Many clients assume money put into RRSPs will stay there until retirement. That’s the goal, but life isn’t always so tidy.
People who blindly contribute, without thinking about whether they’ll need the cash before turning 65, are doing themselves a disservice because withdrawals trigger steep withholding tax:
- 10% on amounts up to $5,000;
- 20% on amounts from $5,000 to $15,000; and
- 30% on amounts over $15,000 (note, rates are different in Quebec).
Worse, CRA will tax your client at her marginal rate if it’s higher. So, if she pulls $35,000 from her RRSP to pay for her daughter’s wedding, it’s taxed as income.
Many now opt for TFSAs or non-registered accounts to fund these short-term cash needs. But these aren’t the only times clients should steer clear of RRSPs. Here are four more.
1. When on the cusp of retirement
Say a client has a dip in income when he’s five to 10 years from retirement. It could be due to health issues, stepping out of the workforce to care for a parent, or just a slow year if he’s paid on commission.
If this puts him in a lower bracket than in retirement, and if he expects his retirement income will cause OAS clawback, he should consider taking money out of the RRSP now and investing it in a non-registered account (assuming TFSAs are maxed out).
Clawbacks begin when income’s above $71,592; and OAS distributions are completely nixed when income hits $115,716, notes Cynthia Caskey, a vice-president and portfolio manager at TD Wealth Private Investment Advice in Toronto.
How long until you
She says these clients should consider corporate-class mutual funds in non-registered accounts. “It’s a taxable account, but because of the deferred nature of a lot of the growth it’s a great option for controlling when and if [he] harvests those gains. It’s tax-efficient for someone who’s trying to stay under the OAS ceiling.”
This strategy essentially produces tax alpha. “People are always talking about MERs, but if you can help someone keep 20% to 30% more in his pocket for a number of years, and it continues to compound, the MERs pale in comparison.” Caskey notes an additional advantage of corporate class: tax-deferred switching between funds, which isn’t available with individual securities or ETFs.
Stephen Reichenfeld, a Calgary-based private wealth counsellor at Fiduciary Trust Canada, says clients who take early retirement may also benefit from RRSP withdrawals. One such client, whose spouse continues to work, withdraws about $12,000 a year.
Since the client isn’t working, her money comes out virtually tax-free.
“They are trying to drain as much money as they can out of her RRSP over the next 13 years,” Reichenfeld says. In total, the couple will pull out about $156,000, and use it to catch up on TFSA room and continue with ongoing contributions. What’s left over will go into a non-registered account.
If they leave the money in the RRSP, total RRIF payments will reach about $1.3 million. Reducing the principal now will mean a smaller tax bill later on.
“Clients in their mid- to-late-50s who are no longer employed should take a good look at this option,” says Reichenfeld.
But even if they’re still employed, RRSP contributions may be a mistake, says Matthew Ardrey, consultant and manager, financial planning at T.E. Wealth in Toronto.
Take a case where a client’s semi-retired and has $500,000 in RRSPs, plus a pension. She retired early from her automaker employer of 30 years; to alleviate boredom, she works part-time at Home Depot.
Continuing her RRSP contributions yields a 22% tax deduction today; but once she starts drawing down those savings, she’ll be taxed upwards of 40%. So, rather than adding to the RRSP, she should use TFSA room or non-registered accounts.
“There’s no advantage to a non-registered account over a TFSA,” says Ardrey, “but a non-registered account can have an advantage over an RRSP.”
2. When implementing a capital gains strategy
Wealthy investors should consider non-registered accounts instead of RRSPs to build tax-efficient portfolios from individually purchased stocks, Caskey suggests.
Money coming out of RRSPs is taxed at the client’s top marginal rate. This removes the tax advantage of capital gains.
Not so with a non-registered account.
The portfolio should be built with blue-chip stocks, Caskey says, and these clients must have a minimum 10-year horizon. This gives unrealized gains time to compound.