Two pensions and hefty savings create an RRSP tax vulnerability

In Alberta, a couple we’ll call Harold, 57, and Suzy, 60, have made a good living. They have no children, no debts, and two defined benefit pensions that will pay $72,748 a year before tax, once they hit 65. Harold works for a large computer company. Suzy retired from a job in health care and receives an annual pension of $19,416. She is eligible for $12,156 CPP and $7,004 OAS at 65.

Harold’s annual pension income at 60 would be $64,332 until 65. That would make total pension income for the couple $83,748 a year. After 15 per cent average income tax, they would have $5,932 a month to spend, almost enough to cover their present budget. They could cover the difference from non-registered savings of $118,000.

At 65, Harold’s pension will lose a bridge of about $11,000 so that the amount paid will be $53,332 a year. CPP at $12,156 per year and $7,004 annual Old Age Security push his total income to $72,490 before tax.

When Harold is 65, their total income from job pensions, CPP and OAS would be about $111,070 before tax. Add income from nearly $934,000 of financial assets and the picture that emerges is a rock solid retirement. What could be wrong?

“We don’t know when to start drawing RRSP funds or when to take CPP and OAS,” Harold explains.

Family Finance asked Caroline Nalbantoglu, head of CNal Financial Planning Inc. in Montreal, to work with Harold and Suzy. “They have a problem with high taxes in their 70s when their RRSPs have to be converted to RRIFs,” she explains.

Optimizing the time to start benefits requires balancing tax-deferred growth in RRSPs with higher future taxes payable.

TAX STRATEGIES

Suzy and Harold could take CPP early at age 60 and give up 36 per cent of the age 65 benefit. Suzy’s cost of early application is reduced by her early retirement. She would lose 36 per cent of her age 65 CPP benefits for as long as she lives, but with the couple’s income surplus over expenses, her CPP benefits could be diverted to her TFSA. If well invested at our assumed rate of three per cent after inflation, the return would partially make up for the loss of 7.2 per cent per year penalty charged.

The tax benefit, which might be an annual saving of 10 per cent compared to the tax she might pay at 65 or even more if she were to delay payouts to age 70 when CPP would add 42 per cent to the age 65 payout, would be additional compensation. It is hard to achieve CPP’s “7.2 per cent annual bonus” for not starting benefits before 65 or 8.4 per cent per year paid after 65 with no investment risk and inflation fully covered.

The couple’s RRSPs currently total $707,336. They have stopped contributions. If these accounts grow at three per cent after inflation with no further additions for the next 12 years to the time that Suzy’s RRSPs have to begin payouts at age 72, they would have $1,008,492 ready for payouts. If they convert to an annuity-generated payment system that will discharge all capital and income beginning at Suzy’s age 72 and running for the next 23 years to her age 95, the funds would produce $61,330 a year.

Their non-registered savings, currently $118,000, can grow with present contributions of $1,600 a month, but we’ll not count the growth given Suzy’s recent retirement. We’ll let them use it to cover any shortfall between the time they retire and start to draw down their other savings.

Future TFSA income based on present balances of $108,437 growing at the present rate of $7,200 per year for the next 12 years at three per cent after inflation would rise to $259,850 and support payments of $15,342 per year. There would be no need to pay out the TFSA balances and indeed, with ample income, it would be prudent to keep the accounts intact and growing, Ms. Nalbantoglu suggests.

Using the RRIF annuitized payout of $61,330 a year at Suzy’s age 72 and adding $72,750 for their job pensions, plus $12,156 twice for CPP and $7,004 twice for OAS, they would have taxable income of about $187,742 including the untaxed proceeds of their TFSAs.

On the taxable income alone, with an even split of eligible pension income, they would each have about $86,000 of tax exposure. That would attract a marginal tax rate of about 30 per cent and average tax of about 22 per cent.

They would also be subject to an OAS clawback of 15 per cent on the $12,000 they would earn in excess of the $74,000 clawback threshold.

As a result, their total tax rate of clawback and regular tax would be almost 50 per cent at the margin and 37 per cent on average. They would have about $10,600 to spend each month, far more than present allocations including savings. They could use this surplus for donations to good causes, the planner suggests.

A CHOICE OF PLANS

We can juggle ages for start of RRSP payouts, but it is clear that they have choices: 1) start CPP early to get more money upfront before age 65 in exchange for less money later; 2) start depleting RRSPs as soon as possible to avoid higher taxes later. They would give up tax-free growth of pensions and savings for lower taxes on future income. What they take out of CPP could be invested, but matching the 7.2 per cent annual penalty for each year of withdrawal before 65 or 8.4 per cent for delaying withdrawals from CPP to 70 with investment gains is tough.

Withdrawing RRSP savings before mandatory RRIF payouts begin at 72 would lower future taxes. Any surplus could go to stocks whose dividends and capital gains are taxed at advantageous rates. They could bump up TFSA savings now to take full advantage of the $5,500 present individual mutual limit. Tax rates and rules may change. In this case, uncertainty is the price of frugality, Nalbantoglu concludes.