Markets are volatile. Interest rates are low. Inflation is higher for seniors. Life expectancy has improved.
But your client’s goal has not changed. He wants the highest, most consistent income stream possible.
So how can he reach his goal in today’s economic environment? Save on taxes when you convert his maturing RRSPs. Here are some options.
Convert into a Registered Retirement Income Fund (RRIF)
The RRIF option is the most popular because he’ll have the flexibility to choose his investments.
If he doesn’t need the income right now, let his RRSP grow on a tax-deferred basis. However, there are required annual minimum withdrawals that will vary from 7.38% of his portfolio’s value at age 71 to 20% at age 94. To beat this, he can use the age of his younger spouse or common-law partner (if he has one).
If he needs the income, he can convert his RRSP into a RRIF before December 31st of the year he turns 71. The required annual minimum withdrawals will be calculated using a percentage known as the prescribed factor, which is 1/(90-age). If he is over 65, he may be eligible to split up to 50% of his RRIF income with his spouse and hopefully cut his tax bill in half.
When choosing RRIF investments, make sure his payout ratio—his desired annual income over his total portfolio’s value—is sustainable in the long term. A realistic ratio will be around 4.5 to 6, depending on age and the investment vehicle used. Otherwise, his portfolio will shrink with every withdrawal and he could run out of money earlier than expected.
Purchase an annuity
Some people say today’s interest rates are too low to purchase an annuity. I don’t agree.
If your client retires this year and needs the highest consistent income stream possible, she doesn’t have time to play with markets.
If she’s 65 and wants a payout ratio of 5% or more, I recommend annuitizing at least 20% to 30% of her portfolio. If she can’t count on an employer pension plan, she should consider purchasing an annuity from an insurance company.
Using her RRSPs assets, she can opt either for: a life annuity that will pay a fixed stream of income that is guaranteed for the rest of her life; or a term annuity that will pay her a fixed stream of income until she reaches age 90. If she chooses the second option and passes away before age 90, the remaining payments will be paid to her beneficiary or her estate.
Take a lump sum
This is usually the most inefficient way to mature an RRSP because each withdrawal will be taxed as ordinary income (e.g. a salary), and your client could end up paying taxes at the top marginal rate. Moreover, lump-sum withdrawals don’t qualify for pension-splitting.
However, if she plans to retire in a tax haven where pension and investment income isn’t taxable, or is taxed at a very low rate, lump-sum withdrawals may be the way to go. The CRA withholds 25% on payments to non-residents. It could be her only tax bill.
Locked-in plans (LRSP and LIRA)
In the same manner as an RRSP, your client will have to convert his locked-in plan into a life income fund (LIF) or a locked-in retirement income fund (LRIF).
LIFs and LRIFs are similar to a RRIF except that pension rules in most provinces stipulate an annual maximum withdrawal. For example, the maximum LIF payments for Quebec, Manitoba, Nova Scotia and British Columbia will reach its maximum of 20% by age 88. Under certain conditions, he could withdraw even more than the maximum in a given year. This is called “unlocking.”
For example, federally and Ontario regulated pension plans offer a one-time opportunity to unlock up to 50% of the value of the plan. Other unlocking conditions include: small account balance, reduced life expectancy, financial hardship, non-resident status, etc.
Start withdrawing from your RRSP before 65
If your client retires early, he may want to maximize CPP and QPP by differing payments until he reaches 65. Meanwhile, it might be smart for him to start withdrawing from his RRSP.
Let’s say he retires at 60. If his RRIF annual minimum withdrawals when he reaches 65 or 71 will bring his income level into the OAS clawback zone, he could reduce his tax bill by withdrawing substantial amounts from his RRSPs between age 60 to 65.
Consider an Individual Pension Plan (IPP)
If your client has been the owner of an incorporated business for several years, she should consider setting up her own pension plan.
An IPP is a defined benefit pension plan based on her prior and future employment income (reported on a T4 slip). When capitalizing her IPP for prior years of employment, the Income Tax Act requires that she transfer part or the full value of her RRSP into your IPP. Using this strategy, she may benefit from supplemental tax deductions for her corporation and from the ability to split income with her spouse, even before 65.
If she doesn’t need the cash, she could give her RRIF income to registered charities and use the donation tax credits to offset her taxes.
Caution: Meltdown strategies
Some advisors are promoting advanced solutions to eliminate tax on RRIF income, but they’re quite complex. Be sure to consult a tax advisor before implementing such strategies.
Here’s one concern. A leveraged investment strategy, where money is borrowed to invest outside a RRIF, can be used to generate enough interest (which is tax deductible) to offset the RRIF income. But interest paid on money borrowed to invest in a mutual fund offering return-on-capital (ROC) distributions may not be tax deductible.
Francys Brown, LL.M., is a Tax Advisor and Owner of FBSA Financial Taxation, based in Montreal.