches.

Locked-in Retirement Income Fund (LRIF): This is a more flexible version of the LIF, that eliminates the requirement to convert the account to an annuity at age 80 (not available in all provinces).

A note on small “locked-in” balances

If you are age 55 or older and the total value of all of your locked-in accounts is less than 40 per cent of the years’ maximum pensionable earnings (YMPE), you can request to have these locked-in funds transferred to an RRSP or RRIF, thus removing the locked-in status. The YMPE is currently $44,900, so this feature applies only to balances of $17,960 or less.

This is just a cursory look at all of the options available, but it should allow you to start to investigate the options that may or may not be available to you.  As with everything, try and determine what your objectives are before you make the decision.  Here are some basic points to consider in making your decision:

  • What kind of retirement assets do I have at my disposal?
  • Do I need a guaranteed income amount (i.e. x dollars)?
  • Do I need a guaranteed income term (i.e. for x years)?
  • Do I want to leave an estate value for my beneficiaries?
  • Do I want to manage the asset?
  • How is the asset going to be taxed if I leave a balance when I die?

For instance, an annuity might not provide the most attractive rate of return, but it will guarantee that you do not outlive your income.  For others, a prudently managed RRIF will deliver the retirement income that is needed, and maybe more.

The Child Care Expense Derby

find out who should really claim child care expenses on their tax returns

Can't decide who should claim the child care expenses at tax time?

My wife and I earn similar (but variable) incomes, and so each year we engage in what we call the “Child Care Expense Derby.”  We have the government to thank for that.  Every year I am a bit suprised by who it goes to (“and the winner is…”), but I am glad for the opportunity to get some tax back for the money we put into child care.  I always like to go to some handy tax calculators to figure out where I stand before tax time to see if I can predict the winner.  Here are two: my website (not very complicated), and TaxTips.Ca (more complicated).

The reason for the derby is this – we are never exactly sure which income will be the lowest until we get our employers’ T4’s, and then the spouse with the lowest income is the one who receives the benefit of the child care tax deduction.  Also, thew winner of the Child Care Expense Derby will be the spouse who contributes less to their RRSP.  The child care expenses can cause a big swing: tax rules allow expenses to be deducted in the following amounts:

  • a maximum of $7,000 per year for each other eligible child who is under 7 years of age at the end of the year; and
  • a maximum of $4,000 per year for each other eligible child (between the ages of 7 and 16).

This means that a family of three children under the age of 7 has deductions of up to $21,000 – nice work.  You could notice significant savings on your taxes, approximately a $7,000 tax savings for the average Canadian, who earns income at approximately a 30% tax rate.  The eligible child care is defined by CRA as on their website follows:

  • an eligible child care provider;
  • a day nursery school or day-care centre;
  • a day camp or day sports school;
  • a boarding school or camp (including a sports school where lodging is involved); and
  • an educational institution for the purpose of providing child care services.

Note that this is not an exhaustive list expenses, and other expenses, such as advertising for a care worker, or agency fees to find a care worker are also included.

The downside here is for a family that only has one income, or when the incomes are far apart (i.e. one high income and one low income), the deduction may not be as great that two mid- or high-income earners.  But it is still powerful.  Imagine a family with one income of $75,000 and one income of $45,000.  (Let’s say there are two children under 7, so $14,000 of eligible expenses).  The lower income spouse at $45,000 would reduce their taxable income by $14,000, using the childcare expenses as a deduction against income.  This would be a tax savings of approximately $3,300 for the year.

You should also note that this deduction gives you the exact same tax relief  as an RRSP deduction, so if you have to make the choice between who does what, don’t let the lower income spouse do any RRSP deduction until the higher income spouse has maximized their RRSP contribution.  This will ensure that the higher income spouse gets more deductions against their income, and that the lower income spouse does not put RRSP contributions in at an exceedingly low rate.  Some planning should help you avoid this.

This should help when it comes to deciding what to do about care for your kids, to help and reconcile the finances at the end of the year, and to generate some other tax benefits while you are at it.

Debt and the RRSP contribution – Worth it?

RRSP loans are generally recommended as a way to “jump-start” your savings, or advertised as a way to create wealth where it did not exist previously (check out this sample Google search I did – most of these entries encourage debt).  There are a number of strong opinions out there that can debunk the myth that borrowing to invest is  good for you.

Borrowing to invest is a tricky straegy at the best of times.  Using debt for investment will increase both the gains and the losses that you receive in the market.  However, using debt can mean that you lose more than you actually have – you have lost someone else’s money.  

Leverage can do more harm than good, and must be done carefully.  If you are going to make the executive decision to use debt to invest in the RRSP, then you should be able to answer yes to one or more of the following questions:

  1. Am I at the highest marginal tax rate? If you are, then you will get the maximum benefit (i.e. tax refund) from your RRSP deduction.  If you deduct at lower tax rates, you will get less in the form of a refund at tax time.
  2. Am I going to be able to pay this off before the next RRSP season?  If you are (or you expect some compensation, a bonus or some inflow of cash that you do not currently have) then go ahead.  If not, you will likely just be in the same boat next year, forced to borrow again, and get into a “vicious” circle of debt again and again.
  3. Am I going to get a cash refund by making the contribution?   If you are, then you can have some confidence that you will soon be able to reduce your debt.  If you are not going to generate a cash refund and instead only reduce your taxes owing, then you will not be able to reduce the balance of your “quick loan” at tax time, and you will be encumbered by a great deal of debt.
  4. Is your other debt generally under control?  If so, then you might consider this as a one-time event.  However, if the reason that you have not made an RRSP contribution in the past is because your cash flow is committed to servicing other debt burdens, then this is definitely a bad idea.  Spend time getting your debt under control, and then revisit your RRSP savings later on.

So, in general, an RRSP loan is not a good idea, unless you are simply using it as a bridge until you get other funds coming in.  Also note that the interest payments on RRSP loans are not tax deductible, so there is no added deduction benefit to the investor.

I would venture to guess that, over the long term, taking a year off your RRSP contribution would serve you far better in the long run.  Perhaps, instead of borrowing to make an RRSP contribution, you start a monthly deposit plan and get ahead of the debt curve.

Your RRSP and Long Term Wealth

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.