When people think of income planning, they usually think of retirement. Prior to retirement, Canadians are mainly concerned with paying debt and accumulating retirement assets, so they ignore income-planning opportunities.
There are, however, a number of situations before retirement where income planning can play a role within a broader wealth plan. In these situations, it may be appropriate, and even tax-efficient, for clients to take income from their portfolios before they retire.
These often-overlooked opportunities range from utilizing low tax rates for family members to maximizing the benefits of professional corporations.
As part of managing a full and balanced portfolio, pre-retirement income planning involves looking at all the different “buckets” available — RRSPs, TFSAs, insurance products, non-registered portfolios, and other products — and making use of them in ways that are creative and hopefully more tax-efficient.
Scenario #1: Generating income for the professional practitioner
Low tax rates are currently in effect for professionals and small business owners who earn active business income inside a corporation. Allowing business income to accumulate within a corporation is an excellent way to reduce overall taxes. The downside, of course, is that this money must remain within the corporation.
This is the first scenario where it is appropriate to create and draw income from a personal investment portfolio before retirement. This personal portfolio must generate sufficient income to fund the owner and his or her family’s lifestyle until it is time to pull money out of the company. This may be at retirement, or, in certain situations, upon an owner’s death.
By creating an income stream from existing funds, the low tax on corporate earnings can be deferred until the funds are eventually pulled out. This tax deferral is as high as 35% in certain provinces. With such a large discrepancy, corporate portfolios can accumulate substantially and create a much larger retirement portfolio.
Scenario #2: Taking RRSP income before age 71
At age 71, Canadians must convert their RRSP to a RRIF and begin drawing income. What was once a vehicle used to accumulate assets has now become a vehicle from which to take income. Some retirees are advised to keep their RRSP intact until age 71 and live off their non-RRSP investments, because income earned within an RRSP is not taxable until it is pulled out. This tax deferral allows investments to grow faster. While general financial planning recommends this strategy, in some cases it makes sense to take income from your RRSP prior to age 71 and forgo this tax deferral. This is often referred to as an RRSP meltdown strategy.
One strategy involves taking money from your RRSP if you have little or no other taxable income. If structured properly, you may also receive up to $2,000 with few or no tax consequences by gaining access to the $2,000 pension credit. These benefits may outweigh the lost tax deferral opportunity.
A second strategy consists of melting down your RRSP to avoid the Old Age Security clawback. This involves taking income out of an RRSP in low-income years to reduce the value of the RRIF created at age 71. This lowers minimum payments — which are based on the value of the RRIF — and minimizes the Old Age Security clawback. In 2011, the Old Age Security clawback begins when net income exceeds $67,688. For each additional dollar of net income, $0.15 is clawed back to repay the Old Age Security benefits received.
There are other planning options, including creating income for children, spousal loans and using TFSAs. Click here to read more.
Mike George is the Director of the Wealth & Estate Planning Team at Richardson GMP Limited. This team of in-house experts and professionals provides coordinated support to advisors to ensure clients have complete and comprehensive wealth plans in place.