RRSPs help your clients delay taxes, not erase them.
So it’s crucial to explain that RRSPs are made up of pre-tax dollars when discussing clients’ long-term savings and goals, says Bill Reichenstein, CFA and professor of finance at the Hankamer School of Business, Baylor University.
He adds, “What may seem like $500,000 today may actually be closer to $300,000 when you factor in the potential tax rate of 40% at the time of each withdrawal.”
To prepare for this reality, he says advisors need to discuss the implications of taxes with clients far in advance, even if “they want to stick to the traditional approach and leave RRSPs for later use,” says Reichenstein.
He says it’s best to look at these accounts “as partnerships with the government. It owns a percentage of your [clients’] money, [but] how much depends on the marginal tax rates they’ll be at in retirement,” as well as on the withdrawal approaches they choose.
If a client has an RRSP, you also need to allocate their portfolio based on approximate after-tax amounts of these funds from the outset, suggests Reichenstein. This will ensure that portfolio is properly structured.
Read: Craft better portfolios
Say your client is retired. She has $1 million in bonds in her RRSP, and $500,000 in stocks in an open account. Assuming no capital gains, she would actually have $600,000 after tax in bonds and $500,000 in stocks. So she actually has a 43.5% stock allocation, not 33% as first appears. She should only factor in her RRSP based on its after-tax value.
To make the most of this RRSP, this client can also save on taxes if they choose to withdraw funds before age 70. Prior to this, they’re more likely to have a lower marginal tax rate. “This strategy will help [her] keep more of money and add several years to [her] portfolio,” says Reichenstein.
Read: 5 common RRSP pitfalls
It takes advantage of the progressive nature of the tax code, he adds, and continues with his example: Assume the retiree has $1,193,025 in an RRSP and $500,000 in a taxable account. She is 63 and requires $62,500 in income each year. She’s taxed at 15.5% on the first $41,707 of taxable income and 40% above this level.
To keep things simple, says Reichenstein, we’ll keep investment returns and inflation rates at zero. (He says the end result isn’t affected by this assumption.)
This client has two options for withdrawal. Continue reading to find out how each option affects their savings and purchasing power in retirement.