March 5, 2019
Most articles are written about “contributing” to an RRSP. This one highlights that many people should either avoid RRSPs or stop contributing to them.
Going a step further, calculations should be made to determine if you should withdraw funds from an RRSP.
In many cases, we will recommend that people convert their RRSP to a RRIF before age 71. Age 64 or 65 are common ages for conversions to a RRIF, which we will explain below.
For some people, the decision to convert an RRSP to a RRIF early is purely for cash flow reasons and out of necessity. For individuals in the top tax brackets, taking the regulatory approach and keeping the funds in an RRSP until age 71, for maximum deferral, is normally the best option.
The transition to retirement often coincides with your final RRSP contribution. It could be your last high-income earning year, or it could be offsetting the retiring allowance by using up your RRSP Deduction Limit. In some cases, if you arrange to retire early in the year, an RRSP contribution may not be necessary. In years where your income is uncertain, then we do not recommend contributing early in the year. Closer to the end of the year, you can determine whether contributing to an RRSP makes sense.
If taxable income is on the lower end, then you should consider converting your RRSP early, especially if you are 65 or older. If you are not maximizing your Tax Free Savings Account (TFSA), then pulling funds out of an RRSP and funding a TFSA can reduce your tax bill in the long run. If you are not receiving eligible pension income, then we advise individuals 65 and older to covert a portion of their RRSP to a RRIF. Those 65 years and older can claim up to $2,000 as a pension income amount, effectively allowing each individual to pull $2,000 out of their RRIF tax free.
Another very important factor is that couples can income split RRIF income beginning at age 65. Individuals who are collecting Old Age Security, and earn more than $77,580 in 2019, will have to repay (often referred to as clawback) 15 per cent of the excess up to the total amount of OAS received. If possible, care should be taken to withdraw funds out of an RRSP so that the combined taxable income is below the annual clawback threshold.
If the goal is to minimize tax in the current year, contributing the maximum to RRSPs and delaying RRIF withdrawals until age 72 may provide this outcome.
Let’s change the focus from minimizing tax in the current year to minimizing tax during your lifetime. The key variable on whether or not you minimize tax during your lifetime is life expectancy. To illustrate, we will use a hypothetical client, Jill Jones.
Jill is single and has recently retired at age 65 with $500,000 accumulated in her RRSP. We have projected that CPP, OAS and investment income will result in Jill receiving annual income of $22,000. Jill also has access to non-registered cash, so cash flow is not an issue.
Jill does not have to convert the RRSP to a RRIF early for cash flow. We ran some preliminary projections for Jill with two broad scenarios: 1) convert RRSP to a RRIF immediately and begin pulling out $28,000 annually, and 2) waiting until age 71 to convert to a RRIF and withdrawing the minimum required payments beginning at age 72. To illustrate the estimated tax on both of these scenarios, we used different life expectancy, being age 65, 71, 77, 83, 89, and 95. Below are the 11 outcomes we outlined with Jill. For purposes of this illustration we used a conservative four per cent rate of return.
Option 1 — Convert RRSP early
| Planned conversion age | Annual end of year withdrawal | Deceased age | Estimated estate tax | |
|---|---|---|---|---|
| Outcome 1 | 65 | $28,000 | 71 | $184,261 |
| Outcome 2 | 65 | $28,000 | 77 | $149,486 |
| Outcome 3 | 65 | $28,000 | 83 | $105,485 |
| Outcome 4 | 65 | $28,000 | 89 | $51,370 |
| Outcome 5 | 65 | $28,000 | 95 | $2,525 |
Outcomes 1 through 5 have Jill beginning to pull funds out slowly starting at age 65. By beginning to pull funds out immediately at low levels, Jill will have more funds at her disposal to enjoy her retirement. She will be able to claim the pension income amount and top up her TFSA. She can invest any residual income to generate tax efficient dividend income and capital gains. Jill is reducing the risk of a significant tax bill as a result of a shortened life, especially in outcomes 3 to 5 when compared to option 2 below.
Option 2
| Planned conversion age | Annual end of year withdrawal | Deceased age | Estimated estate tax | |
|---|---|---|---|---|
| Outcome 6 | 71 | 0 | 65 | $225,687 |
| Outcome 7 | 71 | 0 | 71 | $294,394 |
| Outcome 8 | 71 | Minimum | 77 | $261,243 |
| Outcome 9 | 71 | Minimum | 83 | $212,211 |
| Outcome 10 | 71 | Minimum | 89 | $142,742 |
| Outcome 11 | 71 | Minimum | 95 | $51,089 |
Outcomes 6 through 11 have Jill keeping her funds within an RRSP until age 71. In the reviewing the above numbers with Jill, we outlined the biggest risk in deferring the conversion to a RRIF is if she passed away in her late 70s or early 80s. The tax rate on the majority of what is left in the RRSP is taxed at 49.8 percent (assuming tax rates remain at current levels). If Jill lives to age 95, then keeping to minimum withdrawals over the years has turned out to be a good decision. Delaying conversion and withdrawing the minimum payments help those investors who are concerned about living too long and running out of funds.
Many other options exist for Jill. Often the right answer is in-between, including a partial conversion or a full conversion between the ages of 65 and 71. When clients ask for my advice, I normally begin the conversion with planning for the most likely outcome. Genetics, current health condition and lifestyle are also factors. Asking clients this question, “What concerns you most, the thought of living too long and running out of money or potentially having to give half of your hard earned money to Canada Revenue Agency?”
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This publication has been prepared by The Bank of Nova Scotia for Scotia Wealth Management clients. It is for general information purposes only and should not be considered or relied upon as personal and/or specific financial, tax, pension, insurance, legal or investment advice. We are not tax or legal advisors, and we recommend that individuals consult with their qualified advisors, including tax and legal advisors, before taking any action based upon the information contained in this publication. The opinions and projections contained in this publication are our own as of the date hereof and are subject to change without notice. Scotia Wealth Management is under no obligation to update this commentary, and readers should assume the information contained herein will not be updated. While care and attention has been taken to ensure the accuracy and reliability of the material in this publication, neither The Bank of Nova Scotia nor any of its affiliates or any of their respective directors, officers or employees make any representations or warranties, express or implied, as to the accuracy or completeness of such material and disclaim any liability resulting from any direct or consequential loss arising from any use of this publication or the information contained herein. This commentary may contain forward-looking statements based on current expectations and projections about future general economic factors. Forward-looking statements are subject to inherent risks and uncertainties which may be unforeseeable and such expectations and projections may be incorrect in the future. Forward-looking statements are not guarantees of future performance and you should avoid placing undue reliance upon them. This publication and all the information, opinions and conclusions contained herein are protected by copyright. This publication may not be reproduced in whole or in part without the prior express consent of The Bank of Nova Scotia.
