Building an RRSP was easy; depleting it will take strategy

Registered Retirement Savings Plan contributions are like steps taken to climb to the top of a mountain.  At some point you make it to the top and you have to begin planning your steps back down.

It can be both an emotional and financial decision when entering the retirement phase and choosing when to begin depleting your capital.  Specifically, when does it make sense to begin pulling your funds out of an RRSP?

In 1996 the federal government announced that people aged 69 through 71 must convert their RRSP to a form of retirement income, such as a Registered Retirement Income Fund, by December 31st.  In addition, the new conversion age was reduced to age 69.  It was quite controversial at the time as census data showed that our population was growing older.

Last March the government essentially reversed the 1996 change.  The Federal Budget proposed increasing the age limit to 71 from 69 for RRSPs and registered pensions being converted to a form of retirement income.  This proposal has now become law and is a positive announcement for investors as it adds more flexibility when planning retirement.

Many investors may feel that the greatest benefit of an RRSP is the ability to obtain a tax deduction for the contribution.  In actual fact, the greatest benefit of an RRSP is the ability to defer tax on the amount contributed.  A person aged 21 may defer tax for 50 years.  The benefit of deferring tax works best for investors that keep the funds invested for a significant period (no early withdrawals).

Here’s an illustration:

Using Janet, a 69 year-old single person that has taxable income of $45,000 (pension income, non-registered investment income, CPP and OAS) and an RRSP of $300,000.  This person requires $20,000 over and above the pension income, CPP and OAS received this year.  Let’s also assume that the non-registered investments are in GICs earning 5 per cent.  Jane is contemplating two options:  Use some of the money in her bank and non-registered investments; or de-register an amount from her RRSP.  With Option 1 Janet uses $20,000 of her non-registered investments (currently earning 5 per cent) then her current year’s income will decrease by $1,000 ($20,000 x 5 per cent) to $44,000.  In addition, Janet’s RRSP will have further tax-deferred growth.  Option 2 involves pulling $20,000 out of her RRSP, increasing Janet’s taxable income to $65,000.  With Option 2, Janet will have a higher tax bill to pay as RRSP withdrawals are considered taxable income.

From a financial planning standpoint you should first spend non-registered cash and investments prior to converting your RRSP to a RRIF.  Wait until age 71 to convert your RRSP and withdraw only the minimum amount at age 72.  This allows for maximum tax deferral.   Delaying withdrawals may not be suitable for everyone and the following are a few factors that can change this recommendation:

  • Tax bracket:  If you are in the highest marginal tax bracket we generally recommend waiting as long as possible to convert to a RRIF.  Deferring tax is your best option.  Individuals that have no income may benefit from taking advantage of the basic personal exemption and withdrawing some RRIF savings.    Most people have incomes that are somewhere in-between these two extremes and the decision becomes more difficult.
  • Pension income amount:   In the above illustration, the person already has pension income and is able to utilize the pension income amount.  For those 65 or older without qualified pension income, it may make sense to convert a portion of your RRSP to a RRIF and pull $2,000 a year out (couples may each claim this amount).
  • Income splitting: The income splitting proposals announced for 2007 will have an impact on financial planning books.  Several strategies to minimize tax may be implemented for couples with income levels that are significantly different.  Couples that have been doing their own income tax returns may want to meet with a qualified accountant when the 2007 tax season arrives.
  • Government benefits:  Individuals should use caution when looking at income tested government benefits.  Sometimes receiving a payment from an RRSP or RRIF may cause certain income-tested benefits to be clawed back.
  • Life expectancy:  Individuals should take a good look at their family health history and current lifestyle.  If an individual knew how long they were going to live, a tax minimizing analysis could be done using a few assumptions.  This unknown is one of the main complicating factors. Enjoying your funds while you have quality of life is also an important component to consider.
  • Singles should understand the tax consequence if they were to die.   Couples that name each other as beneficiaries have less risk than single individuals as a person’s RRSP or RRIF may roll over tax deferred to the surviving spouse.  Widowed or single individuals have greater risk of having to pay a significant tax bill as they generally have no option to defer tax.
  • Couples have the flexibility of choosing the younger spouse’s age when calculating the minimum required income amount from a RRIF.
  • Flow-through shares:  Investors who have a high tolerance for risk may find that offsetting all, or a portion of, a RRIF payment may provide the opportunity to defer tax further.  Caution should be exercised prior to making any flow-through investment to ensure suitability with respect to risk tolerance and liquidity.
  • In-kind withdrawals:  Just as you can make an in-kind contribution to your RRSP, consider making an in-kind withdrawal from your RRIF.  This type of withdrawal is still considered taxable and you should have funds available to pay any tax liability when you file your tax return.
  • Available funds:  The size of your RRSP and whether you have outside savings is one factor.  We encourage individuals to analyze their cash flow need and create an income plan.  This will assist you in determining when to take RRIF income and how much.