THE PROS — AND PERILS — OF MAKING EARLY WITHDRAWALS FROM YOUR RRSPS
Some experts urge strategically drawing out funds, while others suggest keeping your money where it is, Jonathan Chevreau says.
Can RRSPs get too large? Some advisers warn retirees and nearretirees that clawbacks of Old Age Security and, sometimes, the Guaranteed Income Supplement means an RRSP can create a significant tax liability down the road.
One such adviser is Doug Dahmer, founder of Burlington, Ont.based Emeritus Financial Strategies. He warns the strategies that served us well in our wealth accumulation years — deferring tax as long as possible — need to be reversed once you reach the “decumulation,” or spending, years. Otherwise, continued tax deferral can lead to “damaging and irreversible tax traps” that can cost several hundred thousand dollars.
His remedy is the “strategic RRSP drawdown.” In years with minimal cash flow, you draw more from RRSPs in order to replenish reserves of open (after-tax) money. These are to be used in years where cash-flow demand is high, when relying solely upon registered funds would create punitive marginal tax rates and OAS clawbacks. Depending how much you withdraw at any given time, your financial institution will withhold a minimum amount of tax (at least 10 per cent), but there could be further tax payable when you file your annual tax return.
“The tax-saving opportunities lie in the valleys between the years of peak spending,” Dahmer says.
At present, OAS begins to be clawed back when taxable income reaches $73,000 and is completely eliminated at $119,000. Only about four per cent of seniors at age 65 face OAS clawbacks, says Jamie Golombek, managing director, tax and estate planning for CIBC Wealth Advisory Services. However, Dahmer says that’s because of income-splitting; without it, 12 to 15 per cent of retirees would face OAS clawbacks.
If there’s a time to draw down RRSPs it’s during low-income years following job loss, or for freelancers with variable incomes who can enjoy incomesmoothing. Golombek says that if your taxable income is below $45,000, tapping RRSPs could result in a “permanent saving of tax.” But, he adds, the downside is if you don’t need the money and live 30 years more, that’s a long time to lose the tax-free compounding you would have enjoyed had the money stayed in a registered plan.
An early RRSP drawdown should be most tax effective when you are in the lowest tax bracket (if only temporarily) and expect to be in a higher one later, or if you’re worried about dying prematurely and having your registered plans taxed, to the detriment of your heirs.
If you no longer earn employment income in your early 60s and are in a low tax bracket, you could tap your RRSP for a few years, knowing later in the decade you may be in a higher bracket once government pensions and perhaps Registered Retirement Income Fund income start to be tapped.
If you work until 65 rather than 60, you could make 65-to70 your low-bracket years, deferring CPP till 70 and doing the same with OAS. In 2013, the rules changed, allowing you to defer OAS for five years, which results in a 36 per cent bigger payout at 70. The added bonus is you’d also get a higher CPP payout (42 per cent more).
However, drawdown strategies are less compelling since minimum annual withdrawal amounts on RRIFs were cut to 5.2 per cent, from 7.38 per cent, after age 71. Ottawa belatedly recognized the combination of extended life expectancy and low interest rates meant retirees were forced to withdraw too much from RRIFs, withdrawals that are fully taxable.
The fact we expect to live longer also means we should place a greater premium on the tax-free compounding that leaving money in registered plans enables. In a CIBC report titled Just do it: the case for tax-free investing (published soon after TFSAs were introduced) Golombek said investors often view investment income earned inside RRSPs as merely “tax deferred” but his analysis finds that is “simply incorrect.”
It’s one thing to withdraw money from registered plans because you need the money AND you’re in a low tax bracket. It’s quite another to withdraw money you don’t really need in order to live. After all, if you don’t plan to spend it in the year you withdraw it, going forward that money will attract annual tax on interest, dividends and possibly capital gains. Yes, you can put the first $5,500 withdrawn into TFSAs each year, but beyond that, you’ve created an unnecessary tax problem. And not just for this year (since RRSP withdrawals are taxable in the year received) but for all the years going forward that the investment generates taxable income. If you DO live another 30 years, that’s 30 years of taxable income you could have avoided by keeping the money inside the RRSP or RRIF.
“We’ve proven mathematically that you’re nearly always better off in an RRSP in most cases, depending on your tax bracket and time horizon,” Golombek says. “Generally, you’re better off if the money remains tax sheltered than taking it out and investing in a non-registered account. It depends on your return and life expectancy.”
Dahmer, on the other hand, insists “those who fail to take advantage of drawing extra from their RRSPs when their tax rates are low are passing on an opportunity that can never again be.”
Once you factor in CPP, pensions, spousal RRSPs, different life expectancies for spouses and more, there’s no one simple answer that applies to everyone. It’s best to book a session with a retirement income specialist well in advance of shifting to your decumulation years.
The tax-saving opportunities lie in the valleys between the years of peak spending. DOUG DAHMER